A Resourceful "Day"
06/03/2005 12:00 am EST
There are few advisors with the in-depth knowledge and experience in the resource markets than Adrian Day. Here, he shares his long-term outlook on energy and metals, and offers some of his favorite long-term plays in these areas.
"When you look at resources you need to look at the overall economy. And it strikes me that the economic recovery we have seen in many parts of the world appears to be losing momentum. That’s not to say we’re heading downwards into a recession. But the growth is slowing. It’s true of the US, Europe, and Japan. Global leading economic indicators have turned south and have been negative for four months in a row. So that does not bode well for the economy at least in the near term. And of course, resource markets depend on economic growth and economic strength for the demand side of the equation.
"There are two fundamental risks affecting the global economy that would affect the resource market. One is China, and what happens there. As we know, China has been the engine for most of the growth in demand for most resources over the past several years. So what happens in China is very, very important to what happens to the resource market. My own feeling is that China, where growth had temporarily decelerated, appears to be bottoming and many indicators are that inventories are running down again and that shipping rates are building up again. This would suggest that growth is picking up again. Meanwhile, the Olympics in China are going to require an enormous amount of infrastructure projects, which is going to require an awful lot of demand for a whole range of resources. Thus, any slowdown in China over the next six or nine months is going to be a temporary slowdown, in my mind.
"There are, however, some major negatives in the Chinese picture, and the biggest one is the banking system, which is in very bad shape. Nobody disputes that. There are problems with consumers as well as companies and industries with non-performing loans. If consumers start defaulting on their loans, it could lead to a slowdown in the economy if the money is not available to lend out. The second major consideration that impacts the resource market is the US dollar. Most commodities are priced in terms of US dollars. So all else being equal, a decline in the dollar means an increase in the price of these commodities. My summary is that over the medium to long term— over the next two to five years, the dollar has the potential to decline significantly from where it is right now.
"In the short term, however, we are experiencing a rally in the dollar based largely on market sentiment factors and a short-term dollar rally that could last for several months. As long as the Fed is gradually raising interest rates and the rest of the world isn’t, it will support the dollar. Once the Fed stops raising interest rates, then I think the US dollar will start falling again. But longer-term, the dollar is vulnerable. In order to keep the dollar where it is, the US needs about 80% of the world’s export capital. This is a phenomenal number. But it doesn’t take foreigners to sell to cause a drop in the dollar. It only takes foreigners to put less of their new money to work in the dollar for the dollar to decline. So I think it is clearly unsustainable for the US to keep attracting that much of the world’s capital, particularly as other countries progress. So I think over the long term there is very little question that the dollar will decline.
"Meanwhile, when you look at the resource markets with a broad brush, what we see is a lack of new projects. A lack of significant money has been put in to exploring new projects and developing new projects. And that’s been true for several years. But up until the recent past, there have always been high levels of inventory to meet any acceleration in demand. But over the last few years, with the big pickup in demand from China, those inventories have run down. And for many resources right now, there are virtually no inventories around at all. As we know it takes many years after the discovery of a project, before that project starts producing. So we can look today and be reasonably certain of any significant increases in production that is likely to come over the next few years. The plain fact is that in a whole range of resources, there is very little that will affect the balance of demand and supply in the new few years.
"I think the oil and gas market has a very favorable outlook for several years ahead. Most of the oil fields that have provided supply to meet rising demand over the past few decades are now mature, are maturing, or are in a declining phase. Oil, like all resources, is a depleting asset. You’ve got to replace your production just to remain flat. So if global growth continues, and Chinese demand continues, but we’re only replacing 75% of our reserves, this is a recipe for rising prices. If we look at gas, we see much the same situation. And while gas is a domestic market, we are seeing supply declining. Gas is very much a supply story. Again, we are simply not finding enough gas to replace what we are producing. Gas production in the US has gone down, quarter after quarter for 12 consecutive quarters and I think the gas market is going to be very, very strong.
"One of my favorites ideas now is Arc Energy (CA:AET.UN Toronto), which is one of the oldest and largest of thee Canadian energy trusts. It is primarily a gas company, with a great track record. Currently, it’s trading at $18 Canadian and yields about 10.5%. The second one that I like a lot is Daylight Energy (CA:DAY.UN Toronto). This is a company that has been around for five years, but only set up as a trust about six months ago. Because it’s a new trust, the yield is higher. People apply a discount. The current yield is over 14%. Now, this sounds like very high yields, which normally would make one think they are very risky. But these companies are very, very solid. The one thing you do have to remember with these trusts, is that the dividends you receive is entirely dependent on the price of oil and gas. If the price of oil and gas goes down, then earnings will go down and the dividend will go down. But if you’re positive on the price of gas over the long term, then I think the royalty trusts are phenomenal.
"I think the environment for gold is also very positive with low, but rising, inflation, and a geopolitical situation that remains uncertain. But I would emphasize that in the outlook for gold, the dollar decline is the most significant factor. There is also a very positive micro or industry environment. Despite the rise in gold from the $250 level, new mine supply has actually declined for the last two or three years. Last year, production was down 5%. This is very significant. Meanwhile, demand remains positive. One is the demand from Asia, particularly from India and Turkey (which is generally used as a conduit for Middle East buying). We are also seeing buying from Europe, something we did not see at all through the 1990s. And lastly, there is significant potential demand from China. The Chinese gold market is liberalizing and over the next few years as this occurs I think some of the potential of Chinese buying will be realized.
"Among the gold majors, Newmont Mining (NEM NYSE) is definitely one to own. It’s a great company with really good assets around the world. It has a good balance sheet with less than 10% debt to capitalization, which is very low for such a capital-intensive industry. And it has some of the smartest people in the world running this firm. It’s probably also got the best growth profile, not just over the next few years with the mines that are coming on stream, but also in terms of the exploration land that they own. They actually own land around the world that is greater in size than the entire United Kingdom. That’s a lot of land and much of it is in highly prospective areas. Believe it or not, they still have a lot of unexplored land in Nevada. I think Newmont is definitely the gold stock of choice. Newmont will tend to follow the price of gold more than the juniors. So if the gold price goes down, Newmont is probably also going to decline. This is not the kind of stock that you can expect to buck the trend in the metal itself. But conversely, if gold goes up significantly, then you would expect that Newmont will as well."