Commodities: Stay Diversified
Investors should approach commodities with caution. Although we still believe the longer-term case for commodities remains intact, buying at reasonable valuations and being prepared to take profits off the table at opportune times is a good way to play the sector this year.
Commodities have enjoyed a solid rally off the December lows, with the CRB Index gaining 16 percent in a month. Oil was solidly up, as were prices for steel, nickel, gold and iron. These movements mark a counter rally to the extremely oversold conditions the sector was experiencing; time will tell if commodities can have a decent 2009.
Regarding oil, and because it’s usually the frontrunner for commodities, the US is expected to add 25 million barrels of oil to its strategic reserves this year, for a total of 727 million, while China is expected to take its oil reserves to 102 million barrels.
A recovery in demand remains the ultimate factor for a well-founded, sustainable upward move in commodities. The state of the global economy will play a big role in determining the timing as well as the strength of such a move.
For now the sector is still trying to recover from the devastating collapse in demand, which was also amplified by destocking as everyone in the chain was running down their inventories. Nevertheless, it seems that demand should be stabilizing at these levels and destocking should have run its course. Current levels should be seen as a sustainable support.
Production cuts will also play an important role in stabilizing the market. This downturn saw companies cutting production much faster than at any other time in the past. Supply shrank rapidly, which, although not visible at the time, should now start having an effect, particularly as demand shows initial signs of a recovery.
In addition, as market conditions are stabilizing, any announcement that more supply cuts are underway will have a more profound supportive effect for the market.
The 19 percent steel production cut announced in November made no difference to the market at the time, as the selling was in full swing. And yet this was a powerful message; the steel industry is notoriously fragmented and is therefore usually very slow in responding to demand destruction. A similar announcement today would have a different (i.e., more positive) effect on the market.
The two pillars of investing in commodities have been the industrialization of the emerging markets and supply bottlenecks. China remains at the forefront of the former, and longer term the picture looks more promising than the current environment would let us believe.
China’s stimulus, though taking place in the middle of a global financial crisis, includes a lot of plans that were ready to go anyway. China continues to press its substantial urbanization plans, as well as its efforts to improve the domestically driven economic development model. The recently reported growth in power output in China (after two months of negative numbers) is an encouraging sign of stabilization.
And China isn’t alone. India, the Gulf Council Countries, and even Russia, among others, are in the process of revitalizing their economies, too. Contrary to what the grim headlines scream, they’ll still be able to proceed with their plans long after the crisis is over and the global economy starts functioning again.
There will be cancelled projects and delays along the way, given the prevailing economic conditions, but the change is structural and critical, and so will continue.
BHP Billiton (NYSE: BHP) is the world’s largest mining company by market capitalization, with operations in Australia, Africa, the Americas, Europe, and Central and Southeast Asia.
It’s the world’s largest producer of export thermal and coking coal and mined lead, the second-largest producer of nickel, the third-largest producer of iron ore and mined copper, a top five producer of alumina and aluminum and a top 10 producer of uranium, diamonds and refined copper. It’s also an important oil and gas producer.
BHP Billiton fits our preference for big, diversified miners as the best way to be in the sector right now and also benefit from any potential upside. The company produces a diversified portfolio of commodities, and thus enjoys less volatile earnings streams, which, in turn, provides better protection to cash flows.
Importantly, BHP is a low-cost producer of most of its main commodities, which, again, means more predictable cash flows and less sensitivity to commodity prices. The company can easily plan for its investments. The approximately USD22 billion to be spent on projects in the next four years looks like an easily achievable target.
The company has one of the strongest balance sheets in the industry, with net debt a relatively low USD6 billion. A strong balance sheet has become one of the most important features in this environment, as it should be.
BHP should be able to increase dividends this year, and given that the Rio Tinto (NYSE: RTP) acquisition is no more the expectation is that management will reactivate its USD10 billion share buyback program. The company had completed USD4 billion in the last couple of years, but it’s now expected to move ahead with the remaining USD6 billion this year.
Looking back, the proposed BHP/Rio Tinto merger is still a very interesting combination, as their respective assets fit extremely well and promised big synergies. However, many entities were against it from the beginning, including the Chinese government, which felt that such a giant would have a monopoly on the raw materials it so badly needs.
This was the reason Chinalco moved quickly to secure a 9.4 percent stake in Rio Tinto; Chinalco has recently announced its intention to increase its stake to 15 percent. The Chinese have said they’d like to eventually own close to 50 percent of Rio Tinto, something Australian authorities will be very reluctant to approve, at least for now.
The stock rallied strongly off the late 2008 lows and has recently lost some ground. Pullbacks should be viewed as a good entry point, and profits should also be booked periodically.
We like the company for the long term based on its ability to reap big benefits from the global economic transformation we’re witnessing. BHP Billiton, a new addition to the New World 3.0 Portfolio, is a buy at current levels.