Commodities 2011 Halftime Report

 

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

 

Commodities don’t all perform in the same way. In any given year, a particular commodity will go gangbusters and outperform the group. However, that commodity will typically come back to Earth and underperform the following year or the year after that. This is why active management is important when investing in commodities. Active managers can benefit from rotating from winners to laggards or by investing in the companies which produce, farm or mine commodities most effectively.

 

After two straight years of tremendous gains for many commodities, the first six months of 2011 haven’t been as kind. As of the end of June, only two commodities (silver and coal) saw double-digit increases, and only six of the 14 commodities we track—less than half—were in positive territory.

 

Silver was the leader, rising more than 12 percent, followed closely by coal (up 11.95 percent). Other commodities increasing in value included gold (5.6 percent), crude oil (3.83 percent), lead (2.16 percent) and aluminum (1.73 percent).

 

Returns are based on historical spot prices or futures prices. Past performance is no guarantee of future results.

Silver

 

Silver prices got ahead of themselves earlier this year, climbing 58 percent to nearly $50 an ounce. This registered a four standard deviation move, representing extreme territory on our models. Thinking silver, which has historically been a narrowly-traded market, had become a potential haven for speculators, officials stepped in and raised margin requirements on the Comex. This quickly deflated the bubble and prices naturally reverted back toward the mean but remain well above where they began the year.

 

Coal

 

Strong demand from reconstruction projects in Japan along with reduced supply because of flooding in Australia, Indonesia, South Africa and Colombia led coal to be the second-best performer.

 

No country was more affected by the lower supply than China as coal powers the Chinese economy. The country is the world’s largest consumer, gobbling half of the world’s coal. Coal accounted for 71 percent of China’s energy in 2008—more than three times the United States’ share. The Electricity Council estimates that China’s coal demand will reach 1.92 billion tons in 2011, up nearly 10 percent from 2010. Chinese electricity use was up 13.4 percent on a year-over-year basis in May and is now expected to rise 12 percent this year. (Read: Coal Use in China Shines Light on Growth)

 

Gold

 

Gold prices passed $1,500 for the first time ever in mid-April of this year and ended the quarter just slightly below that mark as a mixture of the Fear Trade and Love Trade proved to be an enticing concoction for investors here and abroad. The World Gold Council reported that demand for gold as an investment was up 26 percent on a year-over-year basis during the first quarter. In China, demand for gold was so strong it outpaced the combined gold demand of the U.S., France, Germany, Italy, Switzerland, the U.K. and other European countries. (Read: Asian Tiger Sinks Teeth Into Gold)

 

Although gold prices held steady during the first half of the year, the share prices of gold companies have lagged. Ralph Aldis and I discussed this hot topic in depth a few weeks ago. (Read: Will Gold Equity Investors Strike Gold?) Many gold companies’ corporate cash flows and earnings per share have been rising, and more companies are paying dividends. Gold stocks also appear cheap compared to the price of gold. We believe investors will be drawn to these qualities, lifting gold stocks along with the strong bullion price.

 

Oil

 

After two straight years of solid gains, oil prices finally surpassed the $100 per barrel mark once again early in 2011. This time, it was a dose of geopolitical risk and a natural disaster that sent oil prices shooting upward. Oil prices have since bounced around the $90-$100 range for West Texas Intermediate (WTI). That range has held up despite U.S. consumers cringing at gasoline prices, the International Energy Agency (IEA) releasing an additional 60 million barrels of oil to the market and China’s ardent attempts to cool its economic growth. (Read: Playing Cat and Mouse with Global Oil)

 

Despite tightening measures, China’s per capita oil consumption has retained its upward trajectory and is headed toward levels similar to Taiwan and South Korea. There’s still quite a gap to close before that happens, but China’s oil consumption per capita has increased over 350 percent since the early 1980s to an estimated 2.7 billion barrels per year in 2011. Nearly 100 percent of that has taken place in the past decade. In addition, oil consumption per capita has risen sharply in recent decades in other Asian countries such as Malaysia (nearly quadrupled) and Thailand (doubled).

