Commodity volatility: which stocks should you hold?

It’s no secret that an investor rotation out of resource stocks – increasingly exposed to commodity price weakness – and into under-valued industrials, financials and US/Asian assets has been gathering momentum for the last few months. The penny has finally dropped that the Small Resources Index – which grew 47 per cent in the six months to 31 December – can’t keep plundering forward at such a rapid clip, without anything giving way.

Up until recently, many investors were unperturbed by itinerant weakness in commodity prices, especially given the levels they’re trading at relative to historical averages. But what’s fuelled an outbreak of heightened risk-aversion was the severity of the recent savage commodity sell-off – the biggest experienced since 1987.

Contributing to the drop in the Small Resources Index so far this calendar year was underlying weakness in copper, gold, silver and crude oil prices. Analysts attribute recent commodity market falls to disappointingly weak US economic data, mounting fear over monetary tightening in China/India, and concerns over Europe’s recovery. Notable amongst recent falls were silver which recently experienced its biggest weekly drop since 1983 – 20 per cent; and oil which fell 10 per cent – its biggest tumble since September 2008.

Some commodities may look technically oversold, but there’s further weakness in store, with copper – an indicator of share market movement – attracting most attention since the COMEX futures broke the technical support of 410 early May. Also fuelling fears that commodities could continue falling were recent warnings from both BHP Billiton and Rio Tinto’s respective chairs that a slowdown in global commodity demand means record prices are unsustainable. Despite strong demand from China and India, iron ore, like copper is also expected to fall from record highs.

As a result, there’s mounting fear that commodities prices may continue bouncing closer to historical averages, and a lot sooner than originally envisaged. With commodities still well over-priced, Chris Stott research head at a Wilson Asset Management expects further price weakness both across the board, and notably within the ‘bulks’ like coal and iron ore. “Recent commodity price falls suggest that a lot of ‘hot speculative money’ is now rapidly leaving the sector,” says Stott.

While no resource stocks will be immune to further near-term share price weakness, Stott expects the large caps to fare better than junior miners that recently ran-up a lot harder. He also expects any junior miner IPOs that do manage to get away within prevailing market conditions to struggle to deliver the rapid share price appreciation enjoyed by their recent counterparts.

Given the severity of recent commodity shocks, John Young analyst with Wilson HTM says the jury is now out on exactly how well the near-term demand for commodities will hold up. Assuming the current momentum on commodity price weakness continues, the significant price correction in precious/base metals and bulks – expected to hit sometime between 2013 and 2014 – could arrive a lot sooner.

Over the long-term, Wilson HTM is forecasting the price of silver and iron ore to both fall by around 50 per cent. The June 2011 price of tin, hard coking coal, copper, gold, thermal coal, and lead are also expected to drop by 49, 48, 47, 41, 24 and 22 per cent respectively over the long term. At face value, it looks as if Wilson HTM believes that commodity prices – oil and zircon excluded – are going to literally fall off a cliff.

Without knowing a myriad of other factors, notably the associated cost base, trying to forecast commodity prices over the long-term can be highly misleading. But in reality, Young says even this level of correction would still mark a return to more historical commodity price levels. Despite the prospect of future falls, prices are expected still remain higher than they have in the past – especially given a corresponding correction in the A$ (see table).

Given the magnitude of underlying global demand, commodity prices pegged at permanently higher levels than in years past is expected to become the ‘new norm’. Nevertheless, investors should prepare for some short-term volatility.

So where will investors find the winners and losers over the next few months as the resources sector continues to recalibrate itself? Pengana capital Managers portfolio manager Tim Schroeders expects large cap diversifieds like BHP Billiton (BHP) and Rio Tinto (RIO) to weather a protracted period of market correction better than some pure-plays or explorers moving into stgelopment phase. “Investors are likely to remain cynical about junior resource stocks until there’s greater clarity over where markets are heading,” says Schroeders.

On the pure-play front, Schroeders expects copper stocks to fare better than their nickel counterparts where supply issues remain prone to volatility. He says investors holding large cap diversifieds will be able to sleep at night knowing they’re exposed to tier-one assets with strong operations capable of making good money at different parts of the cycle. “The redistribution of ‘hot money’ elsewhere means the risks in the near-term are on the downside, but over the long-term the fundamentals for resources still hold,” says Schroeders.

Like Schroeders, George Raftopulos portfolio manager with Atom Funds Management says the current environment favours diversified large caps like BHP and Rio Tinto and some key pure-plays – including Atlas Iron (AGO), PanAust (PNA), Venture Minerals (VMS), Grange Resources (GRR), Alcoyne Resources (AYN) and even Linc Energy (LNC). “Given that the long-term fundamental view remains bullish, the safest way to play resources is having an eclectic mix of large low-cost operators with good resources and strong infrastructure,” says Raftopulos.

But instead of completely ignoring or selling-off junior resources stocks – currently trading within a pricing bubble – he recommends locking-in recent gains and retaining a core holding over a long-term horizon. “It’s worth holding onto those junior explorers with good resources and a low-cost base,” says Raftopulos. “The value of the underlying resource should move up exponentially, the further along the stgelopment chain the stocks travels and you don’t want to miss out on this upside.”

Roger Leaning head of research with RBS Morgans remains overweight resources, but also favours diversified large caps, especially those with robust cash flow and low-cost operations exposed to infrastructure commodities like iron ore, copper and coal. As Australia’s ‘proxy diversified’, Leaning says it’s often overlooked that BHP is also the country’s largest listed oil producer – nevertheless, he says Rio Tinto still makes for better exposure at current levels.

Despite being leveraged to a single commodity, he also favours pure-plays like PanAust (PNA), Equinox Minerals (EQN) and Oz Minerals (OZL); and in coal Aston Resources (AZT), and Gloucester Coal (GCL).

For investors who remain overweight in junior resources, Leaning says now’s the time to check their positions and the associated risks. He says investors may want to consider rotating into good under-valued domestic industrials, especially net importers enjoying strong purchasing power like GWA Group (GWA). “But if you’re going to hold junior miners, take the time to understand the stock, and stay close to the key milestones that will trigger price appreciations going forward.”

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