Buoyed by improving commodity prices, natural resources stocks have demonstrated renewed strength after one of the worst bear markets in years. Although fund managers took advantage of markets that were oversold last winter, they believe the rally will be sustainable as the macroeconomic picture brightens.

The recovery in commodity prices — with oil at around US$68 a barrel — has resulted in a more normalized environment, says Norman MacDonald, lead manager of Trimark Canadian Resources Fund and vice president, investments, at Toronto-based Invesco Trimark Ltd.

“Companies can now get a better sense of how to manage their capital budgets, and their businesses overall,” says MacDonald. “For the past eight months, companies were in the dark — just as we were.

“I don’t think that happy days are here again, based on the type of moves we saw in commodities and equities. [But] what happened is [prices of resources stocks] fell too far in November, and again in March,” he adds. “As an investor, you never saw the benefit of high oil prices reflected in equities. But on the way down, you shared equally in the pain.

“From that perspective,” he continues, “when stocks were discounting well below the marginal cost of production, it’s time to get a little interested in buying some quality companies that have exposure to these types of commodities, whether it be oil, natural gas or copper.

“I’m bullish,” MacDonald concludes, “because I’ve invested in a lot of companies that did not get involved in all the hype. With all that has gone on in the world economy, to see oil settle at around US$60 a barrel is pretty comforting.”

MacDonald maintains that oil prices will climb higher because the marginal cost of production is rising, and new sources of oil are either technically challenging to develop or in politically unstable regions.

A bottom-up growth investor, MacDonald was cautious at the end of 2008, when he assumed management of the Trimark fund, and had 12% of the fund’s assets under management in cash. Today, having spent much of the cash on oil and gas stocks, he has 39.3% of AUM in oil and gas, 14% in precious metals, 13% in base metals, 11% in forest products, 6% in areas such as specialty chemicals and 6% in cash.

One favourite holding in the 55-name fund is Nexen Inc. Primarily an oil producer, Nexen has an offshore project in Nigeria, which will come onstream in 2012, and an oil production base in the North Sea. Nexen is also running the tarsands program in Long Lake, Alta., that uses steam-assisted gravity drainage.

“The company has a lot of unique assets, but the market has been discounting them,” says MacDonald. “The market should focus on the offshore Nigerian project and the expansion opportunities at Long Lake.”

MacDonald bought the Nexen stock last December at around $16 a share, on the basis that it was trading at significant discount to its net asset value of $30-plus per share. The share price is now $28.

Another favourite is Inmet Mining Corp. The base-metals firm owns the Los Cruces copper mine in Spain, which is expected to produce about 60,000 tons a year, and holds an interest in the Petaquilla copper mine in Panama.

“It’s a massive undertaking,” says MacDonald, referring to the latter. “A lot of the mine’s potential has not been factored into the stock price.

“When a company can sell 15% of the project, and monetize it, it automatically lends instant value to the remaining 85%,” he says noting the company is looking for strategic partners in the mine.

MacDonald paid around $18 a share last December when he added to the holding, although the stock is now $46. He has no stated target.



The robust market rebound is reflecting a vigorous economic recovery, argues Andrew Cook, lead manager of Marquest Resource Fund and a partner with Toronto-based Marquest Asset Management Inc.

“We’re expecting a V-shaped recovery. There was very little growth in the fourth quarter and first quarter, so credit came to a standstill. Once the credit tap was turned on again, pent-up demand, combined with low inventories, means that you will get a big initial recovery,” he observes, noting that co-ordinated global fiscal and monetary stimulus programs are playing a major part.

@page_break@Looking back, Cook maintains that a cyclical downturn in demand drove prices down very quickly. In response, he says, companies shut down production or postponed development projects: “Companies either didn’t have the confidence of [knowing] where prices would stabilize or there was a lack of financing.

“From our view,” Cook adds, “we’ve had a mid-cycle correction in the secular trend, where the supply side has improved somewhat. When combined with a cycli-cal uptick in demand, you will get a strong rebound in commodity prices.”

Although Cook does not want to forecast the oil price, he believes that the new “floor” is US$40 a barrel.

The story is similar for other commodities. “The incremental demand growth is being led by the emerging economies — China, India, Brazil and the like,” says Cook. “Those countries are in better shape than North America. Consumers are net savers and governments don’t have the debt issues we have in the West.”

About 70% of the Marquest fund’s AUM was in cash at the end of September. “The market was getting narrower and narrower at the time,” recalls Cook, who runs a high-turnover portfolio. “That got us to take money off the table.”

