Is this decline of concern?

by Barry Dawes

Is this decline of concern?

Key Points

  • US equity market in correction mode
  • Bond market frenzy but at levels well below the July 2012 highs
  • Many commodity prices down 15-30% since July 2014
  • Oil price down on output increases and soft demand
  • Shanghai stock market still rising and up 18% since June
  • Iron ore price showing signs of recovery
  • Major resources stocks bottomed last week!
  • Gold prices starting to stabilise and probably moving up
  • A$ bouncing back
  • Copper and zinc prices holding up well
  • Some small cap resources still looking very robust

The current sharp correction underway in the US has brought out significant pessimism on the economic outlook, the valuation of equities and the implications of the global debt position and the current tight liquidity.  The pull backs have been hardest for the sectors that had been strongest and the US `small caps’, the oil and gas and some technology sectors have taken the brunt of the selling.

US T-Bonds have had a major fling over this last period.  10 year yields at <2% and 30 year <3%.  After 30 years of bull market. Scary action that is related to the US$ strength and action that strongly suggests an important turning point has now been reached.  This has been expected for some time but not with any success but it still needs to be closely watched.  When set against the background of action in other markets these bonds do look scary.

Iron ore and oil have been on the front page with their declines but it is probably just as notable that almost all traded commodities from silver to soy beans have seen similar or larger declines since July.   Many may have bottomed last week. Many of these declines seem irrational against the near term fundamentals so it could be concluded that it is more a matter of liquidation by hedge funds and the like rather than a collapse in overall demand.

In particular it is worthwhile to note iron ore imports for China are still strong and growing and in September exceeded 1,000mtpa again.  The last Dawes Points highlighted low steel mill inventories were and that port inventories were coming off again and at just 33-35 days imports these are 40% lower than at the time of the last peak in port inventories.  The iron ore price had all the hallmarks of a final sell off to end a 12 month decline that left about 200mtpa of Chinese magnetite concentrate production losing cash.  At least 125mtpa will soon close so imports for China can only increase.

Iron ore prices are rising again now.  It will be interesting to see if they do the unthinkable and rise strongly through a squeeze.

Oil is something different and has seen rising US crude production with higher output from Saudi Arabia and Russia meeting softer demand from Asia and a shortage of refining capacity in the US. The unconventional oil output from the Eagle Ford and Permian Basins is too much for US refining capacity and with the US Export Embargo from 1975 still in place the oil is banking up.

Oil has the combination of new production, softer demand in some regions, a currency play, production market leadership tussles, substitution and efficiency drives and some good old Middle Eastern geopolitics that could get very ugly.  Trying to work out the fundamental drivers needs some good crystal ball gazing.

Nevertheless, the US production growth from shales where technologies are improving recoveries from about 5 to +12% means fields sizes (Estimated Ultimate Recoverable – EUR – reserves) in the important Eagle Ford and Permian Basins are growing from about 350kbbl to about 550kbbl/well and with about 35-40% coming in the first year that is US$8-20m revenue per well.  The fall in oil to about US$80 will make it very hard for the marginal plays but prime Eagle Ford could work down to about US$60.   We need to note that this business is very capital intensive and new wells need to be drilled consecutively to maintain output.  A fall in net operating surplus will delay the next well.  We also need to be careful that this sector has not leveraged itself up to much.  The US E&P Sector has been a great performer as has been pointed out here several times but the sharp fall could be placing some players under great pressure.

The Shanghai stock market performance (up 18% since June while Wall Street is down 10%) and the record import of iron ore by China last month doesn’t tell me China is falling over. There is the technical issue of Shanghai Exchange now synching with Hong Kong to make Chinese equities more attractive but I consider it is showing much more.

The higher iron ore price last week allowed the big miners to bottom LAST WEEK and hold up well in this Wall St sell off.  Note that this was what happened in 2008 when resources stocks, commodities and China all bottomed in Dec Qtr 2008 whilst the Dow, S&P, All Ords and FTSE etc bottomed in March 2009.

The big oil stocks also seemed to make their lows LAST WEEK as well.  Before the big low in oil prices.  Could be significant.

Gold is showing very encouraging signs of wanting to move higher with trades at US$1250.  As noted in the last Dawes Points, gold is strong with a strong US$ so it is rising in other currencies even faster.

Gold stocks are also starting to move again.  It has been painful these last few years but the ASX Gold Index XGD bottomed in Dec 2103 as did the GDXJ (small caps gold stocks ETF)  even though the major XAU (US Philadelphia Gold Index) and the GDX (its ETF) recently made new lows. Clutching at straws maybe.  But maybe not.  Just check out the performance of the two precious metals royalty companies Royal Gold and Franco-Nevada.  No new lows here.  Strong signals. Much more coming here.

The A$ recently had a sharp pull back to just under US$0.87 but it simply came back to the 100 year downtrend again.  The A$ and gold (especially gold stocks) are closely related.  High gold and gold stocks will mean a higher A$. The A$ on the cross rates tells that same story.

LME metals have held up well during this crisis.  Supply/demand factors are playing here more strongly than the market action with gold and silver.  Not a lot of new capacity and LME inventories for most metals are still low or declining.  How can you not like zinc, tin, aluminium, copper and cobalt.  Supply side crunches area likely with some of these over the next year or two.

And then there are the small caps resources companies here on ASX.  Many with early stage projects are in strife with not much money and limited expectations.  But many with good projects and some funding look very attractive whilst some lucky companies and their shareholders have done very well and are getting more funding.  Scores to choose from.

I have stayed the course on this bullish tack because most things I see confirm what I have been saying in these notes for the past two years.   The market has not agreed on many of these points but equity markets ARE heralding better times as are commodities.

So, the best way forward is to add to that portfolio of stocks with dividend paying gold stocks, some iron ore plays, some LME metals companies, high yielding oil and gas plays, onshore petroleum E&P companies, some technology metals companies and of course some explorers. Note that the major resources companies have very attractive yields of 3-6% and are at very low risk entry points (BHP 3.8%, WPL 6%, FMG 5.5%, PNA 3.1%, RIO 3.7% , NST 2.9%, OZL 5.0%, ORG3.5%)..

The keys are correlated with bonds, currencies, equities and commodities (especially gold) all providing guidance for what the future holds.

The right combination of market moves may soon give the signal that cash is too staid, bonds are too risky and commodity related equities are just far too cheap.

All these features are telling me that it is not the end of the world, that resources are outstanding value and that resolution of this current bout of pessimism will produce a much clearer and positive outlook that was really always there.  This decline is not a concern but a real opportunity.

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