Investing 101

Are resource prices headed higher again?

When you drove your full-sized SUV into a gas station in July 2008, you probably suffered a little sticker shock when it cost you almost $140 to tank up. If you did, you weren’t alone. Many drivers, fearing that oil, already trading at a record $147 a barrel would move even higher, began to downsize to smaller vehicles. We had entered what pundits dubbed the “post-SUV world,” where surging commodity prices dictated how we lived: from the cars we drove to the size of our houses and even what we had for supper. But then the financial crisis hit and all those sky-high prices tumbled. The impact was immediate: mine expansions were cancelled, production was mothballed and oil slipped to $35 a barrel – supertankers weighed down by a cargo no one wanted sat in ports across the world.

So where do we stand today as the world emerges from the recession? A number of commodities, after correcting during the downturn have rebounded, though in most cases not to the pre-recession highs. But Fred Sturm, Co-manager, Mackenzie Universal Canadian Resource Fund, and Mackenzie Universal World Resource Class, believes resource prices remain in a long-term uptrend. Looking out to 2015 he sees many of the same factors that led to surging commodity prices resurfacing, including a fall-off in production, lack of investment in new supplies and growing demand in emerging markets.

While he doesn’t believe prices will jump sharply tomorrow, he says advisors should start thinking about how to position their clients for the next leg up in the resource cycle. “Global economic activity suggests that the supply/demand outlook for almost all commodities should improve in 2011,” says Sturm. “Declining inventories alone are bullish for resource investors. But the speed of the recovery and the potential push to new highs will reflect the tightness of global supply and resumed demand from emerging markets.”

There are already signs of rising prices creeping into the system. Copper is up 150% since the low of 2008, metallurgical coal is up 55% so far this year and Sturm notes that oil is now back over $80 a barrel, a price it has rarely averaged in history. “There are a number of different markers,” says Sturm, “that suggest pricing is coming around again.” In addition to underinvestment and declining production, the supply picture could also grow more complicated as countries hoard their own resources to meet internal demand. For example, in 2008 when Thailand withheld shipments of rice, it triggered a sharp run-up in prices worldwide, and Costco outlets in Toronto limited sales to one bag per customer. “For a brief period when rice prices spiked, instead of saying, ‘This is our chance to dump whatever we’ve got on the world market and generate a lot of revenue,’ they actually said, ‘there’s a shortage and we had better keep what we’ve got for ourselves.’”

The oil sector is particularly susceptible to this type of supply-side nationalism. Sturm points out that 80% of the world’s reserves are controlled by state-owned or partially-nationalized companies, including those in Mexico, Russia and Saudi Arabia. If their governments instruct them to withhold oil to meet the country’s own internal demand, it will push prices dramatically higher. Says Sturm: “It’s not a given that national companies would act in a self-interested corporate manner, independent of the state.”

During the first quarter of the year, the Mackenzie resource team spent time in Brazil, Saudi Arabia and the United Arab Emirates at a series of conferences where they met with energy and mining company executives and government officials. The purpose of the trip was to monitor the speed of potential oil production increases against the growth in internal demand.

Saudi Arabia is a case in point. The population of the country of 28 million people, with the largest oil reserves in the world, is growing at almost 4% a year. Over the next 10 years, it is expected that electricity demand alone will climb by 75%. The country could use its vast natural gas reserves to produce it, but they are either being used in the production of oil or are inaccessible.

“Could it be,” says Sturm, “that without more success in growing natural gas production for domestic needs, that some of the Saudi oil that foreign consumers simply assumed would be readily available for global export will be needed internally to keep their population cool in the desert heat?” And he adds: “If we do indeed begin inserting the word ‘on’ before allocation¹ we could go from a world of aplenty to one of rationing, with all the inherent implications for prices.”

Sturm’s Saudi example becomes even more revealing when cast against current and future oil consumption. According to the International Energy Agency, the world is now consuming about 86 million barrels a day, and of that Saudi Arabia exports about 8 million barrels a day. But the agency also predicts that the world will be consuming another 21 million barrels a day by 2030 – almost the equivalent of tripling Saudi Arabia’s current daily production. “The production for internal consumption needs rather than export,” says Sturm “is one of the themes we expect will become more prominent in a number of commodities over the next few years.”

Sturm first described a potential multi-decade cycle of emerging market demand for resources 15 years ago, and he says it is still “impressive to witness today” how a rising standard of living continues to push up resource demand in emerging markets like China. Take coal production for example. There is plenty of coal in the world, but a harsh winter in China interrupted supply chains. The resulting squeeze has pushed up prices and underlined the need for more production across the world at a time of rising demand. Says Sturm: “Metallurgical coal prices rose by 55% this quarter and are moving higher again as buyers, finding themselves ‘on allocation,’ scurry to secure the extra they require.”

How should advisors approach the resource sector in the coming months? Sturm says many advisors and their clients are still investing in the shadow of the 2008/2009 panic, with near record investor dollars still favouring bonds. In so doing, are they missing a chance to catch the next up leg in the resource story? “The average investor is behind the inflation and profit growth inflection curve,” says Sturm. “But they can still take advantage of occasional stock market dips to realign portfolios.”

Sturm and his team have positioned Mackenzie Universal Canadian Resource Fund and Mackenzie Universal World Resource Class as the broadest way to take advantage of the resource sectors and are constantly looking for ways to benefit from shifting trends. One recent shift in the first quarter of 2010 involved how bulk resources like iron ore and coal are priced, which could send stock prices higher. Unlike other commodities that trade mostly on near-term spot prices, bulks were historically settled based on an annual contract. Now they are utilizing shorter-term contracts that may realize higher prices. “The producers effectively transformed the market,” says Sturm. The funds were already positioned for stronger bulk pricing but recently added back some exposure that was reduced last year in anticipation of iron ore prices advancing.

At about 60%, energy remains a core weighting in the funds, diversified across a number of industries, including oil and gas producers, coal, energy services and alternative energy. Remaining investments are diversified across a number of sectors, including mining, forest products and agriculture.

¹ Rationing of production among different users.