With markets plagued by dimming prospects in Europe, combined with concerns about China’s slowing growth, natural resources stocks lately have taken it on the chin. Yet, fund managers maintain that the longer-term outlook is fairly positive once the uncertainty lifts.

“We are big believers in the secular case for commodities,” says Darren Lekkerkerker, a portfolio manager with Fidelity Investments Canada ULC in Toronto and co-manager of Fidelity Global Natural Resources Fund. “First, there is the growth of emerging economies, urbanization and the emergence of a middle class. Second, there is a very strong case for inflation, given all the debt in the world. Commodities will do well in that environment — particularly gold, but also oil and copper. And, third, there is scarcity of supply.”

Lekkerkerker adds that commodities prices are down in the short term for several reasons. For example, China has clamped down on housing speculation and tightened monetary policy.

“Investors fear there will be a hard landing,” says Lekkerkerker, who shares duties with co-portfolio manager Joe Overdevest. “But we think China will take gross domestic product from a very high 12% growth rate, to a more sustainable growth rate of 7%-8%.

Also, jitters in Europe have been a factor in the selloff, but Lekkerkerker believes the direct impact on commodities is low.

“We are cautious about what’s happening,” he says, “but don’t think this is going to end the secular bull market for commodities.”

From a strategic viewpoint, Lekkerkerker and Overdevest have about 50% of the Fidelity fund’s assets under management in oil and gas stocks, 40% in basic materials and 10% in precious metals.

Backed by a global team of analysts, including 10 in Canada, Lekkerkerker and Overdevest are focusing on commodities that they believe have the strongest growth dynamics: metallurgical or coking coal, oil and copper.

Firms that meet their criteria, says Overdevest, are “those with strong production share growth, high return on equity and return on capital, long-life assets, good execution and competitive advantage.”

One top holding in the 60-name Fidelity fund is Teck Resources Ltd. That firm is a major producer of copper and coking coal (used for making steel), much of which goes to China. Last year, Lekkerkerker notes, China’s steel production rebounded and the country changed from being a net exporter of coking coal to a net importer.

With greater demand, coking coal prices began to climb to US$270 a tonne in early 2010 from US$125 in the spring of 2009. Teck’s 2008 acquisition of Fording Canadian Coal Trust, combined with the 2008 global slowdown, had pushed Teck shares to $5 each from $40. The Fidelity fund took a position in Teck in April 2009, at about $12 a share; the share price has since risen to $35.50.

There is no stated share price target, although Lekkerkerker remains upbeat: “We continue to like coking coal and copper. The valuation [for Teck] is attractive, and we think the balance sheet will continue to improve as the company generates cash flow.”

Another favourite is Baytex Energy Trust, which has a daily output of 44,000 barrels of oil equivalent. (About two-thirds of that is heavy oil, used in road-building, for example.) Baytex has “a very solid production growth outlook,” says Overdevest, adding that 2%-3% production growth, combined with the trust’s 7% distribution, results in an all-in return of about 10%.

“[Baytex] has long-life assets,” he adds, “and the company has done a very good job in bringing on production in a timely manner.”

In early 2009, the Fidelity fund’s weighting in Baytex, a long-time holding, was increased. Baytex, whose units are trading at $32.20 each, is planning to convert to a corporation later this year.



Norman MacDonald, lead manager of Trimark Canadian Resources Fund and vice president of investments with Toronto-based Invesco Trimark Ltd., argues that the commodities sector was ripe for a correction, as it had drawn a lot of speculative investors taking advantage of rock-bottom interest rates.

Says MacDonald: “That was compounded by the fact that China was growing at an abnormally high growth rate.”

Whether the correction represents a buying opportunity depends on the kind of companies on the purchase list.

“In base metals, when I look at the lack of good-quality copper deposits in politically safe jurisdictions, that problem is not going away,” says MacDonald, who notes that the Trimark fund is heavily weighted in Canadian companies. “There may be a lot of speculative money coming out of the base metals space. But the long-term demand from countries such as China and India should continue to trend upward over time. The question is: at what pace?

“The last thing that I want to see is Chinese copper consumption grow at 12% [a year],” he continues. “That means you’ll have a lot of speculative pressure on the price of copper.”

Copper is trading at about US$3 a pound, vs US$1.90/lb. in October 2008.
@page_break@A bottom-up, value investor, MacDonald is reluctant to make any calls on commodities or on rates of growth of global GDP.

“If I look at commodities prices to value [the] companies in the fund,” he says, “I don’t need a global GDP growth of, say, 8%. What I need is a normally functioning global economy [with] 2%-3% [growth].

