- Portfolio Manager
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Key points
- Natural resource stocks feature improving fundamentals and attractive valuations.
- At the same time, higher interest rates and tight inventories provide a springboard for underlying commodities.
- Together, these conditions may present a compelling entry point and an attractive structural opportunity for investors.
We’ve seen it before. Commodities rally in response to a supply shock or a strong economy, natural resources stocks capitalize on high commodity prices, then demand softens, and these cyclical assets mean revert. If you can’t get the timing correct, it’s best to stay out of the way, right? Maybe not this time, as several market drivers appear to be setting up a structural total return opportunity for commodity investors.
As the global economy has slowed, near-term demand forecasts for oil, natural gas, and industrial metals have come down and Russian supply disruptions have been less impactful than feared, so it hasn’t been surprising to see commodity spot prices fall over the past year. On the surface, this all fits an expected cyclical pattern. What it misses, however, is an entirely different total return setup for these assets than what we’ve seen for nearly two decades. Natural resource stocks are exhibiting improved corporate fundamentals at cheap valuations. Meanwhile, higher interest rates and tight inventories create a total return opportunity for the underlying commodities that is, in my view, far more compelling than it has been in some time.
Natural resources: Focus on shareholder returns
Throughout the last commodity bear market in the late 2010s, the message from shareholders to energy and metals producers was consistent: Stop spending pro-cyclically, and instead return excess cash to the providers of capital. Producers did exactly that last year, restraining capex during a period of higher commodity prices. In fact, increases in absolute capex levels were often due to producers’ own cost inflation (higher energy and metals prices affect the energy and metals industries, too).
This mindset shift has led management teams to focus less on volume growth and more on shareholder returns. Companies have paid down debt to clean up their balance sheets and have returned capital to shareholders through dividends and stock buybacks. Take, for example, US exploration and production (E&P) companies, which have historically been the epitome of shareholder-unfriendly behavior. Over the last 12 months, dividend yields and net buybacks have amounted to 12% of their market capitalization (Figure 1). What’s more, over the past five years, capital returns have averaged 5% per annum, a notable improvement over 0% for the prior 23 years.
Figure 1
Low equity valuations have enabled these exceptionally high dividend yields. For the period ending June 2023, natural resource equities traded at 10 times trailing 12-month earnings, versus 24 times for the S&P 500. Even accounting for inherent cyclicality, natural resources trade at 11 times their long-term trend earnings, versus 26 times for the S&P 500. This level has been in the bottom fifth percentile for the last 50 years, reflecting historically cheap valuations that do not match the more shareholder-friendly behavior exhibited. Those buybacks and dividends, along with the risk reduction from cleaner balance sheets, have so far allowed the sector to be much more resilient during this cyclical downturn than it has been in the past. While crude oil is down 31% for the 12 months ending June 30, for example, the S&P 500 Exploration & Production Index is up 11%.
Commodities: Improving collateral returns and roll yield
Despite the usual cyclical volatility in commodity spot prices, the asset class as a whole has seen a similar improvement in underlying return drivers over the past year. Commodity futures have three sources of return: 1) changes in spot prices, 2) collateral returns (typically the yield on US Treasury bills), and 3) roll yield (cost of carry). While spot prices receive all the headlines, it is the other two return sources that enable the asset class to compound over time.
Because short-term US Treasuries are used for collateral in futures contracts, commodities is one of the few asset classes that directly benefits from higher interest rates. During the last decade, an era of historically low (near-zero) rates, commodities earned a compound return of just 0.6% from collateral. Thanks to recent rate hikes, however, commodities are now earning 5.5% in collateral returns alone.
Roll yields were also unusually negative during the last decade, driven in part by high inventories that pressured near-term spot prices relative to future prices. Today, despite the cyclical weakness in demand, oil, gas, and metals inventories remain at or below historical averages. Producers’ capital discipline has helped, as have higher interest rates, which disincentivize inventory stockpiling. As a result, commodity roll yields have been positive since mid-2021 and contributed 3% to the Bloomberg Commodity Index over the 12-month period ending 30 June 2023.
As the dark blue line in Figure 2 shows, the 12-month contribution to the Bloomberg Commodity Index total return from collateral return and roll yield remains near its highest level since 2001. Meanwhile, the light blue line shows the cyclical weakness in commodity spot prices, which have fallen significantly to the lowest level in eight years. Improvements in collateral return and roll yield have helped cushion investors during this recent downturn, highlighting the opportunity for the asset class to again offer positive compounded total returns, even in a modest commodity spot-price environment.
Figure 2
Conclusion
There are many reasons to hold natural resources equities and commodities, most notably for the resilience they typically exhibit during inflation-inspired market sell-offs like we saw in 2022, when broader equities and fixed income assets tend to underperform. Today, a weakening macroeconomic backdrop, disappointing demand from China, and Russia’s continued ability to export oil and gas have all led to a looser supply/demand environment. We don’t know exactly when this downturn will bottom, and it may be tempting to ignore this area of the market to steer clear of its cyclicality. But when we look more closely at the return drivers for natural resources and commodities, the total return setup continues to look greatly improved relative to the 2010s. Current conditions may present a compelling entry point and an attractive structural opportunity for investors.
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Brett Hinds
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