 

Looking Forward to the Second Half of 2011

We think commodity price movements will fare better during the second half of the year. Goldman Sachs wrote in a report last week that it expects global economic growth to be “generally supportive of rising commodity demand” and “this demand growth will be sufficient to tighten key commodity markets over the next six to 12 months.” We believe gold, oil and copper are some of the commodities which could see the biggest gains. For the sake of brevity, we’ll highlight gold here today. Check out my “Frank Talk” blog next week for our previews on oil and copper. (www.usfunds.com/franktalk)

 

Gold

As BCA Research puts it, “[gold] prices have benefited from a ‘perfect storm’ in recent months: falling real interest rates, a weak dollar, fears of a U.S. recession and/or debt default, and European stress.” Those factors, which I affectionately refer to as the Fear Trade, are what sent gold prices flirting with the $1,600 an ounce level this week. There was also the release of Federal Reserve meeting minutes that showed QE3 is possible, though not yet probable given Chairman Bernanke’s testimony this week. By the way, if you haven’t already seen Bernanke’s exchange with Congressman Ron Paul on gold, go to YouTube and check it out for a good chuckle. Washington’s reluctance to present a solution to the debt ceiling issue also contributed heavily to gold’s performance.

 

Paul was bringing attention to the threat of currency debasement, a major reason investors all over the world are turning to gold. According to U.K. research firm Capital Daily, the U.S. monetary base has increased more than 200 percent since September 2008. Meanwhile, gold prices have risen only about 70 percent over the same time period. Capital Daily says “if the two had been directly related, gold should already have risen to around $2,800 [an ounce].” That’s obviously a lofty expectation but illustrates that gold prices haven’t appreciated nearly as much as currencies, such as the U.S. dollar, have been debased.

 

In fact, don’t believe what you read about record high gold prices. Yes, gold hit a high in nominal terms, but the price is more than 30 percent below the 1980 peak of $2,400 an ounce if you adjust for inflation.

 

This was a banner week for the Fear Trade but don’t count out the Love Trade. Gold is about to get even more attractive because we are heading into the fall and winter gift-giving season. This is the time of year when gold jewelers typically do their biggest business. The kickoff is the Muslim holy month of Ramadan, which starts next month and ends with generous gift-giving in early September.

 

The key to this seasonal strength over the past few years has been demand from China and India. You can see from the chart that the rise in gold prices has been closely tied to the rise in gold demand from China and India. Back when the average per capita income in China and India was well below $1,000 a year, gold prices hovered just above $200 an ounce. As average incomes have approached $3,000 a year over the past decade, gold prices have followed. With the long-term outlook for wages in both these economies rather rosy, gold demand should continue to feel the trickle-down effect.

 

 

Those investors looking for more of a technical indicator can take a look at the ratio of gold and oil. Capital Daily says that the ratio of the price for one ounce of gold to one barrel of oil (Brent crude) is currently 13.5. Since 1970, the average has been around 16. Gold prices would need to rise to $1,870 an ounce in order to reach historical ratio levels with $117 per barrel Brent crude oil, according to Capital Daily.

 

Based on seasonal demand strength and sovereign debt fears of the U.S. and several European countries, we think gold prices could be headed higher.

 

Tune in to “Frank Talk” on Tuesday and Wednesday for second half 2011 previews of oil and copper.

 

Index Summary

 

• The major market indices were lower this week. The Dow Jones Industrial Average lost 1.40 percent. The S&P 500 Stock Index decreased 2.06 percent, while the Nasdaq Composite fell 2.45 percent.
• Barra Growth outperformed Barra Value as Barra Value finished 2.30 percent lower while Barra Growth declined 1.84 percent. The Russell 2000 closed the week with a loss of 2.79 percent.
• The Hang Seng Composite Index finished lower by 3.45 percent; Taiwan lost 2.00 percent, and the KOSPI fell 1.61 percent.
• The 10-year Treasury bond yield closed 12 basis points lower at 2.91 percent.