“Commodities, such as copper, aluminum and nickel, are fundamental building blocks in countries [such as] China,” he continues. “Not the need for a second vehicle or a second computer. And there’s justification for that because a lot of Chinese companies have been buying assets around the world. They are making strategic investments in Canadian oil companies, for instance.”

Running a 42-name fund, Mac-Donald has taken profits recently in the oil and gas sector, which now accounts for 38% of the Trimark fund’s AUM, and has added to the precious metals weighting, which has grown to 15% of AUM from 10% in the past few months. There is also 13% in base metals, 12% in forest products, 15% in miscellaneous holdings and about 6% in cash.

“There was a lot of value in the big-cap gold companies,” says MacDonald. “If I told you there was a company generating 16% return on equity and trading at 15 times 2011 earnings, your last pick would have been a gold company. That’s what I found in a name like Barrick Gold Corp.”

The Trimark fund’s position in Barrick, a long-term holding, was increased to around 3.7% of the fund’s AUM.

On the oil and gas side, Mac-Donald likes names such as Range Resources Corp. The Fort Worth, Tex.-based firm is developing natural gas wells in the southwestern section of the Marcellus shale deposit (which is spread across Pennsylvania, West Virginia and New York). Range Resources is involved in so-called “wet gas,” which includes natural gas, butane, propane and natural gas liquids that are worth about US$1 per cubic metre of natural gas.

“[Range Resources was] the first mover into the [Marcellus] play,” says MacDonald. “Land costs were about US$500 an acre, compared with US$15,000 an acre in some recent land sales. Being a first mover, and being in the sweet spot of this play, [Range Resources has] the ability to withstand low natural gas prices. The longer this depressed natural gas situation continues, I’ll use it as an opportunity. I’m comfortable with the stock.”

Range Resources stock is trading at about US$50.60. Although MacDonald has no time frame, he believes the stock could be worth more than US$60, “even in a long-term scenario of natural gas at US$4 [per cubic metre] on the [New York Mercantile Exchange].”



The natural resources sector should rebound because the global economic recovery is still in its early days, says Benoît Gervais, co-manager of Mackenzie Universal Canadian Resource Fund and vice president with Toronto-based Mackenzie Financial Corp.

“There is continued growth in population and in emerging markets, which is still the biggest driver of the sector,” he says. “We know there is not a housing bubble in China — and the ratios are conservative by any measure. What we are dealing with is what always happens in the second and third innings, or the first third of an economic expansion.”

Europe’s crisis is putting a damper on things, Gervais admits: “We are more interconnected, financially, than we’ve ever been. And that’s holding back stock prices. Over the next few months, we’ll see whether this is a sovereign issue or a corporate issue.”

Meanwhile, on a positive note, countries such as China are expecting loan growth to slow to 15% from 30% in the past six months or so.

A year ago, Gervais and fund co-manager Fred Sturm, executive vice president and chief investment strategist with Mackenzie, had anticipated a global recovery — but not one that was so strong as to drive crude oil or copper prices into the stratosphere.

“It will take two or three years of moderate growth before we put the squeeze on [commodities] again,” Gervais says, “and maybe have a ‘bonus’ year in 2015, and then it won’t matter what stock you pick. For now, we’re in a period of moderate growth, tempered by crisis in Europe. I’m sure we’ll find other areas of concern in the next couple of years.”

Gervais and Sturm look for companies that benefit from volume growth or whose stock has the potential to be revalued. From an asset-allocation perspective, about 50% of the Mackenzie fund’s AUM is in energy stocks, 12% is in paper and forest products, 12% is in base metals, 12% is in precious metals, and 12% is in agriculture.

On the energy side, Gervais argues that natural gas is looking more attractive because changing technology will bring production costs down a lot: “You will either have volume gains, as a producer, or you have to find another way to benefit from low prices, as a service provider or a pipeline.”

One top play in the 100-name Mackenzie fund is El Paso Corp., which operates one of the world’s largest pipelines. Says Gervais: “Cheap energy means people buy more. But it needs to get to market. If you are a pipeline owner with connections into the shale gas areas, you’ll do more business.”

Acquired two years ago, El Paso’s stock price is now about US$11.50 a share. There is no stated target.

Another favourite is Rio Tinto PLC. “Most of its value is anchored in the iron ore business,” says Gervais, noting that Rio Tinto, BHP PLC and Vale SA dominate the global iron ore sector.

However, Gervais believes that Rio Tinto is cheaper than its peers and has better near-term growth prospects and access to infrastructure — particularly in iron ore-rich Australia. “Not only is Rio Tinto in a first-world country,” he says, “but it has extra capacity in its rail and port. On the other hand, BHP is largely tapped out in its port capacity.”

The Mackenzie fund has acquired its shares in Rio Tinto over the past couple of years. The stock is trading at US$46 on the New York Stock Exchange.

IE