In-depth look at commodities

In the wake of the financial crisis of 2008-2009, you’d be forgiven for expecting commodities prices to continue to fall or rise very modestly. That’s what typically happens after a global recession. Yet this time around, commodities prices for the most part have shown remarkable resilience and have rebounded surprisingly quickly. And that’s giving analysts and investors alike something to talk about. In most sectors, prices are stabilizing or increasing steadily now that economic activity is resuming.

Still, some sectors have more positive outlooks than others. For example, oil consumption in developed nations hasn’t necessarily rebounded as much as expected, and yet oil prices appear to have hit a floor.

Meanwhile, the North American natural gas picture isn’t pretty, and prices are trading in a tight range. Fortunately, consumption in Asia has prevented global demand from completely deteriorating. On the mining side, gold, as much a flight-to-safety investment as ever, has surprised some analysts and investors with its inability to break $1,500 per ounce, even at the height of the financial crisis. And in base metals, some interesting global trends are driving prices for commodities such as copper, zinc and aluminum.

O&G juniors look promising

Taking a look at crude oil, it’s been nearly five months since the Deepwater Horizon exploded in the Gulf of Mexico, and the event is still making news. The latest is BP engineers will detach the temporary cap that’s stopping the gush while trying to avoid more damage to the environment. It’s clear this story isn’t over, but what’s less clear is its long-term effect on the oil and gas industry.

According to Warren Verbonac, senior oil & gas analyst at Union Securities Ltd., the impact should be minimal. Some deepwater drillers will have higher costs for pre-emptive safety measures, but the industry overall won’t experience many consequences. Although there’s some industry sentiment that the entire industry will be under great scrutiny for years to come, Verbonac doesn’t agree.

“Once this blows over, people will realize events like this are few and far between,” he believes. “The last one in the U.S. was in 1969 at Santa Barbara.”

For Verbonac, the outlook on oil mainly depends on the Asian economies and the economic recovery in Canada and the United States. He believes North America may be in a mild recovery now, but there hasn’t been enough of an increase in industrial or consumer activity yet to push oil prices higher.

“Current supply and demand are closely balanced,” he says. “There’s a small reserve, but once the economy [rebounds], we’ll be back to higher oil prices to ration the supply.”

He expects oil prices to average $80 per barrel this year, and to stick close to that range in 2011, which should provide healthy returns for light oil producers.

On the supply side, Verbonac says “every company is looking for light oil plays, and they’re rare, especially in North America.”

The bigger companies are looking for bigger plays that don’t exist. There are some smaller plays, though. This means the best prospects are for junior oil and gas companies, and that’s where the best investments lie.

But while certain oil producers are doing quite well, Verbonac warns that investors need to be very selective when investing in the energy industry; production growth and strong cash flows occur only in a minority of companies in the sector.

Natural gas, on the other hand, has been taking a beating over the past couple of years. Verbonac says this is mainly a supply issue, as U.S. gas reserves have risen every year for the past ten years.

“Natural gas is oversupplied in North America, and likely will be for years,” he says.

Prices will remain in a tight trading range, and he isn’t recommending any North American gas plays. Outside of North America, though, and particularly in Europe, he believes the fundamentals of supply and demand are better balanced for natural gas.

Top picks

Verbonac’s top three picks are Ithaca Energy Inc. (IAE:TSXV), Sterling Resources Ltd. (SLG:TSXV), and Winstar Resources Ltd. (WIX:TSX). He believes Ithaca and Sterling will both benefit from their low-risk development prospects.

Ithaca’s strength lies in its production, cash flow and ability to self-finance. It has a strong balance sheet and is trading at a significant discount to its proven and probable asset value. Verbonac says the company should be a risk-free growth story for the next two to three years.

Sterling, meanwhile, has large gas plays in development and one of the most extensive inventories of any junior oil and gas company, and Verbonac believes the company will be a significant producer in two to five years. It’s one of the few juniors to have an active exploration program.

