Opinion: Commodity stocks are back this time — really
Supply is declining, as rig counts and mining data show, and that’s good for share prices
It has been quite a run for commodity stocks in 2016.
The best performers in the S&P 500 SPX, -0.22% year-to-date include a host of energy and materials names, including
- Newmont Mining Corp. NEM, +0.80% , a copper and gold miner up about 125% since Jan. 1
- Oneok Inc. OKE, -1.22% a natural gas pipeline company up almost 85% since Jan. 1
- Range Resources Corp. RRC, -5.68% , a small oil and gas producer up roughly 70% since Jan. 1
While the resurgence for commodity stocks easily could have been written off as simply a dead-cat bounce this spring, the continued outperformance of miners and frackers since then seems to hint that this is more than just a short-lived trend.
Yes, investors have had their hearts broken by commodity stocks in the past. And yes, serious concerns about demand and pricing remain — and in the middle of earnings season, that matters more than ever.
But an increasing number of investors are piling into miners and energy stocks with an eye on more than just short-term potential.
And there’s good reason why.
The supercycle swings both ways
In January, the Bloomberg Commodity Index — a benchmark of almost two dozen different natural resources — bottomed out at its lowest point since 1999, with a nearly 70% decline from its peak before the Great Recession.
All across 2015, we heard about the clear end of the so-called commodities “supercycle” that had featured rising prices alongside rising demand across the late 1990s through the financial crisis, and how those days were long gone.
But let’s be clear: While comparisons from peak to trough make good headlines, they are just plain hysterical. Yes, it’s true that crude oil CLU6, -1.56% plummeted from above $145 a barrel in mid-2008 to a low in the mid-$20s in February. But if you believe in the so-called supercycle, you have to look at the flip side — the potential for oil to rally more than 1,000% as it did from short-lived lows near $12 a barrel in 1998 to the pre-crisis peak.
Why should we believe that oil’s rally is now finished just because it has snapped back and stabilized, when history shows there’s so much more potential?
Perfectly timing the ride up or the ride down is, of course, a fool’s errand. But it seems generally true that we are much closer to the bottom of the commodity price cycle than we are the top.
Low prices will resolve low prices
Many investors have heard this argument before, of course, and can point to plenty of “bottoms” that in hindsight were just one more data point in a sustained downtrend as demand failed to keep pace with supply.
Those focusing on the demand side for commodities aren’t going to get any argument from me; I think we are unlikely to see a spike in consumption anytime in the next few years. But I do think the slow resolution of oversupply through continued production declines is an important trend that cannot be overlooked.
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As Cohen & Steers puts it in a recent white paper titled “The Light at the End of the Tunnel,” chronic low prices for metals, fossil fuels and other commodities eventually force producers to either slash production or go out of business.
“After five years of steadily declining commodity prices, many producers have reached their pain threshold and have begun to cut back investment in future supply — a critical first step toward balancing the market,” according to the investment manager’s report. That balancing will be a long, hard process of course, with “an average recovery of 19 months and a slow-recovery scenario of 29 months,” but investors can already see proof that the early stages of this trend are bearing out.
Just look at U.S. rig counts, as reported by Baker Hughes. In March, rigs hit an all-time low, and while production sites have recovered slightly, they remain half of what they were a year ago.
Or look at gold miners XAU, +2.20% . Sure, they’ve benefited from a risk-off environment in 2016 and currency fears stoked by the Brexit drama. However, the massive gains in this sector GDX, +1.72% aren’t simply attributable to those factors alone; the average all-in extraction costs for miners have dropped sharply thanks to cost-cutting sparked by previous price declines, and production forecasts are anemic even in the face of a current price recovery. It seems miners have learned their lesson after several years of pain, then, and aren’t simply the beneficiaries of short-lived investor sentiment.
Or perhaps most dramatically, consider that China is laying off 5 million to 6 million workers in the coal and steel sector in response to overcapacity.
It’s simple supply and demand, really. When supply gluts cause prices to crash, commodity firms can only stick to business as usual for so long before they slash jobs, shutter facilities and slow down production.
Rig counts, mining stats and other data points show this is indeed happening. So the question isn’t whether commodity demand will spike, but when commodity supplies will stabilize and decline.
Commodity stocks shouldn’t be rallying — but they are
If you agree even in part with the previous statements, the most compelling arguments for commodity stocks now are actually reasons why they shouldn’t be rallying.
After all, the world’s second-biggest economy — China — continues to suffer economic headwinds and a deep industrial slowdown that will sap energy and materials demand.
Furthermore, the U.S. Dollar Index DXY, +0.04% has been surging since its May lows. After a brief rollback on Brexit news in June, the greenback powered steadily higher across July and should continue to act as an anchor on commodity prices.
And if the Federal Reserve does follow through on another interest-rate increase this year as it has hinted, that trend will only get worse for commodity prices.
And let’s not forget that despite dramatic share-price improvement, many energy and materials companies remain deeply unprofitable. Stocks of companies that are in the red from a profitability standpoint but have run up 50% to 100% in the past few months seem more like positions that beg to be sold, not positions you should be adding to.
Yet the rally continues across energy stocks, miners and other big commodity names.
I don’t pretend to know when the “bottom” will be in. I can certainly see a serious contraction in gold GCQ6, +0.38%oil, copper or any other commodity at some point in 2016 for some of the reasons listed above.
But I do agree with the notion that chronically low prices are slowly resolving the problem of chronically low prices. And in that scenario, we don’t need a surge in demand to see a sustained rally for the sector.
We just need to be patient and wait for the supercycle to bottom out and reverse course — something that both commodity stocks and commodity prices have indicated is already happening in 2016.