Rebalancing Markets Fuel Positive Sentiment for Hard Assets

Rebalancing Markets Fuel Positive Sentiment for Hard Assets VanEckRebalancing Markets Fuel Positive Sentiment for Hard Assets

3Q’16 Hard Assets Equities Strategy Review and Positioning Our hard assets equities strategy’s positions in Energy and Diversified Metals & Mining sectors were, in particular, significant contributors to positive performance. Within the Energy sector, positive performance stemmed mainly from the Oil & Gas Exploration & Production (E&P) sub-industry. The Oil & Gas Drilling sub-industry also made a useful contribution to performance during the quarter. By contrast, Oil & Gas Equipment & Services was the only energy sub-industry to detract from the strategy’s performance and its impact was relatively minimal. Other sub-industries that made positive contributions of note to performance were Copper and Coal & Consumable Fuels. During the quarter, the strategy continued to hold no position in Integrated Oil & Gas.

3Q Performance Contributors

The top performing company was major diversified mining company Glencore,1 which continued to benefit from debt reduction and overall restructuring initiatives that began in 2015. In the face of persistent skepticism from the market, Glencore has proved demonstrably that it has been able to provide a workable blueprint and subsequently execute its plan to deleverage its balance sheet and improve its cost structure. Not only has Glencore delivered (as we expected) thus far on what it said it would do, it continues to implement its debt reduction program. This has, in some instances, been in contrast with other major metal mining companies that, despite rhetoric to the contrary, have been slow to recognize the need for, or have been unsuccessful in, executing similar restructuring measures and have largely been playing ”catch up” with Glencore in the eyes of the market. Rounding out the top 5 performing positions were E&P companies, Pioneer Natural Resources,2 Parsley Energy,3 and SM Energy.4 These companies benefited from the high quality of their assets and acreages, in particular those in the Permian Basin. The final top five contributing company for the quarter was metal mining company Teck Resources5 which benefited from strengthening zinc and coal prices.

3Q Performance Detractors

Over the past three years, global demand for coking coal has been relatively solid at an annual level of around 990 million tonnes (Mt). China is one of the most important consumers in terms of setting prices, since it accounts for approximately 60%, or 590Mt, of global coking coal demand. It is followed by Japan at 69Mt, India at 49Mt, and South Korea at 40Mt. Demand from the U.S. is for approximately 21Mt per annum. In a reversal from the second quarter when gold was the strongest performing sub-industry, in the third quarter, gold was the largest detractor from Fund performance. Gold mining companies Barrick Gold,6 Goldcorp,7 and Randgold Resources8 all suffered from a consolidation in the gold price during the period, and by quarter end we had reduced our exposure to each. The two other poor performers during the quarter were E&P companies Hess,9 which had to contend with a dry hole in Guyana, and Gulfport Energy.10 Positive Market Sentiment and Demand for Commodities in 3Q Despite the continuing uncertainties in the market surrounding the U.S. presidential elections, and in the face of moderating global GDP growth, sentiment was on the positive side and demand for commodities remained remarkably resilient. As in the second quarter of the year, the most significant macroeconomic factor influencing the hard assets strategy was the extraordinary monetary accommodation extended by central banks around the world, which continues to add support for economic growth and demand for commodities.

Gold Consolidated After 2Q Rally

After an explosive first half of the year, the gold market experienced significant consolidation during the third quarter and gold mining companies suffered. On a positive note, gold mining firms overall have been bolstered by restructuring and strategic improvements and appear well positioned to withstand a short-term decline in the gold price.

Global Demand for Crude Oil Remained Strong

Global demand for crude oil and, in particular, gasoline increased once again during the quarter. U.S. gasoline demand remains at record highs and the country is now consuming approximately 10 million barrels a day. The country’s gasoline demand continues to exceed the unrefined crude oil demand of every country in the world except China. Supply disruptions with the potential to impact future production continued during the quarter including the lingering effects of attacks instigated by militant groups in Nigeria, an uncertain and confusing political situation in Libya, and a deteriorating economic and social environment in Venezuela, where production had fallen some 6% from approximately 2.35 million barrels a day (bbl/d) at the beginning of the year to approximately 2.2 million bbl/d by the end of the quarter. On a positive note, oil sands production in Canada was no longer affected by the wild fires that impeded second quarter production.