Finally, Winstar has one of the highest-impact exploration programs out there. Verbonac believes the stock’s current price understates the value of the company’s reserves and ignores its exploration potential. He feels the company’s oil production could significantly change by next year.

Norman MacDonald, portfolio manager of Trimark Resource Fund, has his own thoughts on the BP oil spill and the future of oil prices. MacDonald believes we’ve hit a floor and that floor is the $60 to $75 per barrel range seen prior to the 2008-2009 economic crisis. Although he doesn’t try to predict the long-term price of oil, he also doesn’t envision prices dropping below $60 per barrel again, for two main reasons.

“A big chunk of OPEC supply was supposed to come from the Gulf of Mexico,” he says, and the oil spill has definitely affected that supply. Now supply has to come from other regions, and companies operating in those regions depend on oil prices remaining above a certain floor to make exploration and development worthwhile. Companies in the Canadian oil sands, for example, really need to see prices of at least $60 per barrel to continue operations.

“Years ago, $30 per barrel may have been enough,” says MacDonald, “but not today.”

The second factor that’ll affect oil prices going forward is the stabilization of demand. Contrary to what’s happening in natural gas markets, “China doesn’t have to keep growing at 15% a year to have good demand for oil. The industry doesn’t need them to continue to grow at that rate, because demand is stabilizing in the United States and other developed nations.”

Essentially, the base demand for oil is no longer uncertain now that we’ve emerged from the economic downturn. With the economy recovering in the United States and globally, consumers have shown the extent to which they’re willing to cut back on oil consumption at current prices. When oil prices were trending around $140 per barrel in 2008, there was a distinct decline in demand, which is not happening at current prices.

In addition, it seems investors have gotten used to poor economic indicators and have already priced in the worst of the bad news, leading to greater long-term stability in oil prices. For example, when negative housing reports were released by the U.S. National Association of Realtors in late August, prices dipped temporarily but were already trending higher a few days later.

Gold should hold steady

Elsewhere in the commodities sector, MacDonald is neutral on gold, as demand and supply fundamentals appear to be holding steady. However, he says gold companies are starting to see cash flow growth in their bottom line, which is interesting.

“Central banks are starting to hold gold they were selling in the 1990s,” says MacDonald. That’s partially because 2008 scared a lot of people, and we’re now in a climate where not everyone trusts currencies. It’s also partially because of the rising popularity of ETFs. Gold is a big attraction of ETFs, where it’s almost viewed as an alternative asset class.

As far as demand goes, “It’s tough to find quality deposits in good political climates,” MacDonald says. At the same time, “What gold companies spend on exploration is peanuts. Where dollars are being spent, it’s in existing deposits, because that’s where the biggest bang for the buck is.”

Going forward, MacDonald expects more consolidation between gold companies. It’s a depleting asset, so he doesn’t expect prices will ever go back down to $600 per ounce. But they won’t rise much higher either. “What drives demand for gold is people saying ‘We better hold a bit of gold, just in case.’ Yet 2008 was a huge shock to the financial system, and gold never went above $1,500 per ounce,” he notes.

Trimark Resources Fund is currently weighted about 35% in oil and gas and 18% in gold. MacDonald continues to buy companies that aren’t expensive; companies with prices reflected in the stock. The fund’s three largest weightings in oil in gas are Cenovus Energy Inc. (CVE:TSX), Canadian Natural Resources Ltd. (CNQ:TSX) and U.S.-based Forrest Oil Corp. (FST:NYSE). For gold, its three biggest weightings are Barrick Gold Corp. (ABX:TSX), Detour Gold Corp. (DGC:TSX) and Eldorado Gold Corp. (ELD:TSX).

Rik Visagie, senior mining analyst at Octagon Capital Corp., has a similar long-term outlook on gold. “It is what it is,” he says. He believes prices are up because demand is based on perception, and there’s some concern the economy could collapse again. However, he thinks the economy will settle down.

