Natural resources stocks led the market higher until spring because of strong commodity prices and demand from fast-growing China and India. Fund managers note that intense market volatility in recent weeks has wiped out much of the year’s earlier gains, but they remain confident that longer-term prospects remain positive.

“The market was vulnerable in the first place,” says Charles Oliver, co-manager of AGF Canadian Resources Fund and senior vice president at Toronto-based AGF Funds Inc. “We had a huge rally in the first quarter, and the market went a little too far. The market cannot go straight one way, and never does. The pullback was very justified.”

The market has been concerned about a potential slowdown in the U.S., he notes: “The question is: how big will that slowdown be? Whenever the Federal Reserve Board raises rates, it creates some nervousness. There are a number of things driving volatility, and that’s one of the concerns.”

Volatility has also been exacerbated by the emergence of new funds that invest in indices such as the Goldman Sachs commodity index and allow institutional players to influence the equilibrium between supply and demand.

“There is a very tight balance between supply and demand and inventories,” Oliver says, noting, for instance, that copper, which traded for a long time at around US95¢ a pound, went as high as US$4 on fear on shortages. “When you have the introduction of a number of new investors in an already tight market, you can have significant moves in the commodity prices.”

Oliver remains bullish on resources stocks, however, even if he has some concern about a U.S. slowdown.

“I am a big believer in growth in China and Asia. For the next three to five years, we will continue to see very tight inventories,” he says, noting that lead times for new mines are five to 10 years.

“We do not have significant new supply coming online, and we continue to see strong demand out of Asia,” he adds. “These areas will have a major impact on the supply and demand imbalance. I am clearly in the bull camp.”

A bottom-up growth investor who runs the fund with Robert Farquharson, vice chairman of AGF Funds, Oliver is favouring the energy sector — it accounts for about 55% of the fund.

“Historically, that weighting has gone from 40% to 70%, depending on valuations. Right now, it’s a neutral stance relative to the other commodities,” he says.

Base metals account for 19% of the fund and precious metals for 21%. There are also very small weightings in paper and forest products and in utilities.

One of the largest holdings among the 150-plus names in the fund is Canadian Natural Resources Ltd. “It’s becoming a global player and has operations in West Africa, the Gulf of Mexico and the North Sea,” says Oliver, adding that its daily output is about 400,000 barrels of oil equivalent that includes natural gas production. “And it’s not an expensive stock — it trades at 15 times 2006 earnings.”

Acquired more than five years ago, when it was trading at less than $10 a share, the stock recently traded at $54. Oliver has no stated share price target.

Another favourite, on the precious metals side, is Bema Gold Corp. It is noted for its two Russian mines: the Julietta operation, which produces almost 100,000 ounces a year; as well as the Kupol mine, which is due to start production in 2008. The latter, says Oliver, “is probably one of the best new development mines on the planet, and will produce about 500,000 ounces a year.” Bema also has a joint venture in Chile known as Cerro Casale, which could potentially be a similar-sized producer. “These are world-class assets,” says Oliver.

Acquired about three years ago at around $2.75 a share, the stock is now $5.10.



Market volatility is largely the result of three factors, says Scott Vali, vice president of Signature Advisors, a unit of Toronto-based CI Investments Inc., and a member of the team that manages CI Signature Canadian Resource Fund. “There is a debate in the U.S., with respect to the growth outlook and whether there are inflationary pressures and if the U.S. Federal Reserve Board has to increase interest rates some more and thus slow the economy,” he says.

@page_break@There is also debate about China’s expansion, and whether its authorities have been able to tame its torrid economic pace (10.2% annualized growth in the first quarter).

“We’re looking at what they are doing with respect to municipal loans and housing. They have tried to tighten some of the lending practices, but to date it doesn’t look terribly successful,” says Vali. “On a longer-term basis, [China’s expansion] is far from over.”

The third factor, he says, concerns the sustainability of global growth should the U.S. decelerate: “It’s all about the extent of the slowdown and how much the other economies will pick up the pace.”

One certainty is that high oil prices are expected to stay, he says. Geopolitical tensions in the Middle East and West Africa are supporting prices at the current levels of around US$70 a barrel.

Vali says there is sufficient supply of oil in the world and prices could drift down to the US$60 mark: “But that is still an excellent price for producers on a go-forward basis.”

He remains positive on the sector, although he did some selling in spring, especially as he believed that some metal prices were unsustainable in the near term.

Longer term, however, “we are still bullish,” says Vali. “We think demand from China will not go away any time soon. Inventory levels are supportive of these prices on a longer-term basis.”

Utilizing a blend of top-down and bottom-up styles, Vali is running a 50-name fund skewed toward energy stocks. The sector accounts for 55% of the fund and is dominated by integrated and senior oil companies. It also has a mix of junior exploration and production firms and service providers. There is also about 16% in precious metals, 23% in metals and mining firms and 6% in cash.

