Source: Streetwise Reports 07/09/2018
In a period of economic uncertainty exacerbated by threats of a trade war, Samuel Pelaez, chief investment officer and portfolio manager with Galileo Global Equity Advisors, delves beyond the headlines to discuss the factors that are influencing gold, oil and other commodities, and why he believes we are on the cusp of a once-in-a-lifetime opportunity in commodities.
The Gold Report: Sam, recently we've seen a major intersection of the markets with politics. Would you touch on macroeconomic themes you see happening with politics, gold and other precious metals?
Samuel Pelaez: This is probably one of the times, in recent memory at least, when we've seen the greatest level of political interference in markets. In particular, trade has an enormous impact on the world of resources. The United States and China are the two largest producers and consumers, importers and exporters of resources globally, so any news headline involving trade between the two nations, and now protectionism and potential trade wars, would have a disruptive effect on resource markets. We've actually seen quite a bit of that over the last two or three months, and it only appears to be intensifying as we go deeper into the summer.
There are a lot of signals that would suggest this is probably not the greatest time to be investing in resources. But once I list those points, I'd like to show how this actually may be setting up one of the greatest opportunities that we've had in a couple of generations to be allocating to the resource market. I'll start with the negatives and then slowly transition into how this could be an opportunity.
To begin with, we have a pretty aggressive tone from the U.S. toward China as it relates to trade. If the U.S. levies additional import tariffs or duties on resources, the U.S. being the largest importer of many of them, that suggests domestic production will do well. But domestic production is insufficient, so it's going to increase the price of some of these commodities in the short term. But over the long term, this increase in price may actually have a detrimental effect on the economy. If the U.S. levies imports on iron ore or steel, then the price of construction goes up in the U.S.; the price of car manufacturing and cars as a general consumption product also go up. And over time, this has a nefarious effect on the economy and on consumption.
Initially the tariffs may be read as a positive, but it has very negative implications for the economy as a whole. Very early on in the conversations about steel import duties, I saw a chart that showed there are about 330,000 Americans who work, directly or indirectly, in the steel industry, but there are more than 330 million Americans who ride in cars daily. The protectionist measures help a substantial amount of people, 330,000, and the communities around them, but it has a negative effect on the pockets and the economics of families of 330-plus million people. This has a disruptive effect on the resource universe.
The other thing that's been impacting commodities and natural resources negatively in recent times is the slowdown in economic activity globally. Since 2016, we were in a pretty strong upward trajectory as measured by the Purchasing Managers Index (PMI). PMI is one of our favorite economic indicators because it's has some statistical predictive power as to what's going to happen with the price of resources in the future. The PMIs turned around the end of 2015/early 2016. Up until the beginning of this year, they were in a very strong uptrend. Since then, we've started to see them slow down. We are still in expansionary territory, which is positive, but we've started to see them slow down to a point where the resource world may have to adjust to that new level of demand growth.
With those negatives in mind, we've seen a few of the major commodities—not oil, which is in a specific category that I will touch on later—haven't had a good year. As of June end, copper, the most important base metal, is down nearly 10% year to date. Iron ore is down 9%. Coal is also down. Gold prices are down as well. This reflects the slowdown.
TGR: With all these negatives, why do you say we have a once-in-a-lifetime opportunity in resources?
SP: There is a chart that we've been discussing over the last year or so. Jeff Gundlach from DoubleLine Capital LP included this chart in his 2017 year-end review, suggesting that we're near the beginning of a new cycle, and resources are one of the sectors of the market that should perform best going forward. The chart shows the S&P Commodities index, divided by the S&P 500 Index. The chart measures how many units of resources you can buy with a unit of the S&P 500. This chart has never been at a lower level than where it's sitting right now, suggesting we may see a major mean reversion where the S&P Commodities Index outperforms the S&P 500 Index for a number of years.
The last time the ratio was at these levels was in the dot-com bubble. Remember, there was a lot of exuberance in the markets; lots of growth expectation and technology was leading the markets. Resources was not a sector that people were allocating to. And that was the genesis of the later industrialization of China. It was a great catalyst. And from then, the S&P Commodities Index outperformed the S&P 500 Index by a factor of about 4:1 over the next decade.
