Don’t get precious about resources

According to investing wisdom, the trouble with commodities is that suppliers are so good at adjusting to demand that the price never stays high for long. In other words, every bull market in commodities carries the seeds of its own destruction. Only in oil have producers been able to control supply efficiently enough, through a cartel, to prop up prices.

That may be so, but many analysts and fund managers take the view that the present bull run still has powerful legs. Over the five years since February 2000 and the collapse in stock prices, the funds in the Standard & Poor’s Commodity & Natural Resources sector of UK registered funds have returned an average of more than 100%. Over three years they have returned an average of 68.8% and they remain in positive territory, returning an average of 8.8%, over the last three months to mid-February.

But while resources funds, particularly those investing in energy stocks, continue to do well, funds in the S&P Gold & Precious Metals sector have disappointed. Although over the long term, average returns have been excellent (117.3% over five years), volatility is high (9.4 against 6.7 for the MSCI World Metals & Mining index over three years). Over three months the average fund in the sector is down more than 11%. And over one year, a fall of 4.2% substantially underperforms the World Metals & Mining index, which returned 25%.

So why are precious metals funds doing relatively badly at a time when prices are rising? Simply, the price of base metals is rising even faster.

Uranium, iron ore and coking coals are in much higher demand, especially from China. “Investors will not buy gold if they can get iron ore,” says S&P senior analyst Alison Cratchley. “Iron ore producers are in a particularly strong negotiating position with steel makers. There is some debate at present about the extent to which suppliers can force big price increases on to steelmakers, but the Brazilian iron ore producer CVRD, which is probably the biggest in the world, has persuaded Japan’s steelmakers to pay over 70% more – and had been asking for a 90% increase.”

Another factor is the dollar. “Lately, the dollar has rallied quite unexpectedly and this, too, has affected gold and precious metals,” says Cratchley. She agrees with the World Gold Council that if dollar weakness generally prevails, gold could hit $500 an ounce this year, especially if mining output continues to fall short of demand. But a more general dollar recovery could hold the price below $400.

Similarly, a falling dollar will maintain upward pressure on commodity prices overall. There are plenty of good reasons to think that the Commodity & Natural Resources sector will deliver strong returns again in 2005. Graham Birch, who manages seven resources funds for Merrill Lynch, lists continuing geopolitical instability, the continued growth of China – even though it is slowing at present – and low interest rates as giving support to the sector.

He expects oil prices to stay relatively high, and is alert to renewed interest in nuclear power and, therefore, uranium production. Renewable or green energy sources are also attracting Birch’s attention. He expects the cost of power generation from wind and geothermal energy or natural gas to fall in 2005 to a cost much more competitive with nuclear or coal-based energy. Furthermore, Birch sees new technologies, such as fuel cell development, on the brink of becoming commercially viable. He will also be watching keenly the development of global carbon emissions trading. The EU emissions trading scheme, which began on January 1, is predicted to be worth about E16bn (£11bn) by 2010. Analysts from Point Carbon expect the figure to be nearer E34bn.

David Whitten at First State Investments, who, like Birch, trained as a geologist, is slightly less upbeat on the outlook for resources, pointing out that all the Organisation for Economic Co-operation and Development’s indicators point to slowing global growth, which could spell a narrowing supply/demand gap.

On the other hand, there is no evidence of excess capacity around the world. This, plus the fact that exploration activity is low and greenfield developments minimal, supports firm commodity prices.

Whitten, who runs the First State Global Resources fund, has continued to hold an overweight position in the energy sector and the major diversifieds, such as CVRD, BHP Billiton and Rio Tinto. He is focusing on low-cost producers with quality assets, strong management and rising production.

Cratchley points out that an investor’s success will depend on picking the right fund. Funds in the Gold & Precious Metals subsector will, to a large extent, remain a hostage to the dollar’s fortunes, but otherwise, the continued success of resources funds will depend on their individual mandates as well as the manager’s stockpicking ability. Energy funds continue to do particularly well.

Volatility of returns, though, tends to make all resources funds risky. Over the short term at least some of this volatility can be blamed on profit-taking in the sector, but over three years, volatility still ranges from 5.0 for ABN Amro Resources fund (average volatility Commodity & Natural Resources 5.8) to 9.9 for the smallest of the gold and precious metals funds, SGAM Fund Equity Gold Mines (average volatility Gold & Precious Metals 9.4). However, against this backdrop of volatility there have been some impressive returns, with top performers in each sector over the same period yielding returns of 158.1% (JPMF Natural Resources) and 59.8% (Merrill Lynch Gold & General).

There continues to be some disparity of returns in the shorter term. For example, while ABN Amro Resources has grown 12.1% in the past three months, Merrill Lynch IIF World Mining returned less than half that (5.9%). The average fund has also underperformed the FTSE All-World Resources index over 12 months (23.1% against 37.2% for the index) and over the past three months (8.8% against 10.5% for the index).

Vice-president, global fund data operations at Standard & Poor’s