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Is the next resources boom starting?

Photo of Karl Siegling By Karl Siegling

min read

Consider some portfolio additions in the mining and energy sectors, but know the risks.

The chart below highlights the truly cyclical nature of resources and the large demand-supply imbalances that result from the huge amounts of capital needed to extract commodities. It shows the S&P/ASX 200 Resources index over 16 years, covering a resource boom, the global financial crisis and the resources bust.

Cadence presented the chart at its last AGM.

As trader and author Ed Seykota famously said in his interview for Masters of the Market: “Commodities are the purest form of trading in the world and resource companies are a leveraged version of the same trade.”

The interesting question this chart poses is: are we currently in the next resources boom?

It is 12 years since the last one and nearly nine years since that bust. The resources market is up more than 50 per cent since the index “bottomed out” at around 2,000 in January 2016.

Image of resources index chart 2000-16

Source: Cadence

Readers may remember the resources mantra of “stronger for longer” from around 2002 until 2007. Initially the story was of China growth. As the resources boom continued, the mantra evolved to “stronger forever” and included India, so the combined mantra became “Chindia, stronger forever”.

Of course, history tells us that the resources index fell by 72 per cent from top to bottom. Just as very few experts predicted the initial resources boom and the subsequent bust, so will market participants have great difficulty predicting the next boom.

One consistency with the latest resources rally is that is has taken most market participants by surprise. Just as we had convinced ourselves that the booming resources market would never end, we more recently convinced ourselves that the falling market would never end. Then, suddenly, in January and February 2016, it did.

The sectors within this index that have performed exceptionally well have been iron ore and energy, particularly coal.

Are resources gains sustainable?
The million-dollar question, of course, is are we in a new upward trend or just a longer-term secular downward trend for resources, with a brief rally? The follow-on question would be, how do we profit from resources in this environment?

Having spent significant time on this sector in the second half of calendar year 2016, evaluating and visiting companies in Perth and Queensland, including mining services companies, Cadence’s initial conclusion is “the worst of the resources bust is behind us, but the signs of a resources boom are tentative”.

That is a quote from the CEO of a medium-size mining services company in Perth and it sums up the situation well. Sharemarkets can be very efficient and the resources index has started to move upwards at the first tentative signs of a recovery.

(Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article.)

Many mining services companies have already started to react to these signs, prime examples being Monadelphous Group, Imdex, MACA, GRG International, Austin Engineering, RCR Tomlinson and Swick Mining Services.

Cadence had Monadelphous in its portfolio and started adding to the position at around $8 and again as the company started to announce improving earnings.

Resources company share prices have also started to reflect the first signs of recovery with some commodities moving much sooner and more quickly than others.

Iron ore and coal have moved significantly, assisting Rio Tinto and BHP Billiton in share price recovery, along with Fortescue Metals. Whitehaven Coal has been another stellar performer.

Many energy stocks have performed well, including Santos, Woodside Petroleum and Origin Energy. Each investor may have their personal favourites in this group or many of the other candidates not mentioned. The main theme is that these sectors have “run hard” in 2016.

Later-cycle resource stocks
What interests us now are those later-cycle companies that may be recovering later than iron ore and coal, and thus we may be purchasing at better valuations than companies that have already moved strongly.

The sector of interest at the moment is base metals and stocks such as Independence Group (in our portfolio and being added to), OZ Minerals (not in our portfolio) and Metals X’s recently spun out base metals assets (not in our portfolio). Others are Iluka Resources and Alumina (neither are in our portfolio).

Independence Group (IGO) is completing its Nova Nickel capital expenditure and has started shipping nickel. Volumes are set to grow significantly. In addition, the gold assets of Independence Group continue to perform well.

The group recently conducted a capital raising at $3.75 to pay off debt associated with the Nova project. We participated in the capital raising and saw this as a good opportunity to enter IGO again after not owning shares since 2008.

A prudent risk-management approach to resources investing
The process of selectively entering resources stock with smaller positions (1 per cent of total portfolio funds) and then adding to positions as they perform or selling them if they don’t, allows us to enter what might be the next boom on a risk-adjusted basis and to enter an uptrending market, early in the trend.

What is clear is that most market participants do not own large positions in mining and energy stocks and resources have largely been out of favour for close to nine years. Our fund has benefited from being short in resources over four years.

In calendar 2016 these short positions lost money and were the first signs to us that resources stock prices had stopped falling and were rising. Should our resources investments continue to perform we will add to these positions over time.

If commodity prices continue to recover we should start to see the recapitalisation of medium and smaller resources companies, and this in turn should lead to further investment opportunities, much like it did in the last resources boom.

With resources being such a key part of the Australian economy, it will be important in 2017 to watch the sector closely, particularly some of the later-cycle commodities, for signs of a continued recovery.

Should history prove an accurate indicator of the resources cycle, market commentators and “experts” will start to take notice once the resources index has doubled or tripled.
 

About the author

Interested in reading more investment insights from Cadence Capital’s Karl Siegling? The Cadence Investing Series is a 12-part educational series covering several topics of investing such as market psychology, fundamental analysis and technical analysis. Invaluable insights for the engaged investor.

From ASX

The 2016 ASX / Russell Investments Long-Term Investing Report is a useful resource for investors who want to know more about the long-term performance of asset classes, including Australian and international shares.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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