U.S. Oil Rig Count Rebounded Slightly

In the U.S., the rig count continued to rebound slightly and increase at a modest pace from previous trough levels. However, we continue to note and emphasize that any rebound remains very much incremental when compared with the nearly 1,300 rigs in the U.S. that were taken out of commission between 2014 and 2016.

Zinc and Coking Coal Excelled for Base/Industrial Metals

In the base metals space, zinc experienced further rebalancing of supply and demand. Fundamentals continued to tighten with a reduction in overall supply accompanied by solid demand (Read Zinc’s Year to Remember: A Supply-Side Story for details). Nickel markets erased losses from early in the quarter following the results of environmental mine audits in the Philippines in which three quarters of mines fell short, with 20 mines facing suspension, and an announcement by Indonesia that the ban on exports was being reconsidered. At the company level, restructuring continues. Balance sheet strengthening appears to be the primary objective with reducing operating costs a secondary focus. Additionally, we are just now starting to hear chatter from some companies about re-engaging growth projects. By the end of the quarter, the prices of metallurgical coal (an essential steel-making raw material used to produce coke which, in turn, is used in the production of steel) had climbed more than 100% since the beginning of the year. The overwhelming driver behind this price recovery has been supply. In addition to both lower seaborne and domestic supply, global inventories are also at multi-year lows.

Deal Activity Dominated the Agriculture Sector

In the agriculture sector, the quarter was marked by two major deals and the potential for further consolidation in the potash market amid oversupply. U.S. agriculture giant, Monsanto, agreed to be bought by German giant Bayer11 while Canada’s Agrium12 and PotashCorp13 of Saskatchewan agreed to merge. In grains, an ideal growing season in the U.S. lead to close to record production in both corn and soybean.

Positive Outlook for Remainder of the Year

In the fourth quarter, we see the macro drivers continuing to be central bank policy and the ramifications of the forthcoming presidential election in the U.S. Broadly speaking, commodity demand has proven to be remarkably resilient. Despite concerns about global growth there is still firm demand and healthy consumption. On the supply side, we continue to see the effects from the lack of investment and capital expenditure reductions over the past several years.

OPEC Production Decision Puts Focus on Saudi Arabia and Iran

At the very end of the quarter, OPEC (Organization of the Petroleum Exporting Countries) came to an agreement to cap production. This move appears to us to indicate that Saudi Arabia and other OPEC members have reached their threshold of pain, which appears to be roughly in the $40 to $45 price-per-barrel range. Anything below that would probably only serve to consolidate and accelerate any decisions they might make as a group which indicates that, surprisingly, there may actually be a price floor. Mainstream interpretation seems to be that the OPEC announcement is a reaction to $40 oil. Maybe it is, but we believe it could also be the excuse that Saudi Arabia has needed to allow it to force through some serious, and absolutely essential, economic restructuring. It now has the low price of oil to blame publicly.

Saudi Arabia is Worried About Oil Price Spike in Next 18 to 24 Months

We believe that the move by Saudi Arabia is a longer-term one and that, in particular, it demonstrates the country is also worried about a spike in oil prices in the next 18 to 24 months. Any such spike may: a) help Iran the most (something Saudi Arabia is not too keen on doing); b) eventually cause the price to plummet back down; and c) accelerate alternative energy use. Evidence of this can be seen in the press release issued by OPEC following its September meeting, in which it said that its objective was ”to stabilize the oil market and avoid the adverse impacts in the short- and medium-term.” We also see this move as a way for Saudi Arabia to indicate to Iran that it is happy for the country to try and ramp up production from 3.6 million to 4 million barrels a day (something Iran is struggling to do as shown in Chart A) over the next four to five years. The Saudis are fully aware that this is extremely unlikely to happen any time soon as Iran has only hit the 4 million barrels per day figure three times since 1978.