 

Domestic Equity Market

 

The figure below shows the performance of each sector in the S&P 500 Index for the week. One sector increased slightly and nine sectors declined. The best-performing sector for the week was energy which increased 0.12 percent. Other top-three sectors were utilities and consumer staples. Financials was the worst performer, down 3.91 percent. Other bottom-three performers were industrials and consumer discretion.

 

Within the energy sector, the best-performing stock was Range Resources, which rose 10.03 percent. Other top-five performers were Southwestern Energy, Chesapeake Energy, Nabors Industries, and EQT Corp.

 

 

Strengths

• The internet software & services group was the best-performing group for the week, rising 7 percent on strength in the stock of Google, which reported quarterly revenue and earnings that exceeded the consensus estimates.
• The gold group outperformed, up 5 percent, led by its single member Newmont Mining. The price of gold increased for the week.
• The tires & rubber group outperformed, gaining 4 percent, led by its single member, Goodyear Tire & Rubber. While warning that unit volume in the second quarter could fall short of expectations, a major brokerage firm with a “Buy” rating on the stock noted that the tire companies have passed through several rounds of price increases to consumers already this year, and commodity costs are now moderating, which should result in a favorable price benefit.

Weaknesses

• The electronic equipment & instruments group was the worst performer, down 15 percent on weakness in its single member, FLIR Systems. The maker of thermal imaging and infrared cameras warned that its quarterly revenue and earnings will miss analysts’ estimates, citing weak demand from government customers.
• The retail computer & electronics group underperformed, down 8 percent. GameStop stock sold off after a brokerage house analyst downgraded the stock to “Underperform” from “Sector Perform,” citing the belief that the company’s used-game business is likely to face increased competition from Best Buy Co. Best Buy stock was also weak. A major brokerage firm lowered its second quarter earnings estimate and reiterated its “Sell” rating on the stock, citing weakness in pricing on TV sets and deteriorating traffic to consumer electronic retailers in July.
• The real estate services group underperformed, down 8 percent, led by its single member, CB Richard Ellis Group. Investor concerns over an economic slow patch affecting the commercial real estate sale and leasing business may have been a factor in the decline.

Opportunities

• There may be an opportunity for gain in merger and acquisition (M&A) transactions in 2011. Corporate liquidity is high, thereby providing the means to pursue acquisitions.

Threats

• Failure to resolve the federal budget issue creates uncertainty, which is not helpful for markets.

 

The Economy and Bond Market

 

The yield on the 10-year U.S. Treasury note decreased by 12 basis points this week to yield 2.91 percent.

 

Although initial jobless claims decreased in the week ended July 9, continuing jobless claims in the U.S. were 3.73 million in the week ended July 2. The chart below shows the number of continuing claims in thousands. The current level of claims is still substantially above the level existing in the years 2004 thru 2007. Also, the continuing claims figure does not include the 3.83 million people who have used up their traditional benefits and are now collecting emergency and extended payments under federal programs.

 

Strengths

• Initial jobless claims decreased 22,000 in the week ended July 9 to 405,000, which was below the consensus forecast of 415,000.
• China’s second quarter real GDP was up 9.5 percent year-over-year, above the consensus estimate of 9.3 percent, and China’s industrial production for June rose 15.1 percent year-over year versus the 13.1 percent consensus.
• In response to a question, Federal Reserve Chairman Bernanke said he expects the economy to grow at an annual rate exceeding 3 percent in the second half of this year.

Weaknesses

• Moody’s Investors Service cut Ireland’s debt rating from Baa3 to Ba1, a level below investment grade.
• The University of Michigan Consumer Confidence Index fell to 63.8 in July from 71.5 the prior month. This was the weakest reading since March 2009 and below the 72.2 consensus.
• The U.S. trade deficit increased in May to $50.2 billion, the highest level in almost three years, and above the $44.1 billion consensus.

