BCIM - Can Commodity Stocks Ride Out Demand Uncertainty?

2023-06-27 03:29:00 ET

Summary

• Commodity prices mixed as recession and weak China demand outweigh supply limits.
• Companies may be in a better position to handle the weakness than in the past.
• Balance sheets are stronger than in previous cycles.

Recession fears and tepid demand from China have weighed on commodities, but according to Jennifer Nowski, Portfolio Manager with TD Asset Management, firms may be better positioned to weather the weakness than in the past. She explains to MoneyTalk Live's Greg Bonnell.

Transcript

Greg Bonnell: Well, despite some concerns about tight supply, commodity prices have been a mixed bag. Many metals, oil, and gas prices flat or down year-to-date. Joining us now to discuss what's driving the trend and what it means for companies in the space is Jennifer Nowski, portfolio manager with TD Asset Management. Jennifer, great to have you back on the show.

Jennifer Nowski: It's good to be here. Thank you.

Greg Bonnell: So let's talk about what you have described as a mixed bag in the space right now. What are the drivers? What are we seeing?

Jennifer Nowski: Yeah, so it feels like much of the debate in the commodity market this year has centered more on the demand side of the equation, with investors evaluating the trajectory and pace of the recovery in China, as well as the slowing economic growth in the US and Europe. Now looking at the supply side, yes, in some markets there is supply growth this year with new projects coming online. However, this is being partially offset by shortfalls amongst existing production, as well as continued producer discipline in many spaces.

Now, commodities can be cyclical and volatile. It's uncertain how long any one cycle will last. However, when we see cross-currents in the industry, it can be a very interesting time to be discussing and looking at commodities.

Greg Bonnell: OK. And that's what we're doing today. You have supply and there you have demand. Let's stick with the demand side, particularly the China part of the puzzle.

Beginning of the year, COVID restrictions are lifted. People thought, well, it's game on not only for China's economy but for the global economy. They're going to want to consume our commodities. That really hasn't played out that way. When could we expect China to actually see some recovery in its demand?

Jennifer Nowski: So yes, China is very important to the commodities market. They can be anywhere from about 50% of demand for some metals. And they're also about 16% of global oil demand. But more importantly, they've been a significant contributor to oil demand growth for many, many years now.

Now, you saw the metals prices in particular respond earlier this year when China late last year announced that it was moving away from their Zero-COVID policy. So the metals price started to anticipate some of this recovery.

Fast forward to today, year-to-date in China, it is recovering. But the pace is somewhat disappointing, particularly to what maybe people had expected in the metals market. If we look on the metals side, there are continued weaknesses in the property sector in China as it works through debt issue.

And on the oil side, although domestic travel has rebounded and recovered in China, international travel remains well below pre-COVID levels. And that's partly because of bottlenecks in getting visas, as well as a limited number of flights to the country.

So in light of this weakness in the recovery, the Chinese government is starting to take measures to stimulate the economy, including some rate cuts recently. These are directionally positive for the commodity market. But I would caution that in the past China has had very large stimulus measures that really boosted fixed asset investment. And at this point, it doesn't seem like that's the route they're going to take.

Greg Bonnell: Even when it comes to their Central Bank policy, I think doing 10 basis points at a time, we're used to bigger things on this side of the world. Let's talk about if commodity prices then remain weak, what are we thinking about some of the energy and mining companies? How do they fare in an environment like that?

Jennifer Nowski: So over the past 5, 10 years, commodities prices had weakened. And many of the producers had to reevaluate their strategies and became really focused on cutting costs, cutting CapEx, and strengthening their balance sheet. Now, those balance sheets got an extra boost in the past couple of years when commodity prices were stronger.

So as we sit now looking through estimates for 2023, the large-cap energy and mining companies look like they're going to have net debt to EBITDA of about 0.5 times, which is very strong and provides them with some insulation heading into wherever commodity prices may go from here.

The other thing to bear in mind is that some prices are still fairly good for producers. So, for example with oil in -- call it the $70, for a large-cap oil producer, that can produce a free cash flow yield in the high single digits, which is still fairly robust.

Greg Bonnell: In an environment like that where you're still seeing free cash flow for some of the bigger producers, or even at times when the commodity prices are a little firmer, if we're worried about supply, why weren't they investing in that in the past? I mean, what are the dynamics in that part of the market?

Jennifer Nowski: So, resource companies have really shifted their mindset. A decade ago, it was all about growth, massive investments. Now they're very focused on being very disciplined with their investments and generating returns for shareholders.

So during the past boom in the 2012-2014 period, you saw CapEx was very elevated. The commodity prices were strong. The companies were chasing growth. Then commodity prices weakened, and they had to reevaluate all this, and CapEx got cut significantly.

Now it is starting to come off the lows it reached. However, the growth has been very modest. It's been driven partially from inflation, but some modest growth projects. However, it's still nowhere near the levels we saw in the boom a decade ago.

Now why is this? Partly maybe learning from past mistakes. But it really comes back to, again, that focus on financial discipline.

So for, say, the US shale players, which tend to be shorter cycle, they have realized that they run more efficiently at a lower growth rate, so 0% to 5% production growth. Some of the oil majors have outlined multiyear CapEx plans where they plan on keeping CapEx within a specific range.

And on the mining side, you have the added complication of some projects being very large. It takes a long time to permit. You can't change these things quickly. And so when you have periods where we still have had commodity price volatility, it makes them hesitant to greenlight those really large projects.

Now the macro implication of all of this is that supply growth would likely be limited. And that's supportive of the price.

Greg Bonnell: Let's talk about the path forward then for these companies, we're taking a look at some balance sheets that are stronger because of a lot of the factors that you outlined, even though there might be a downturn. And all of this is cyclical. You got some cash. What do they do with that money? I mean, there's a whole host of things you could do with cash on the balance sheet. What might they do?

Jennifer Nowski: Yeah, so I expect the financial discipline to remain in them to pursue a balanced approach between all three options.

First, maintaining that strong balance sheet. I believe there is a desire to do that.

Second, they will continue to return cash via dividends and buybacks. And we just went through Q1 earnings about a month ago. And for the energy companies, that was a key focus of investors was how much cash was coming back.

And the third, M&A. So M&A has picked up a bit. However, it's not the big transformational M&A that marks the top of the last cycle. This sort of M&A, by and large, is more contained, I'd say.

If you look at some of the gold miners or the US EMPs, there were some deals there. And those were largely to shore up production and provide inventory for the long term.

On the large diversified miners, there were also some deals. And that's usually to get exposure to some metals that they think have a stronger long-run profile. For example, BHP ( BHP ) bought OZ Minerals, this year, which is an Australian copper player.

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