This chart shows that we're in a similar predicament right now. If we go back to what happened two decades ago, there's going to be an opportunity where resources have the potential to outperform the overall broader market, as measured by the S&P 500, by multiples. Last time, it was 4:1 over a decade. I'm not sure what it could be this time, but if mean reversion does take place, I find this chart a very compelling reason for allocating to resources.
You can tie this opportunity with the medium- to long-term trend of what's affecting resources, and you'll see we have a few very interesting major projects in the works. We have the much-discussed One Belt One Road Initiative and China partnering up with over two dozen countries to rebuild the original Silk Road. We're seeing development of trains, highways, ports and new utility plays, both nuclear and others. So that's going to be a multigenerational development that will be very heavy in demand for resources. With the last cycle, we saw the development of China. Maybe this cycle will be the development of that corridor in Central Asia that connects China with Europe.
The other interesting catalyst that comes to mind is President Donald Trump's infrastructure rebuild. If you've been to New York and have seen La Guardia Airport recently, you would have seen how aggressively they are rebuilding that airport. I think we may expect to see a big wave of renewals and rebuilds across the U.S. The U.S. being the largest economy in the world, we cannot disregard how important this rebuild could be for the global economy, but especially for the resource market.
Third, and perhaps this is a little bit harder to quantify, if we dig through the resource literature, what we've found is that new technologies have allowed resource companies to extract resources more profitably, to explore and develop them more profitably as well. But when you look at the deposits that are being mined or the oilfields that are in production today, they are of much inferior quality to the ones we had 30 years ago. Grade profiles have declined. We are extracting crude from greater depths.
That's a race that we have pretty much lost against nature because of all the new deposits that are being discovered, none of them equates to the quality of deposits that we've been mining over the past few generations—for instance, the big copper mine near Salt Lake City, Bingham Canyon, which opened in 1906. We don't have any deposits of that quality, that great profile in a jurisdiction where it's safe to develop both from an environmental angle but also from a security angle. And it suggests that it's going to be harder and harder to make the economics of these mines work, which generally bodes very well for resources and the prices of commodities if we do have that development of the One Belt One Road and also the development of the infrastructure plans in the U.S.
Going back to the original point I wanted to make: Even though the news headlines suggest that resources is not a great place to be, when you look at the medium-term and the long-term opportunity as evidenced by that chart, I believe this is one of the greatest opportunities that we'll have in our lifetimes to take advantage of this great economic growth.
TGR: What signs are you seeing that this turnaround is happening?
SP: Corporate M&A is one that we've been waiting for to kick off. Interestingly, the month of June has been very productive from that angle. Earlier this year, we had a few other deals. They're what I call share-for-share deals, a company acquiring another one using their shares. That type of M&A doesn't release capital into the market.
When a company acquires another company with cash, it is the equivalent of an influx of liquidity to the resource market. It's a transfer of capital from a corporate balance sheet to the investment community in the resource space. And those situations tend to feed further activity in the markets. Markets get excited, people need to reallocate the capital, there are positive changes. It's a very exciting time to be in the markets. In June, we've started to see sizable cash deals.
One that comes to mind was South32 Ltd. (S32:ASX), the Australian base metals and industrial metals company, buying Arizona Mining Inc. (AZ:TSX), which owns a sizable base metal deposit, very well located near I-10 in Arizona, with a multidecade mine life. There are nearby properties that are also coming into play that have the same feeder zones that may also be part of a larger transaction going forward.
Companies are more comfortable with their balance sheets and with the markets. The new tax plan for companies in the U.S. has certainly helped. It improved the economics of the projects. I think this trade war conversation also factors into it because if the U.S. is going to go through this new wave of infrastructure buildout, it's going to push for domestic inputs as much as possible. If we're looking at this as a multidecade project, then buying and building a mine today to be in operation in five or six years may be a great time to benefit from this new demand.