Cook began moving back into stocks in October and November. Currently, about 45% of the fund’s AUM is in oil and gas stocks (mostly natural gas producers), 30% in precious metals, 15% in areas such as agriculture, 5% in base metals and about 5% in cash. The asset mix is based largely on relative valuations in the various subsectors.

One of the top holdings in the 35-name fund is Iteration Energy Ltd. The small-cap natural gas producer is primarily active in north-eastern British Columbia and western Alberta.

“We like natural gas and want exposure to a company that has the ability to grow its production volumes,” says Cook, adding that Iteration will produce about 17,000 barrels of oil equivalent per day this year, which should grow to about 19,000 BOE in 2010.

Acquired in April, at $1.18 a share, the company’s shares are now $1.36 each. Cook’s 12-month target is $1.75, based on rising commodity prices.

On the precious metals side, Cook likes Semafo Inc. The firm is active in West Africa, and should produce about 240,000 ounces of gold this year and about 300,000 ounces in 2010. About two-thirds of that is coming from its flagship Mana mine in Burkina Faso. Although the price of gold has been hovering around US$985 an ounce, Cook is focusing on production growth.

“I’d rather own a producer than the commodity itself. With Semafo, we have growing production and improving margins,” says Cook. “[The company’s shares are] also trading at reasonable valuation.”

The stock price is $2.20. Cook’s 12-month target is $3.25 a share.



Investors should put the rally in perspective, says Robert Lyon, manager of AGF Global Resources Class and vice president of Toronto-based AGF Funds Inc.

“Keep in mind how far we came off. At the start of the year, we had a lot of stocks down 50%-80%, over the preceding 12 to 18 months,” says Lyon, who argues that fears of a global systemic breakdown sent stock prices down to distress levels.

“Yes, we have had a rally off the bottom,” he says. “Suncor Inc., for instance, went from $20 to $37. Sounds impressive? But that’s only half of what the stock was a year ago. The magnitude of the moves, in percentage terms, is somewhat exacerbated by the fact that we started at such a low point.”

The question is: given the rapid turnaround, where do markets go from here? The answer, says Lyon, depends on the scope and pace of the global recovery.

“Commodities are strictly supply and demand animals,” he says. “For the past five years, the global economy hummed along with higher than average growth — and the entire globe was growing at the same time. In the face of that demand pressure, supply was unable to keep up. It came to a head in late 2007 and early 2008.”

A return to global economic growth is what is needed to spur the next major move upward in commodities prices, says Lyon: “That will be day by day, week by week, as the market assesses the new data points.”

Lyon believes that the resources sector is in better shape because producers have demonstrated better discipline during the downturn. “Growth will return,” he says, “but the question is: at what pace? I don’t see it as an ‘if’ but a ‘when’.”

From a strategic viewpoint, Lyon has invested about 54.4% of the AGF fund’s AUM in Canadian stocks, 19% in the U.S., 6.4% in Britain, 4% in Brazil and smaller holdings in countries such as Australia. From a subsector standpoint, there is 45% of AUM in oil and gas stocks, 40.5% in materials (including 20% of the fund in precious metals) and the rest in areas such as fertilizers.

Like some of Lyon’s peers, he took advantage of the market volatility last fall to deploy some of the fund’s cash to increase existing holdings and to acquire a few new ones. An example of the latter was Fresnillo PLC, a Mexico-based silver mining operation listed on the London Stock Exchange.

The stock had its initial public offering last summer, but Lyon balked then at the lofty price. The market correction brought the price down and Lyon purchased it at around 190 pence a share.

“It’s the largest pure silver producer in the world, with about 35 million ounces [in] annual production,” says Lyon, noting that the company has benefited from rising silver prices since October. “It’s a low-cost firm with a strong balance sheet, so it has all the attributes that you want in a mining company.”

The stock is now at 728.5 pence a share, and approaching fair value.

Lyon also has added to holdings in the 90-name fund, such as oilsands producer Canadian Natural Resources Ltd. “All the fundamentals in this company are good,” he says, noting that management has been in place for many years and the company has a low-cost structure. But the stock was lagging its peers during the winter because of fears that the commissioning phase of the Horizon oilsands project was in trouble. That prompted Lyon to add to the position.

“For the first time in 25 years, you have in some of these companies multiple years of visible, predictable growth,” says Lyon. “The market hasn’t given credit to some of these companies — Canadian Natural is at the top of the list.”

The stock is now trading at $63.50 a share, after bottoming in March at $34 a share. Lyon anticipates it could reach the $75-a-share range in the next 12 months, based on oil prices staying at current levels. “Without help from the [oil price],” he says, “the stock has some upside.” IE