Opportunities

• Federal Reserve Chairman Bernanke told Congress the central bank is prepared to take additional action, including buying more government bonds, if the economy appears to be in danger of stalling from here.

Threats

• The Greek bailout came and went, so the market shifted its focus to Portugal last week. This week the focus was on Italy. This has been the pattern for the last year; as soon as one issue is “resolved,” the market just moves on to the next “problem.” This pattern won’t stop until long-term solutions are implemented.

 

Gold Market

 

For the week, spot gold closed at $1,593.55 per ounce, up $49.40 per ounce, or 3.2 percent for the week. Gold equities, as measured by the Philadelphia Gold & Silver Index, gained 4.40 percent. The U.S. Trade-Weighted Dollar Index was essentially unchanged for the week.

 

Strengths

• Gold prices hit a record high on Friday after hints of further policy easing from the Federal Reserve and a Moody's warning that the United States may lose its top-notch credit rating. This news hurt the dollar and sparked buying of assets seen as safe havens.
• A significant headline missing from most news feeds was the fact that gold hit a new record high.
• Peru's Minister of Energy and Mines Pedro Sanchez said mining investment in the country has tripled during the presidency of Alan Garcia, who will leave office this month, reaching $13.78 billion between 2006 and 2011. Sanchez also said the mining sector now represents 8 percent of Peru's GDP, 72 percent of total exports and 50 percent of the income tax. Unfortunately, that was the past president and not the new one who wants a super tax on mining profits. Perhaps rational minds will prevail.

Weaknesses

• A congressional subcommittee hearing on cleanup of abandoned mined land sites on public lands was dominated by testimony from anti-mining interests. Opinions were expressed that the full cost of the problem was not known and financial assurances were needed so as to prevent any future hardrock mine cleanup from falling upon taxpayers.
• It was further highlighted that the Obama administration wants new fees leveled on mining projects not only on public land but also private lands, with the proceeds diverted to the Bureau of Land Management.
• South Africa's gold output fell 5.8 percent in volume terms in May compared with the same month a year earlier.

 

Opportunities

• The United States Mint has taken the demand for more mass production silver bullion coins seriously of late. It is expanding its offering to a planned total of 57 new coins by 2021 with the introduction of the America the Beautiful Bullion Coin Series. Canada's Royal Canadian Mint has followed suit expanding its offering of mass production silver bullion coins to eight by 2013 with the launch of its Canadian Wildlife Silver Bullion Coin Series Program. This should drive more retail investment into silver products.
• The U.K.’s first ever gold-dispensing ATM was launched in London’s Westfield shopping center. It follows the opening of gold vending machines in Las Vegas and Abu Dhabi, which received the world’s first gold ATM machine last year. The company behind the gold bar vending machines plans to install 50 machines across Britain over the next few years.
• As Chinese home sales fall, property developers are getting into mining in a big way, producing gold, lead, zinc and molybdenum. According to the China Mining Association, at least 15 major property developers have shifted investments into the mining industry, with a total investment of about $3 billion as of the end of June. Most of the investment is going into mines producing gold.

Threats

• With gold hitting new highs, several companies came to the market to raise over $400 million this week. A wave of new equity offerings could be a headwind to price gains for those stocks.
• Microchip, a major supplier of microcontrollers and semiconductors to the broader economy and a company noted for telegraphing changes in business conditions earlier than most companies, pre-announced lower-than-expected results for the second quarter and guided down revenues for the full year. The company noted the downturn it was experiencing was not regional or sector-driven, but global in nature.
• The unwillingness of government leaders to come to grips with economic reality was highlighted this week when the leader of the European Commission gave his solution to the eurozone sovereign credit crisis: “Just ban credit ratings on troubled sovereigns who are receiving financial aid.”