Other catalysts that we're seeing—not so much in the U.S.—but China has continued to allocate very substantial amounts of capital to the space. Just last month we saw CITIC Metal Co. Ltd. (267:HongKong) make a major investment into Ivanhoe Mines Ltd. (IVN:TSX), famous for being led by Robert Friedland. It operates exclusively in Africa, South Africa and the Democratic Republic of the Congo, but it has two of the three most highly sought and highly prospective mining development projects in the world. The CA$723 million cash investment shows that there is a strategic appetite among global players for high-quality, long-life assets.
TGR: Would you talk about the relationship between the price of gold and currency exchange rates?
SP: There have been a lot of conversations in the gold space the last couple of weeks as gold has been selling off. That's been a result of the U.S. dollar going up, which has been happening for several reasons. One of them is the trade situation, the other one being the Federal Reserve continuing to hike rates whereas other central banks around the world are not.
What we found most interesting is gold prices have been going down, but the interest in gold equities has gone up. And that's evident by the inflows that have been documented into the major gold equity exchange-traded funds (ETFs). During the first three weeks in June, we had hundreds and hundreds of millions of dollars a week being allocated into these funds. Initially, it was thought that it was potentially people shorting the market. With ETFs, it's easy to see whether that's the case. We got confirmation that that is not the case; this is actually long exposure allocation to these products.
I think there are two reasons for that. One is gold equities may have a pretty important diversification angle, especially in these kind of markets. We've seen high volatility. We've seen headline-driven investing. People are looking to these gold stocks for some solace from that volatility.
The second, and the one that some people have failed to recognize, is that when gold drops in U.S. dollar terms, as it has been doing for the last month or so, it doesn't mean that it necessarily drops in other currencies. The U.S. is a major producer of gold, but so is Canada, Australia, South Africa and many other countries around the world. The miners that have high exposure to countries like Canada and Australia are not seeing the economics of their mines negatively impacted by gold dropping. If anything, in some cases, like in Canada for example, gold is actually up year to date in Canadian dollar terms. When you're a gold ETF, you're not just buying U.S. domiciled gold companies with production in the U.S. You're also buying companies with production elsewhere.
Our own ETF, the U.S. Global GO GOLD and Precious Metal Miners ETF (GOGO:TSX; GOAU:NYSE), has actually outperformed its peers quite dramatically this year. One of the big reasons for that is the smart beta construction, which has allocated a greater percentage of the fund to Canada, Australia, South Africa and a few other key places. Almost all these stocks trade in North America, but they have direct exposure to the commodity in other countries. Australian gold companies have performed phenomenally well this year. We have an overweight in those. And a big part of that is the currency has dropped more than gold has dropped, so net-net they're actually receiving more revenue in Australian dollar terms than they were receiving last year.
TGR: Let's touch on crude oil for a minute.
SP: Crude oil is the best performing major commodity year to date; prices are up around 20% this year. The entire commodities index is actually up year to date, and it's pretty much all a result of crude being that strong, whereas most of the other commodities that I mentioned earlier are down year to date. There are a couple of reasons for that.
Number one, the Organization of the Petroleum Exporting Countries (OPEC) has pretty much maintained its self-imposed production cap. It had a recent meeting in Vienna to discuss an increase in the cap and is going ahead with boosting production slightly. But there are other factors in the market that have taken some of the production away. One of the things is the re-imposition of U.S. sanctions on Iran, which, as of the late summer, forces U.S. allies to stop buying crude from Iran. The expectation is that that will take about 1.5 million barrels a day out of the market, roughly 1.5% of the volume of the market.
That is being compounded by the fact that the Permian Basin in the U.S. in West Texas is capacity constrained. There's not enough infrastructure for the crude out of this region to reach the Gulf in a timely or efficient fashion. The U.S. was on this very aggressive growth profile of its crude production, but now it is going to start to slow down. That's giving investors some comfort that the U.S. cannot continue to grow its production at the same rate.
Second, and this is short term, Canada is having issues at the oil sands with one of the major processing facilities being taken out of commission for an indefinite amount of time to address technical issues.
With lower production from Canada, stranded capacity in the U.S., Iran being unable to export to U.S., we find ourselves with a very favorable market for crude. We have seen evidence of this in the official Department of Energy weekly inventory numbers. The last week of June saw the largest single weekly inventory draw we've seen in many years. Crude has been the biggest highlight of the year.
