Physical Commodity Prices Continue to Slide
The 5-year commodity bear market accelerated in 2015. The prices of virtually all commodities (soft or hard) saw double-digit declines. The below chart shows 3 broad-based commodity price measures: Bloomberg Commodity, UBS Bloomberg CMCI, and Reuters/Jefferies CRB. Note how they are all off by ~50% in the past 5 years.
There were a few specific commodities that had remarkably bad years. The most newsworthy of course was oil - with both Brent and WTI seeing a roughly 45% drop in 2015. The prices of natural gas and heating oil saw similarly collapses, which is unsurprising considering their high correlation to oil.
Base metals were mixed - with nickel experiencing a particularly negative 12 months. Copper prices slid close to 25% in 2015; supply/demand dynamics indicate that there could be more pain ahead for the red metal. Zinc saw a similar decline but, conversely, global supply/demand dynamics look very positive for the metal.
Precious metals were also mixed - gold and silver held up relatively well, while the PGMs significantly underperformed. Interestingly, the more the metal was linked to industrial consumption (~10% for gold, ~60% for silver, ~90% for PGMs), the worse it did.
Soft commodities (referring generally to "what we eat", plus some other useful commodities that are grown such as cotton or timber) performed significantly better than metals or hydrocarbons. That said, it was still a painful year for growers- the U.S. Department of Agriculture estimates that "net farm income probably tumbled in 2015 to a 13-year low of $55.9 billion, down 55 percent from a record $123.3 billion in 2013."
Below you will find a breakdown of 2015 price performance per major commodity.
Needless to say, the prices of nearly all commodities across the board are plunging towards (and in some cases below) their respective marginal costs of production. This is what happens on a cyclical basis in this industry - where prices very rarely stay constant for long periods of time. Jeremy Grantham, one of my favorite forecasters, elaborated on this phenomenon in a recent investor letter:
"Mr. Market for commodities is a very wild dude indeed. Prices can move between the marginal cost of providing the cheapest next unit, in a glut, to whatever the most desperate marginal user is willing to pay in a shortage. There is no moral equivalency to that in the stock market. Stock experts may say "greed and fear" (or greed and outright panic), and it's true that these impulses have impressively influenced the stock market on occasion, but these passions can also apply to commodities, exacerbating their unique sensitivities to imbalances in supply and demand. Commodities can also involve storage of the asset and attempts to corner the market - rather archaic these days in stocks. Most critically, politics, both local and global, can play a much bigger role in commodities, especially oil, than for stocks as we are seeing once again."
I expect commodity prices to recover over the next 1-4 years - with different subsets recovering at different times. Uranium and precious metals in particular have suffered the longest bear markets in terms of duration - one would expect them to move soonest. Conversely, oil and natural gas have seen the brunt of their decline only within the past 18 months or so. These markets might take longer to work through supply/demand imbalances.
When prices recover, and there is no doubt that they will recover, it will happen for the following two reasons:
(1) increased demand, as today you can buy 2x more "stuff" for the same amount of money versus 2011
(2) decreased supply, as more than 50% of producers are underwater at current prices for many of these commodities
Given the dynamics of this particular bear market (slowing global economic growth, high debt levels amongst many of the world's largest producers, the large number of marginal mines that were brought online in the preceding bull market, etc), it is likely that supply destruction will be the main catalyst for the next recovery in commodity prices. That said, there are still some bright areas of demand growth - one example is the continued renewable + nuclear boom, which I'll be discussing later on in this Market Outlook.
The Junior Resource Market At Large Is In Terrible Shape
In light of the above information, it is unsurprising that 2015 was an ugly year for junior resource companies - with the TSX Venture Exchange falling another 20%+ percent (see chart below). As a quick refresher, junior companies can be thought of as "pre-revenue start ups" that are either exploring or developing a mineral property that they hope can become a cash-producing asset. Characteristically these companies will have (A) a smaller working capital position and (B) a high burn rate, as exploring/developing is extremely capital intensive. Juniors can absolutely thrive in an environment of rising commodity prices but, when markets turn and funding dries up, things get ugly for everyone across the space. Even the highest quality companies are not spared the share price carnage; that is why there is always opportunity when the going gets tough.
Working capital is the lifeblood of the junior resource industry. Properly conducted mineral exploration/development is expensive, plus management has to be paid and the lights have to be kept on. That is why the overall state of the junior market is so bleak right now. As you can see in the below chart (courtesy of John Kaiser), roughly 70% of TSXV-listed companies have a working capital position below $200k CAD.
This tells me that at least 70% of the industry is merely treading water - paying management salaries and other G&A expenses, but creating no value whatsoever for shareholders. Investors should not touch these companies. This is also the reason why TSXV index funds are never smart investments.
All this said, there are exceptions where the baby is being thrown out with the bathwater. There are a select few companies that DO have sufficient working capital to continue advancing their projects. For some context, of our 18 current holdings, none have a working capital balance below $200k CAD, and only three have a working capital balance of less than $2m CAD.
These companies can enjoy the following benefits of exploring/developing in a bear market: (1) talent, equipment, and even fuel is very cheap right now, (2) high quality properties can be acquired for pennies on the dollar, and (3) successful stories stand out as there is much less "noise". In these environments, it is a delicate balancing act between making progress and minimizing share dilution. Those that are successful, however, will be amongst the biggest winners of the next bull market.