Atop the list is Petro-Canada. “It has oilsands exposure, heavy-oil exposure on the East Coast and excellent refining capacity. Relative to some of its peers, it’s cheap,” says Vali. Based on 2007 earnings, he says, the stock’s multiple is about nine times earnings, vs 15 times for Imperial Oil Ltd.

“The market doesn’t give PetroCan full credit for the oilsands exposure, and it has had a few problems with its East Coast assets,” he says, adding that restrictions on foreign ownership also work against the company. “But we think there is a favourable investment case to be made. It should produce robust earnings in the next few years.”

The stock was acquired in 2004 at about $30 a share and now trades at $47. Vali expects it could reach about $72 in 18 to 24 months.

On the metals and mining side, Vali likes Teck Cominco Ltd. A diversified firm with exposure mostly to zinc and copper mining, the company is looking to buy out Inco Ltd., which if successful could boost its own multiple. Vali is mainly interested in the firm’s production profile and that its shares are relatively cheap.

“We are very disposed to zinc and copper. In terms of the fundamentals outlook, they are the most favourable,” he says.

There is not a lot of new production coming onstream, and what is available is running at full capacity. Acquired in 2004 at $22 a share, Teck shares recently traded at $61. Vali notes that the shares are trading at about half the multiple of Australian mining giant BHP Billiton Ltd. Teck could rise to $90 a share within 12 to 18 months, says Vali, “assuming commodity prices stay high.”

Another favorite is Barrick Gold Corp., the world’s largest gold producer. Although the company’s share price has been flat since the start of the year, Vali notes that is partially attributable to the firm’s large hedge book. “But it has been selling that hedge book down — that is, increasing its exposure to the spot price of gold. As the gold price looks as if it will continue to increase — at least, in our eyes — the company should benefit over the coming year,” says Vali.

Bought in 2004 at about $25 a share, Barrick stock recently traded at $31.15. “It [has] been a laggard, but there is an opportunity to catch up,” says Vali. His target is $45 a share over the next 12 to 18 months.



It has recently been time to take a more cautious approach, says Glenn MacNeill, manager of Sentry Select Canadian Resource Class and vice president of investments at Toronto-based Sentry Select Capital Corp.: “We have been selling down some of our small oil and gas producers and moving into large producers, more liquid names, royalty trusts and what I call ‘high-growth, mid-sized companies’.”

Currently, about 57% of the fund is in oil and gas stocks, with 23% in metals and minerals, 11% in precious metals and 9% in diamonds. From a commodity perspective, MacNeill is bullish on natural gas, which has come off dramatically from the highs of last winter, when it hit almost US$16 per million cubic feet.

“With oil at US$70 a barrel and natural gas at around US$6.25 per mcf, gas is a bargain,” says MacNeill. “If you use a heat-equivalent basis, gas is around US$38 a barrel.”

Gas consumption is dependent on the weather. Last winter was a mild one, but MacNeill would not be surprised if the next one is cold. At the same time, strong demand could push natural gas to $10 per mcf, putting it more in line with oil prices. As for the price of crude oil, MacNeill says, it’s very hard to predict, except that geopolitical tensions have a major influence.

“I’m not very optimistic about the Middle East resolving its issues,” he says, noting similar uncertainties in Nigeria and Venezuela. “Short term, it’s hard to predict. Longer term, it will continue to be in demand, which has been growing at about 1.5% a year.”

One of the top holdings in the 70-name fund is Highpine Oil and Gas Ltd. The firm operates in the West Pembina area of Alberta.

“It has a great slate of drilling prospects in front of it,” says MacNeill, noting Highpine is headed by Gordon Stollery, an oilpatch veteran. Daily production has increased to 16,000 BOEs from 6,300 in 2005. At $17.55, its recent share price, it trades at four times cash flow.

The stock was acquired at $17 a share in 2005, although MacNeill has a $25 target within a year.

“The growth in production has been phenomenal; that’s why we’re attracted to it,” he says.

Another favourite is Dianor Resources Inc., the fund’s largest holding at 10%. The firm is developing a diamond ore body in the Leadbetter project that is in conglomerate form, as opposed to the more common kimberlite structure, near Wawa, Ont.

“We have a high degree of confidence in the project,” says MacNeill, adding that the diamond-bearing conglomerate is well in excess of 150 million tonnes and the mine could be operational in about five years. “They’ve been taking diamond samples and the numbers appear to be very positive.”

Acquired in 2005 at about 40¢ a share, the shares recently traded at $1.10 a share; MacNeill’s target over five years is $5-$7 a share.

He adds: “If the diamond-bearing portion of the rock is similar to what we’ve been seeing, it will be a big mine.” IE