 

Energy and Natural Resources Market

Strengths

• China’s steel production hit another record high in June. According to data from the National Bureau of Statistics, China produced 59.9mt of steel in June, equivalent to 729 million tonnes per year (a 11.9 percent year-over-year increase and a 2.8 percent month-on-month increase), beating the previous record high of 718 million tonnes per year set in April this year.
• Gold prices hit a new nominal high of over $1,580 and ounce in Wednesday trading as the combination of dovish comments from Federal Reserve Bank Chairman Bernanke and ongoing uncertainty over contagion in European sovereign debt markets saw a further push in the yellow metal. White metals also rose strongly, with the breakdown in wage negotiations in South Africa likely to lead to strikes.
• Corn prices rebounded this week as a WASDE report released earlier this week showed a smaller-than-expected increase in 2011-12 U.S. ending stocks despite a projected record crop, highlighting tight balances for corn.
• Data from the International Trade Commission showed that total U.S. coal exports for the January–May 2011 period was at 44.52 million tonnes, up 37 percent year-over-year.
• Commodities generally rallied this week on economic data out of China. China’s GDP rose 9.5 percent year-over-year in the second quarter, the statistics bureau said, after a 9.7 percent gain in the previous three months. This was higher than consensus estimate of 9.3 percent. Industrial output advanced 15.1 percent in June. Fixed-asset investment, excluding rural households, also rose 25.6 percent year-over-year in the first half, the report showed.
• Japan's ten utilities consumed 31 percent more liquefied natural gas (LNG) in June than a year ago, according to data from the Federation of Electric Power Companies of Japan.

Weaknesses

• Peru's copper production dropped 4.7 percent year-over-year in May to 98,628 tonnes, with big declines from Southern Copper's mines, according to the country's mining ministry. Meanwhile, zinc production fell 6.9 percent year-over-year to 121,253 tonnes and tin by 24.7 percent year-over-year to 2,189 tonnes.

Opportunities

• In its monthly Oil Market Report, the International Energy Agency forecast that oil use will increase by 1.47 million barrels per day to 91 million barrels per day amid growth in emerging economies.
• BHP Billiton agreed to acquire all the shares of Petrohawk Energy for $38.75 per share, representing a total equity value of approx $12.1 billion and a total enterprise value of approx $15.1billion, including the assumption of net debt. The deal adds three shale oil and gas assets across about one million net acres in Texas and Louisiana with proved reserves of 3.5 trillion cubic feet equivalent of natural gas.
• In a report from the Financial Times, U.S. ethanol producers are consuming 40 percent of the U.S. corn crop which is the first time fuel use has exceeded use by farmers for livestock feed.
• China has ordered local governments to phase out a total 2.04 million tonnes of aluminum, copper, lead and zinc smelting capacity in 2011 as part of a multi-year plan to crack down on energy-intensive and polluting industries, raising the target by 13 percent from the prior target set in May. The iron smelting industry was ordered to cut 31.22 million tonnes of capacity, up 17.7 percent from the May target, as issued by the Ministry of Industry and Information Technology.
• China has announced that it will be increasing rare earth exports by 8.9 percent versus first half 2011 and 97.3 percent versus second half 2010; however, on an annualized basis, total rare earth exports will be slightly lower year-on-year. The move comes amid pressure from the World Trade Organization regarding China's virtual monopoly on rare earth supply.

Threats

• BHP Billiton is facing more strikes at its coking coal mines in Australia this weekend after making small progress at talks with the miners earlier this week, a labor union said. Workers will hold 12-hour stoppages at the Gregory mine on July 17, Stephen Smyth, a division president at the Construction, Forestry, Mining and Energy Union in Queensland said. The industrial action follows another round of six-hour stoppages this week at seven coking coal mines owned by BHP Billiton Mitsubishi Alliance in Queensland’s Bowen Basin, he said. The next round of meetings with the management will be held next week.
• Saboteurs blew up an Egyptian pipeline distribution station in northern Sinai that supplies natural gas to Israel, the MENA news agency reported. This marked the fourth attack on facilities supplying Egyptian gas to Israel this year.