“The question is,” he asks, “how much of your portfolio do you want to invest in gold?”

Base metals poised for growth

On the other hand, due to their bricks-and-mortar usage, base metals may still have significant growth potential. The metal Visagie is really excited about is copper, where he believes a huge market expansion is set to occur. He believes the demand for copper is going to increase significantly over the next 10 to 20 years, due to two emerging trends: the ongoing development of electrical infrastructure in China, India and elsewhere in Asia, and the push for electric cars in developed countries.

When countries expand as rapidly as China and India have in recent years, the existing electrical infrastructure very quickly becomes inadequate. These countries are consuming at rates that couldn’t have been imagined when the original infrastructure was developed. Copper is fundamental to the electrical infrastructure needed to support these emerging countries’ continued growth.

“China [now] consumes 38% of the world’s supply of copper; they were consuming 10% just a few years ago,” says Visagie. “And now India is dovetailing onto that. They have the same population as China, but they’re 15 years behind in development.” With that much catching up to do, long-term copper demand will be very strong.

Adding to the demand side is the current push for electric cars, which is taking place in most developed countries with dense populations. To be effective, electric cars must be lightweight, which makes copper an obvious choice for components.

Currently, each electric car contains 50 pounds of copper. In addition, the rising prevalence of these cars will lead to increased consumption of electricity, and copper is essential to the electrical infrastructure that’ll need to be built or upgraded as electric cars become more common.

“Where will the copper come from? The excess demand could equal the current annual demand,” says Visagie. “New deposits can be developed, but that takes time and millions of dollars.” He adds that supply is also limited by environmental constraints, so the current supply will have to feed demand for some time to come.

Visagie forecasts substantial copper price increases over the next 10 to 20 years, depending on how long China, India and other parts of Asia continue to expand, and depending on how quick consumers are to adopt electric cars as their primary mode of transportation.

And because copper supply is limited, the emergence of electric cars may be good news for other base metals as well.

It’s possible that if there simply isn’t enough copper to go around, electric-car manufacturers may turn to aluminum, or they could develop lighter-weight steels that would be mixed with other base metals such as zinc to galvanize them. This would bode well for zinc and aluminum prices.

Further adding to the positive demand picture for zinc is the mounting environmental pressure facing developed and emerging countries. The base metal will benefit from its recyclable, non-toxic and anti-corrosive properties. In addition, current demand for zinc comes mainly from construction, infrastructure and automotive markets, which will only increase as China, India and other developing nations continue to grow. Yet the effect this will have on zinc prices remains to be seen, as China and Europe have ramped up production this year.

Looking at other base metals, the demand situation isn’t expected to change drastically for lead, nickel or tin over the medium term. However, many analysts expect a supply deficit for these metals in 2011, which should bode well for moderate price increases.

Visagie’s top three picks — Breakwater Resources Ltd. (BWR:TSX), Revett Minerals Inc. (RVM:TSX) and Roca Mines Inc. (ROK:TSXV) — reflect his outlook. In his view, these are all companies with good capacity that can expand easily to capitalize on the market expansion set to happen.

Breakwater has three producing zinc mines, has posted great earnings and is poised for an expansion that could further, and greatly, increase earnings.

Revett, an established silver-copper producer, is the cheapest stock with silver in the ground. The company has one producing copper-silver mine and is developing a second.

Roca, meanwhile, is an emerging molybdenum producer set to capitalize on a record year for steel production. Visagie believes the company’s cash flow will exceed its market capitalizatio

In the end, the most compelling story for commodities for the long term may well lie in base metals, particularly copper, zinc and aluminum. It’s not an entirely new story, but this time, it’s not all about China. Instead, it’s about China and India and the rest of Asia, as well as some interesting technologies that are set to drive electricity consumption going forward – a truly global story for the commodities of the future.

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Danielle Arbuckle is an Ontario-based financial writer.

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