Iranian Crude Oil Production

Monthly in Barrels: 12/31/79 to 9/30/16
(Click to enlarge) Source: Bloomberg. Data as of September 30, 2016. While the focus is squarely on Saudi Arabia and Iran, among other OPEC nations, despite the political uncertainty in Libya mentioned earlier, there do appear to be some moves toward establishing some sort of unified government and we have seen the beginning of some flows of oil in the country. We continue to point out that it is easy to fall into the trap of thinking that a simple increase in the current U.S. onshore oil rig count of approximately 400 rigs can restore the supply balance. But people forget that the U.S. rig count at its high numbered close to 1,700 in 2014 and that it has declined more than 75%, or 1,300 rigs, since then. It will take a considerable increase in the current rig count to bring back any growth in production. In addition, people continue to miss the fact that conventional exploration has been abysmal (discoveries in 2015 were the lowest since 1947 as shown in Chart B), a point that was also hinted at in OPEC’s press release when it was stated that the ”Conference … noted that world oil demand remains robust, while the prospects of future supplies are being negatively impacted by deep cuts in investments and massive layoffs.”

Conventional Oil Discoveries Are in Decline

Yearly in Barrels: 1947 to 2016
(Click to enlarge) Source: Wood Mackenzie; Bloomberg. Data as of August 31, 2016.

U.S. Shale Oil Production Will Need Time to Ramp Back Up

As usual, during the quarter we made a number of trips outside the U.S. and met with many prospective and existing clients. During our visits we noted a recurrent theme of strong skepticism around the rebalancing of commodity markets and, in particular, oil. We believe that much of this has been fueled by headlines that trumpet Saudi and Russian oil production reaching all-time highs, and talk of the strength of the rebound in the oil rig count in the U.S. People seem to truly believe that shale oil is a spigot that can just be turned on and off at will, and there continues to be a misplaced belief that higher oil prices will reinvigorate shale drilling to the point where it starts to raise production and ”unbalance” the fundamentals. We do not believe this to be the case and, in our view, any increase in U.S. production must be preceded by a dramatic increase in the rig count which will require significantly higher crude prices.

POST DISCLOSURE

1 Glencore represented 4.05% of Fund net assets as of 9/30/16. 2 Pioneer Natural Resources represented 3.98% of Fund net assets as of 9/30/16. 3 Parsley Energy represented 3.92% of Fund net assets as of 9/30/16. 4 SM Energy represented 2.42% of Fund net assets as of 9/30/16. 5 Teck Resources represented 3.20% of Fund net assets as of 9/30/16. 6 Barrick Gold represented 1.48% of Fund net assets as of 9/30/16. 7 Goldcorp represented 2.29% of Fund net assets as of 9/30/16. 8 Randgold Resources represented 2.25% of Fund net assets as of 9/30/16. 9 Hess represented 2.04% of Fund net assets as of 9/30/16. 10 Gulfport Energy represented 2.05% of Fund net assets as of 9/30/16. 11 Bayer represented 0.00% of Fund net assets as of 9/30/16. 12 Agrium represented 1.84% of Fund net assets as of 9/30/16. 13 PotashCorp represented 0.00% of Fund net assets as of 9/30/16.
by Shawn Reynolds, Portfolio Manager Reynolds has more than 30 years of experience covering the energy sector. Before his career in finance, Reynolds worked as an exploration geologist and earned degrees in geology and engineering.

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Any discussion of specific securities mentioned in this post is neither an offer to sell nor a solicitation to buy these securities. This content is published in the United States for residents of specified countries. Investors are subject to securities and tax regulations within their applicable jurisdictions that are not addressed on this content. Nothing in this content should be considered a solicitation to buy or an offer to sell shares of any investment in any jurisdiction where the offer or solicitation would be unlawful under the securities laws of such jurisdiction, nor is it intended as investment, tax, financial, or legal advice. Investors should seek such professional advice for their particular situation and jurisdiction. You can obtain more specific information on VanEck strategies by visiting Investment Strategies. The views and opinions expressed are those of the author(s), but not necessarily those of VanEck, and these opinions may change at any time and from time to time. Non-VanEck proprietary information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Not intended to be a forecast of future events, a guarantee of future results or investment advice. Historical performance is not indicative of future results. Current data may differ from data quoted. Any graphs shown herein are for illustrative purposes only. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of VanEck. Please note that Van Eck Securities Corporation offers investment portfolios that invest in the asset class(es) mentioned in this post. Hard assets investments are subject to risks associated with natural resources and commodities and events related to these industries. Commodity investments may be subject to the risks associated with its investments in commodity-linked derivatives, risks of investing in a wholly owned subsidiary, risk of tracking error, risks of aggressive investment techniques, leverage risk, derivatives risks, counterparty risks, non-diversification risk, credit risk, concentration risk and market risk. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of Van Eck Securities Corporation.

