Market turbulence at the beginning of February confirmed something that we’ve been arguing in these commentaries for the past year or so: that the greatest risk to the current bull market is a repricing of the cost of capital as a result of a pick-up in inflation and the end of ultra-accommodative monetary policies globally. We wrote last month about the Elliott Wave Theory; the recent sell off appears to be consistent so far with the fifth and last wave of a cycle. In this case, it was good news (a positive US jobs print) that brought the market’s attention to the dangerous waters ahead, namely the prospect of rates rising faster than expected. We don’t think that this current disturbance is the beginning of the end; rather we see it as the premonitory tremor of an earthquake which will hit, albeit some distance in the future. The graphic below, from Deutsche Bank’s ‘Inflation Sensation’, demonstrates signs of emerging inflationary pressure in most of the world’s leading economies.
Figure 1. Average Inflation G10 economies
Source: Deutsche Bank, Bloomberg Finance LP, Haver Analytics. Note: Blue stands for low and red for high value of inflation with respect to historical averages.
When talk turns to inflation, people tend to congregate around the desks of our commodities team. Oil and metals have historically acted as hedges against inflation and price action in these assets have offered a glimpse into what might lie ahead. We believe there is something different this time around though, for while we remain relatively positive on metals and mining stocks, we are far less constructive on oil and oil-levered equities. We feel that to believe blindly that oil will continue to offer protection against inflation is to miss a number of salient distinctions between this and previous cycles.
It is this very assumption – commodities being a refuge in reflationary times – that may have contributed to oil reaching its current elevated levels in our view. Estimates for global institutional and retail investment in commodities for January stood at c. USD530bn – the highest since 2013 (when oil was USD100/barrel and gold was USD1,500/oz) (Citi 30.01.2018). This isn’t the only story, though. Investor positioning in financial oil contracts has also increased to near all-time highs, with c. USD80-90bn of long crude positions now held by money managers (Bloomberg 12.02.2018) Based on our analysis, we feel these volumes have been driven higher in part by macro, systematic and other momentum traders. The graph below demonstrates the rise of this speculative interest in oil. The degree and sheer size of this interest may be creating a feedback loop – with oil such an important element of inflationary considerations, the fact of speculative investment driving up prices may be stimulating yet more systematic investor interest in oil. This is a situation that could continue for some time in our view, but we’d suggest that this kind of money may not stick around when market conditions change.
Figure 2. Managed Money Brent and WTI Positioning
Source: Bloomberg 12.02.2018.
It’s also worth thinking about fundamental factors currently affecting the oil industry. While demand appears robust, there are suggestions that an unusually cold northern hemisphere winter could be clouding the picture. We also believe that current supply is strong and responsive to recent price rises. And here is a key difference between oil and metals: particularly in the case of shale resources, but more generally in an oil industry that has made major technological leaps forward in so-called “short-cycle” drilling, production can be brought on-stream swiftly and at relatively low cost to producers. Citigroup estimates suggest that, at crude prices of USD60-70/barrel, production from the US, Canada and Brazil alone could add at least 2.5m barrels/day, significantly more than International Energy Agency estimates of 1.8m.
From a supply-side standpoint then, we would not rule out a significant build-up in global inventories in the medium term, and that’s before taking into account any reversal of the current OPEC (Organization of the Petroleum Exporting Countries) and non-OPEC production cuts. We believe that if such supply-side pressures begin to reflect on oil prices, the momentum-driven money that has flowed into oil in recent months could beat a hasty retreat.
The fundamental outlook for metals and mining appears more constructive than for oil at present in our view, particularly considering the raft of supply-side factors currently leaning in favor of the sector. The demand-side outlook is more mutedly optimistic: with accelerating global growth, investment activity could pick up and boost appetite for metals. We do expect China, still the key driver of demand, to continue to experience moderately slower growth going forward, but this may be somewhat mitigated by demand from other economies.
Crucially, supply-side factors appear more constructive when it comes to metals and mining. Over the past six years, mining capital expenditure has contracted sharply on a global scale as mining firms have retrenched in the wake of the Global Financial Crisis. Indeed, according to Barclays, the current pipeline of copper projects at feasibility/ pre-feasibility stage is the lowest it has been in the last 17 years. Furthermore, the industry is contending with challenges such as grade decline and the impact of Chinese environmental and economic reforms. Unlike oil, mining production increases take some time to be brought on-stream and this might be further amplified just now by managers still stinging from criticism about ‘overinvestment’ in the previous boom period. While we believe oil experts have been underestimating the amount of supply coming on-stream, the charts below demonstrate that, historically, the mining industry has generally found it harder than expected to bring on new supply.
Figure 3. Copper supply forecast vs actual supply
Source: Brook Hunt, Wood Mackenzie, Bernstein analysis.
A few more structural points are also worthy of consideration. Firstly, we find there is lower price elasticity of demand for most metals than there is for oil. For example construction firms will most likely continue to build even if copper prices rise steeply; however, if there’s a hike in oil prices people may not drive quite so much. Secondly, we believe oil faces one potentially very impactful existential threat: electric vehicle sales have been growing steadily; if sales pick up further, then this could mark a paradigmatic shift for oil. It could also, by the way, represent a significant new source of demand for metals.
Finally, it would be remiss of any comparison to not consider valuation differences. In this regard too, we think the relative case for mining equities is somewhat more persuasive. For example, the chart below shows the free-cash flow yield advantage of mining companies in the MSCI World Index compared to energy companies in the same index. Furthermore, with the mining sector reluctant to deploy capital to new projects, a side-effect of this has been generally improving balance sheets, which we think could potentially facilitate greater shareholder returns going forward.
Figure 4. MSCI World Mining vs Energy FCF yield comparison
Source: Bloomberg 13.02.2018.
When the market’s attention is focused on the broad macro-economic picture, it’s the job of a good portfolio manager to narrow the angle, to ramify from the general to the specifics of his or her industry. Across the firm, we’ve been thinking hard about inflation. Although, we are not foolhardy enough to attempt to judge how far we are from the end of the current cycle post the recent inflation expectation-driven market turmoil. Our expertise lies in deep fundamental analysis of industries, companies, and management teams. Having done this work, we feel comfortable in our preference for minerals and mining stocks over oil and oil-levered equities, and wait with interest to watch this reflationary cycle play out.