I found the above chart (provided by Exeter Resources) to be very informative. There is of course some discrepancy on when past bear markets ended and new bull markets began (as an example, Rick Rule considers 1982-1992 to be a continuous bear market; the chart below breaks it into two distinct ones.) Semantics aside, this current down cycle has clearly been one of the steepest and possibly the longest lasting that we've seen in the past 3 decades.
This will probably last for another 12-24 months. There are still a substantial number of zombie companies that need to be purged, and also no sign of a broad based rise in physical commodity prices in the near term. That said, we can take comfort in the fact that the severity/duration of this current bear market implies the eventual bull market will be both powerful and sustained.
Booming Renewable Energy Investment Despite Plunging Hydrocarbon Prices
Sources of renewable energy include solar energy, wind energy, hydropower, geothermal energy, and biomass energy. One trait shared by all of these processes is that no CO2 is emitted during power generation. I personally like to lump nuclear power into this category, as nuclear generation also emits zero CO2 and the fates of the nuclear/renewable industries are very much intertwined. Just look to China as an anecdote - where the government is trying tremendously hard to limit the burning of coal, while ramping up investments in both nuclear and renewables dramatically. Many of the figures you will see below exclude nuclear investment, but keep in mind that nuclear and renewables are highly correlated for the time being.
Historically, there has been a strong inverse relationship between the price of oil and the rate of renewable energy investment globally. Despite the fact that less than 5% of the world's electricity is derived from oil, this makes sense considering that natural gas and coal (which collectively generate ~60% of the world's electricity) are highly correlated to the price of oil. Below you will find 5-year charts for all three of these hydrocarbons. Note that each has seen a 40%+ drop over this period.
WTI Crude Oil
Despite the plunging prices of hydrocarbons, this time around we have not seen a corresponding decline in clean energy investment. In fact, global clean energy spending hit a record in 2015 with $329 billion deployed over the course of the year. The chart below demonstrates how spending on renewables has held up in this low-priced hydrocarbon environment.
This divergence from the historical norm highlights 2 different phenomenona: (1) the rapidly improving cost-competitiveness of wind/solar energy and (2) the crackdown on coal power generation by national governments.
Regarding the first point, wind and solar are the two most significant forms of renewable energy - with roughly 50% of renewable spending falling into one of these two categories. McKinsey recently described the dramatic increases in efficiency we are seeing with new renewable installations:
"In 2011, when annual global investment in renewables peaked at $279 billion, 70 gigawatts were installed. In 2014, almost 40 percent more (95 gigawatts) was installed, though investment was slightly lower, at $270 billion. In that comparison lies the most important reason that renewables have held their own, and then some, even as the oil price fell so drastically. To put it simply, renewables are getting cheaper all the time. Moreover, most regulatory supports, such as portfolio standards, tax credits, and feed-in tariffs, remain in place. These do protect the sector to some degree, but the larger story is that of fast-increasing competitiveness."
The below chart (courtesy of the Economist) tells the same story from a longer-term perspective. Note the substantial decrease in price that we've seen in just the last five years!
Interestingly, it is widely accepted by experts that on a global basis solar energy is now more competitive than wind. This was not the case ten years ago. According to the Economist:
"Wind used to be the cheapest, but solar is now overtaking it in most markets. That trend will continue. Almost any external surface can generate solar electricity, and costs are plummeting (not just for the silicon wafers, but also for installation, electronics and storage needed to make the system work). Wind energy is getting cheaper too, with taller windmills erected more cheaply-but the potential gains are less dramatic."
Let's move on to the second phenomenon. The crackdown on coal is harder to quantify, but the signs are everywhere. I've provided below three examples from 2015:
1. With the Paris agreement in December, the entire world (all 195 countries) agreed to surprisingly ambitious CO2 targets. This is massive news for the renewable and nuclear industries - with the New York Times stating that "the deal could be viewed as a signal to global financial and energy markets, triggering a fundamental shift away from investment in coal, oil and gas as primary energy sources toward zero-carbon energy sources like wind, solar and nuclear power."
2. In the United States, just within the past few weeks, the Obama administration placed a moratorium on new coal leases on federal land. This news was cheered by the renewable/nuclear lobbies, while decried by those involved with fossil fuels. Could the same thing happen to federal oil and natural gas leases at some point?
3. The daily pollution seen in cities like Beijing and New Delhi, though tragic, is fantastic PR material for proponents of renewable energy (and of course investors in renewable energy or its material inputs). This is both a political embarrassment and national health worry that has the full attention of the respective national governments. The spike in renewable expenditures seen in both China and India over the past 5 years is a direct result of this very visible problem.
As a final perspective, below you will find a breakdown of global clean tech spending in 2015. It is important to note that it was only in 2013 when China passed Europe as the global leader. Look at the disparity now.
Renewable investment grew by 23% YOY in India, and 17% in China (BNEF). These are massive numbers and there is no sign of an imminent slowdown for either of these players.
These macro trends are undeniably good news for the Partnership. We love "clean energy metals", which are basically the materials that make renewable/nuclear power generation possible. In fact, over 40% of our weighted portfolio is exposed to these materials. More specifically, we own companies focused on the following:
· Uranium, the key nuclear power input
· Scandium, an energy efficiency metal + irreplaceable component of solid oxide fuel cells
· Silver, a key material in photovoltaic solar cells
· Lithium, a key input into the lithium-ion battery
· PGMs, a key input into catalytic converters
The demand-side boom outlined above has yet to be reflected in the prices of these metals. I anticipate that to change dramatically in the medium to long term; 17% YOY growth from the world's largest player in clean energy investment is just too large to ignore!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.