 

Emerging Markets

 

Strengths

• China’s second-quarter GDP grew by 9.5 percent compared to a year ago, better than the market consensus of 9.4 percent, and proving China’s success in managing a soft landing.
• China’s June industrial value-added growth was 15.1 percent year-over-year, 1.48 percent better than May, and showing robust industrial production. China fixed asset investment was up 25.6 percent year-over-year (excluding rural houses) for the first half, while real estate development investment was up 33 percent for the same period.
• China retail sales grew 16.8 percent year-over-year for the first half of the year. Retail sales were up 17.7 percent in June, 1.38 percent better than in May. Urban per capita income was up 13.2 percent year-over-year, in the first half, beating inflation by 8 percent.
• China money supply (M2) rose 15.9 percent for the first half of the year, a level that economists call a reversal to the mean. It is also at the government target of 16 percent for the year. In the year-to-date period, social total financing is Rmb 7.76 trillion, 4.6 percent less than that in the same period a year ago.
• South Korea maintained its benchmark rate at 3.25 percent, after raising the rate 25 basis points in June, while Thailand's consumer confidence rose to 72.3 in June from 71.1 in May.
• Brazil’s regulator approved a merger of Perdigao and Sadia to formally form Brasil Foods. We applaud the decision of the Brazilian regulator as the combined company should be one of the leaders of the frozen foods industry able to compete internationally with Tyson Foods and Perdue.
• Retail sales in Brazil in May increased 0.6 percent month-over-month and 6.2 percent year-over-year.

Weaknesses

• The China Government council met after seeing robust house sales in June and increasing prices. The government said it is going to implement a housing tightening policy in second- and third-tier cities to control housing prices from rising.
• Thailand’s central bank raised its benchmark rate by 25 basis points to show the incoming government that it is independent of the government.
• Singapore's second quarter GDP fell an annualized 7.8 percent from the previous quarter as manufacturing slumped.
• Sugar output in Brazil this year (the world’s largest producer) will likely decline by 6.4 percent. The prospect of lower sugar output has been supportive of sugar prices that rose by nearly 40 percent in the last two months.
  

Opportunities

• Insider buybacks have arrived at H-share companies in Hong Kong. History has shown that the stock prices of those companies usually rise following the buybacks. The chart below by Morgan Stanley demonstrates this positive pattern.

• Sberbank of Russia announced the acquisition of a 51 percent stake in Austria’s Volksbanken, which excludes Romanian operations. The acquisition gives Sberbank entry into eight Eastern European markets, including the Czech Republic, Slovakia, Croatia, and Hungary. The acquisition is part of a strategy to turn Russia’s largest bank into a global bank. Turkey is another potential market for Sberbank’s expansion in the region.
• KBC of Belgium announced its intention to sell its Polish assets, which includes Kredyt Bank and Warta, the insurance company. The proceeds will be used to repay a government loan. KBC announced that it will not proceed with an initial public offering of CSOB in Czech Republic, a competitor of Komercni Banka.

Threats

• Since last April when the Chinese government began its hawkish stand on property price jumps, H-share developers have focused on the opportunity to sell houses in second- and third-tier cities. Developers who sell mainly to those cities are seeing robust sales growth. Now the Chinese government wants to close that market, too. The Government Council met this week to extend housing control policies to those cities, though it is yet to be seen if the government is serious.

• Although a strike lasted just one day in Chile at Codelco, the largest global copper producer with a 12 percent market share, the event illustrates that restructuring of the company (a likely cause of the stoppage) will not be an easy task. The management is aware that the company requires a massive investment program to maintain production levels in light of declining ore grades.

(c) US Global Investors

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