TGR: Let's talk about some companies that you like.
SP: Staying with oil, in Canada, there've been several political situations that have not allowed pipelines to get built, resulting in serious logistical issues. As a result of that, the energy market is Canada is essentially flat year to date. When you ponder crude prices being up 20% in U.S. dollars, the Canadian dollar having depreciated relative to the U.S. dollar, we're talking about a commodity that's moved aggressively in favor of the Canadian producers. Yet we haven't seen much appetite yet.
I call it "peak bearishness"; this feeling that Canada can't figure out a way to export its crude, to develop new midstream infrastructure. I think we've hit the point where that bearishness is so pervasive that people have given up. And perhaps this is the greatest time to be buying.
One Canadian name we own and like is called Peyto Exploration and Development Corp. (PEY:TSX; PEYUF:OTC). The reason we like it is because it's not that junior. It's a company that has a reasonable market cap, being liquid enough for institutions to invest in it. On a value metric, it trades at about a 25% discount to its peers on an EBITDA basis. And the return on capital is about 20%, which is multiple times higher than the average return on capital in the Canadian exploration and development space. It also has a substantial free cash flow yield. Those three factors: the free cash flow yield, the return on capital and the discount on its EBITDA valuation relative to its peers, are some of the factors that we like to look at. So that's one of the companies that I recommend.
Switching gears but still in Canada, we continue to see great opportunity in the lumber market. The lumber market has been one that's been freely talked about in the headlines with the North American Free Trade Agreement (NAFTA) renegotiations, President Trump and potential escalation of a trade war with Canada. What people fail to realize, number one, is the lumber exports to the U.S. have their own provision outside of NAFTA, so the renegotiation of NAFTA does not affect them.
The second is a lot of the Canadian paper and forest producers are very diversified; they have ownership of mills and access to lumber directly in the U.S. They've performed quite well because the U.S. housing market continues to be strong, and there's no angle for them to necessarily be affected by the trade war rhetoric.
While lumber prices are near all-time highs, the companies in the sector are still trading at very substantial discounts to the materials sector, and their returns on capital have been growing in excess of the sector. We recommend the whole sector, and the one stock I would highlight is Canfor Corp. (CFP:TSX). It trades at about a 50% discount to the materials sector, and their returns on capital are nearing a staggering 30%.
TGR: Let's switch gears to metals.
SP: One of the names that I've been quite interested in, that we currently own, and it has a big trade war angle to it is Alcoa Inc. (AA:NYSE). If you recall, a few years back, Alcoa split its upstream and its downstream operations. The new Alcoa, which has retained the upstream—the production of aluminum—was not a market darling after the split. But now it seems to have gotten a new stride. It's trading at a very compelling valuation. Both the return on capital and the free cash flow yield have been increasing. So now it's at a level where we're happy to own it. But also, it has this tailwind from the U.S. infrastructure buildout and the U.S. protectionist measures that have been implemented or are currently being discussed. So that's something that I'll highlight for investors to have a look at. That's on the industrial metals space.
On the base metals space, there are not a lot of opportunities in the U.S. market. Freeport-McMoRan Inc. (FCX:NYSE) is still in discussions with the Indonesian government. It makes it subject to politics and news headline risk.
There are two phenomenal base metals names in Australia if investors are willing to look at the Australian market. My favorite is OZ Minerals Ltd. (OZL:ASX). It also trades at a very attractive valuation. Its returns on capital have not been increasing, but that is because it is self-funding out of its own cash flow the development of what's going to be one of the largest, new base metal mines in the world, called Carrapateena. OZ is spending about a billion dollars from its own self-generated cash flow. It's one of the interesting names that gives you growth prospect without any share dilution. It hasn't had to raise debt or equity to finance this project, so we expect the return on capital to increase quite dramatically once this new mine comes into production, the benefit being you get it without the share dilution that generally accompanies this type of explosive growth.
TGR: You said you had two phenomenal base metal names in Australia; what is the second one?
