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Commodities enter a new phase

Could reduced supply and greater demand make natural resources more interesting to investors? Tom Holl, co-manager of BlackRock's Energy and Resources Income Trust, assesses the sector.

What were the drivers of the recovery in the sector and will it continue?

Following a number of challenging years, 2016 was an improvement for the natural resources sector, driven by improved performance in both the mining and energy sectors. Coking coal returned 227% for the year ending December 2016, while iron ore returned 83%i.

Oil prices have come under pressure in 2017, however, while a number of the mined commodities have experienced flat, or increasing, prices. We expect the sector’s performance to remain volatile but see the outlook as positive. The wider economic environment points to a stable to improving demand picture, while the underinvestment of recent years is constraining the supply side of the equation for many commoditiesii.

Please remember that past performance is not a guide to future performance. This should also not be relied upon as a forecast or investment advice, nor as a recommendation to adopt any investment strategy.

Oil prices have been weak this year. What’s your view on this?

We expect oil prices to move upwards following reductions in global inventories and as meaningful declines emerge in non-OPEC (excluding the US) oil production. OPEC is an organisation of 14 oil-exporting countries that between them own approximately three-quarters of the planet’s known oil reservesiii. In this environment, we continue to believe that exploration and production companies with low-cost assets and strong balance sheets will prove to be positioned the most advantageously.

We see OPEC’s production restraint as helpful in accelerating the rebalancing of the oil market and we continue to expect producers to adhere to the OPEC guidelines more closely than they have in historic cuts; so far, their compliance has been running at more than 80%.

While we expect US shale production to grow, our view for some time has been that this will be needed to offset the declines we expect to see in non-OPEC, ex-US production over the medium term (non-OPEC, ex-US, production accounts for more than half of total global supply and we have seen dramatic under-investment in this segment of the market since the oil price crash in mid-2014iv).

We believe at some point the conversation will switch to global supply needing US shale production growth to meet growing global demand. However, we expect significant volatility as increased US shale production could arrive before the declines in non-OPEC, ex-US production, which could lead to it being harder to buy and sell shares for a time and as such, we are maintaining our preference for holding stocks we believe will provide consistently good returns in the BlackRock Energy and Resources Income Trust portfolio.

Reflation is expected to be a key theme this year. How will this affect commodities?

We started to see reflationary trends emerge in the third quarter of 2016. The term ‘reflation’ is used to describe the first phase of economic recovery after a period of contraction. Reflationary policies can include increasing government spending, reducing taxes, changing the money supply and lowering interest rates.

If you look back over the past 40 years, commodities as an asset class has typically performed well in environments of higher inflationv. So if history repeats itself and we do see a rise in inflation over the next few years, then that is typically a good environment for commodities compared with other asset classesvi, although it must be stressed that past performance is not a guarantee of future returns.

What are your expectations for China, which is so important in determining the outlook for the commodities market?

The past three to four years have seen a slowdown in the rate of China’s economic growth, but we’re still talking about a country that is growing at more than 6.5% a yearvii, which is substantially higher than many other countries. What has changed over the past few years has been the consumption of commodities relative to that Chinese economic growth. We used to think about commodity demand growing at a multiple of Chinese gross domestic product (GDP) growth, GDP being a quarterly measure of a country’s economy. Now, commodities demand is growing at less than China’s GDP growth but it’s a change that has been reflected in commodity share prices.

Perceptions with regard to China tend to vary from overly positive to overly negative. But over the longer term things have been a lot more stable and less volatile than market commentaries might suggest. So we’re relatively comfortable with the trajectory that China is on at the moment.

However, please remember that past performance is not a guide to future performance and the value of an investment and the income from it can fall as well as rise. Furthermore, these statements should not be relied upon as a forecast or investment advice – nor as a recommendation to adopt any investment strategy. Also, these opinions are as at July 2017 and subject to change as economic conditions develop.

Why does the sector look interesting to you?

The natural resources sector is cyclical in nature and after several years of negative growth we believe we are now in the early stages of an improvement in performance. We expect returns for natural resources companies to move towards the long-term averages and historically the shares have performed strongly in such environments.

In mining, we are optimistic about the levels of free cash flow – the amount of cash a company has left over once it has paid all expenses such as buildings and equipment – relative to the companies’ total worth (or enterprise value). Looking at the relationship between free cash flow and enterprise value allows us to measure a company’s success.  China remains the key risk for mining but while we recognise there are structural issues there, we believe the Chinese administration has shown itself willing and able to step in with stimulus and provide economic support if necessary.

Please note that these statements should not be relied upon as a forecast or investment advice – nor as a recommendation to adopt any investment strategy. Furthermore, as noted previously, any opinions are as at July 2017 and subject to change as economic conditions develop. Mining shares typically experience above average volatility when compared with other investments.

What do you see as the key risks for investing in the natural resources sector?

The first risk is that commodity prices fall significantly. That could happen if we were to see a major business fail or if Chinese growth dropped off suddenly. Alternatively, on the oil side, if the OPEC deal doesn’t hold we could see a drop in the oil price. Another risk would be if there were a significant change in attitude towards capital expenditure by commodities companies. But it’s our belief that there is sufficient pressure to stay disciplined and that it would be a threat to companies’ credit rating if they deviated from that path.

The outlook for the natural resources sector has improved over the past year. To find out what the BlackRock Energy and Resources Income Trust has to offer a diversified portfolio, Click here.


i Trading Economics and Focus Economics, July 2017
https://tradingeconomics.com/commodity/iron-ore
http://www.focus-economics.com/commodities/energy/coking-coal
ii Credit Suisse energy analysis, Dec 16. Jefferies mining analysis, December 2016
iii http://www.opec.org/opec_web/en/publications/338.htm
iv International Energy Agency (IEA) May 2017 http://www.iea.org/newsroom/news/2017/may/omr-decision-time.html
vDatastream, 1970 – 2016. Global equities represented by the MSCI World Index, US equities by the S&P 500 Index, global bonds by the BofA ML Global Government Bond Index, US bonds by the US benchmark 10 Year Datastream Government Bond Index, and real estate by the US S&P/Case-Shiller National Home Price Index.
vi Trading Economics, March 2017 (http://www.tradingeconomics.com/china/gdp-growth-annual)

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