Metals to perform on weaker USD and rising rates

Metals to perform on weaker USD and rising rates

Commodity Monthly Monitor – Metals to perform on weaker USD and rising rates

Your reference guide to commodity markets. Includes the latest outlook for each commodity sector and major developments for individual commodities.

Summary

Sentiment toward industrial metals took a leap forward.

The price of the gold driven higher on the lack of follow-up from the Fed.

Oil major producers meeting postponed but not cancelled.

Majority of agricultural commodities post strong gains.

Click here to download the complete report (.pdf)

Summary

The recent decision to keep rates on hold by the US Federal Reserve (Fed) has saved the market from shock as the Fed Fund Futures market indicated only a very small chance of the central bank making a move. The Fed’s so-called “dot-plots” now indicate that the policy makers only expect to raise rates twice this year (down from four) and the market has shifted it expectations out to September for the next move. Recent economic data, particularly strong wage growth (accounting for the February calendar quirk) and payroll data justify more hikes and sooner. The US dollar is unlikely to respond with strength when rate hikes occur as the US dollar is perceived to be the most over-crowded trade according to recent fund manager surveys. Anticipation of the rate hike has been pushing up the USD for many years. Furthermore, in rate rising environments, contrary to popular belief, the USD dollar typically sells-off. This we believe is due to investors attempting to gauge if the first rate hike was correctly timed, as it takes a while for the economic data to roll-in to make a judgement and therefore markets tend to be in a state of limbo/fear. In this environment of a weaker USD and rising interest rates, improving economic fundamentals are likely to be beneficial for many cyclically exposed commodities. Industrial metals, which are likely to be in a supply deficit this year, trade well below marginal cost. This subsector looks to be forming a technical floor whilst demand in China has remained surprisingly resilient in recent months.

Sentiment toward industrial metals took a leap forward, with speculative positioning and prices rising across the complex. Investors appear to be paying heed to firmer fundamentals, with supply deficits expected for zinc, copper and nickel this year. US dollar depreciation and a loose policy setting should help the industrial metals rally continue.

The price of the gold driven higher on the lack of follow-up from the Fed after it embarked on a rate tightening cycle in December 2015. Investors fear that the US central bank is committing a policy error after it downgraded the number of times it expects to raise rates this year. Core inflation remains robust and real interest rates remain low, a recipe for strong gold prices. A loose policy setting helps the more industrial precious metals like platinum and palladium as auto sales will be supported.

Oil major producers meeting postponed but not cancelled. A 40% rally in oil prices indicates that expectations ahead of the original meeting were very positive. Despite the meeting being postponed to mid-April and Iran refusing to participate until its production is back to pre-sanction levels, crude oil production and rig count in the US remain at their lowest since end of 2014, lending support to oil prices.

Majority of agricultural commodities post strong gains with the exception of cotton. Reduced supply from Brazil and India supported sugar prices higher. Weak cotton imports into China dented the demand outlook for cotton sending prices lower.

(Click to enlarge)

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Time to revisit the commodity market

Time to revisit the commodity market

Recent price corrections bring opportunities Time to revisit the commodity market

Most commodities are trading close or below their marginal cost of production, with platinum, nickel, oil and grains the most striking examples. While in the short-term companies and mines can continue to produce even if prices are trading below marginal costs, it is not sustainable in the long term.

Unprofitable operations will have to be shut down or downsized, reducing production to contain costs. We expect the recent correction in commodity prices to be short-lived and believe commodities are attractively valued at current levels. Most of the factors that have hit commodity prices over the past month are temporary, and we believe the price correction creates tremendous opportunities for medium to longterm investors.

The state of play

Concerns about European and Chinese growth, markets digesting higher US rate expectations and US dollar strength, bumper grain crops, and adjustments to oil supply and demand expectations have been the main drivers of the poor commodity performance in 2014 (Figure 1). We believe a number of the increased supply price drivers will be transitory and that the recent period of softer global growth will prove short-lived.

US dollar strength should not hinder a price rebound as dollar strength is being driven by expectations of improving US demand. As China eases policy to boost growth, the US economy recovers and years of gradually tightening capacity start pushing up inflation, commodities should recover from current beaten down levels.