SP: It is called Sandfire Resources NL (SFR:ASX) and has a similar story to OZ Minerals. It also offers organic growth, and has a vastly superior return on capital metric, to the tune of 50%, one of the highest in my whole screen for global resource companies. What that tells you is that this management team is a phenomenal operator and capital allocator. And it is one of the best value base metal stocks globally.
TGR: Shall we turn to gold royalty companies? I understand the GOGold ETF has a focus on gold royalty companies. Which those are you excited about?
SP: There are the three big precious metals royalty companies, well known as the three amigos. The GoGold ETF has exposure to all three of them, Franco-Nevada Corp. (FNV:TSX; FNV:NYSE), Wheaton Precious Metals Corp. (WPM:TSX; WPM:NYSE); and Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX). The royalty business model is extremely attractive. When you enter into a royalty agreement, or a streaming agreement, which is the more novel way to structure it, these companies exchange upfront capital that helps the miners build projects in exchange for quantifiable production, a percentage of the production going forward. That allows these companies to be exposed to the metal prices, and it allows them to be exposed to the growth of the deposit, without necessarily being exposed to the day-to-day friction and cost of mining. We find that to be a very attractive business model. These three companies have also proven to be very successful capital allocators. If you look at the year 2015–2016, when a lot of companies in the resource market—and especially the metals space—were going through hardship, these companies were able to pick up pretty interesting assets essentially at the bottom of the market.
They changed their business model from facilitating the buildout of a mine to facilitating the restructuring of over-levered producers. Glencore International Plc (GLEN:LSE) is a great example. Both Franco-Nevada and Wheaton Precious Metals were able to buy royalty and streaming agreements from existing Glencore producing assets at the time, at very attractive valuations, which translates into very high returns on invested capital. When you look at the companies themselves, and the exact return on invested capital number, it doesn't appear that attractive, but that is because they've already deployed money buying royalties that are not going to kick in immediately; they kick in after a few years. But when you look at the return on capital on a project-by-project basis, the returns on capital are spectacular.
Interestingly, the fourth company, which is an up-and-coming one, and I'd actually like to highlight it because it also trades in the U.S., is called Sandstorm Gold Ltd. (SSL:TSX; SAND:NYSE.MKT). The founders of Sandstorm are among the smartest individuals in the metals industry, I find. They did a transformational transaction in 2016, where they acquired a portfolio of royalties from Teck Resources Ltd. (TECK:TSX; TECK:NYSE), the big Canadian producer of basically most metals. One of the royalties applied to a specific project in Turkey. The company now has a 30% net profit interest, so it will earn 30% of the project's profits. And at the end of June, the company reported the independent economic assessment of the project, which shows a greater than $1.4 billion profit expectation. Sandstorm spent less than US$200 million in total to acquire this stake, and the economic study suggests Sandstrom could be receiving more than $100 million a year from the project's profits.
TGR: Any parting thoughts?
SP: I want to encourage investors to think about the diversification that the resource market gives them relative to the overall market. We strongly believe this should be a permanent allocation in any portfolio, and specifically gold, for the diversification characteristics that it offers in the context of a portfolio.
I'd also invite the readers to consider that chart and think about the next decade—not the next Tweet or the next news headline, but the next decade—and where the world is going in terms of the Silk Road and the One Belt One Road and the U.S. infrastructure renaissance. There is a good feel and vibe about an industrial renaissance in the U.S., and that would necessitate a redevelopment of infrastructure and certainly a significant amount of natural resource inputs.
TGR: Thanks for your insights, Sam.
Samuel Pelaez is chief investment officer and portfolio manager with Galileo Global Equity Advisors. Prior to that he was an investment analyst at U.S. Global Investors, a boutique U.S.-based investment management firm. Pelaez graduated from the Schulich School of Business with Distinction in 2012. He also holds a Masters in Finance degree from The University of Cambridge. He is a CFA charter holder and member of the Toronto CFA Society.
Read what other experts are saying about:
Want to read more Gold Report articles like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent articles and interviews with industry analysts and commentators, visit our Streetwise Interviews page.
Read more by MarketSlant Editor