Metals

Investors focussing on global risks prompted a volatility surge across asset classes, which resulted in a sell-off across cyclical assets. Global equity benchmarks led the correction, prompting prices of several metals to fall below their marginal cost of production. Prior to the price weakness in September, industrial metals had staged a striking recovery in 2014, with a 6.4% rise in the first eight months of the year. While we believe most metals are attractively priced at current levels, we think platinum, palladium and nickel offer interesting opportunities at the moment.

Platinum and palladium markets were plagued by a 5-month long strike in South Africa at the beginning of the year that took over 1moz of platinum and 700koz of palladium off the market (equivalent to 14% of 2013 total production of platinum and 8% of 2013 total global production of palladium). As palladium is extracted as a by-product of platinum in South Africa and of nickel in Russia, it will only be produced as long as it is convenient to extract platinum and nickel, respectively. At the moment, platinum is trading 9.3% below its marginal cost of production (Figure 2) while nickel is around 18% below its marginal cost of production (Figure 3). Indonesia is the biggest nickel producer with 21% of global supply.

The metal ore export ban that began in 2014 remains in place and Chinese producers of nickel pig iron, a lower-quality substitute for refined nickel, have since turned to the Philippines, the 2nd largest global producer with 14% of supply, to keep their industry well supplied.

However, seasonal rains are set to disrupt nickel mining and seaborne transportation of the metal in the Philippines. Disrupted production should start to reduce elevated stockpiles, in turn buoying prices.

While the aluminium price has also fallen below its marginal cost of production and the industry has undertaken considerable steps towards a more balanced market, we believe its price is not yet ripe for a recovery. Despite recent efforts to discipline aluminium supply and the market ex-China being in a deficit, we believe further cuts will be needed to compensate for the build-up in capacity coming from China and for prices to be pushed substantially higher.

Agriculture

While wheat, soybeans and corn are all trading at multi-year lows on the back of expectations for record crops this season, Arabica coffee has rallied over 70% since the beginning of the year on supply concerns.

With grains priced for perfect growing conditions, any small setback in weather in major producing countries or an escalation in trade restrictions in Russia or Ukraine could drive a price rally. The whole grains sector is trading below total cost of production (Figure 4), and because of the seasonality of production, there is likely to be changes in what and how much is grown in coming seasons because sustained weak prices could prompt producers to switch to more profitable crops or use of their land. A decrease in next year’s expected crop should lead to a drawdown of stockpiles and help support prices, which have just begun to stage a rebound.

While the International Coffee Organisation envisages only a slight recovery for coffee in the 2014/2015 season, as a devastating leaf rust disease is likely to prompt switching to other crops, we believe the recent rally was excessive as there is no immediate shortage of coffee and prices remain well above marginal costs of production (Figure 4).

Energy

Weak global demand for oil and distillates combined with ample global supply of crude sent both Brent and WTI prices to the lowest since November 2010 for Brent and June 2012 for WTI. The geopolitical risks in some OPEC countries and the sanctions on Russia have so far very limited impact on global oil supply and failed to provide support to oil prices against market expectations. In the meantime, the OPEC members entered a price war in October, selling their oil at a discount in order to increase market share in Asia, putting further downward pressure on both oil benchmarks. The key to greater support in oil prices lies with OPEC. With oil prices hovering below most major oil producers’ budget break-even levels (Figure 5), we believe it is a matter of time before OPEC start to reduce supply. While the IEA has indicated that most oil produced is still economic at US$80/barrel, the majority of OPEC countries are estimated to require oil prices of at least US$90-US$100/barrel to balance their government budgets. While different oil fields have different breakeven costs, it is generally alleged that US shale oil, which accounts for most of oil production growth over the past few years, has a breakeven price ofUS$60-US$80 (Figure 6).

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The information contained in this communication is for your general information only and is neither an offer for sale nor a solicitation of an offer to buy securities. This communication should not be used as the basis for any investment decision. Historical performance is not an indication of future performance and any investments may go down in value.

This communication may contain independent market commentary prepared by ETFS UK based on publicly available information. Although ETFS UK endeavours to ensure the accuracy of the content in this communication, ETFS UK does not warrant or guarantee its accuracy or correctness. Any third party data providers used to source the information in this communication make no warranties or representation of any kind relating to such data. Where ETFS UK has expressed its own opinions related to product or market activity, these views may change. Neither ETFS UK, nor any affiliate, nor any of their respective, officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this communication or its contents.

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