What's Next for Commodities

By Katy Marquardt

How much juice is left in this commodity boom? The managers of the RS Global Natural Resources fund--which has shot up an annualized 34 percent over the past five years--contend that we're still in the early stages of a bull run, yet the easy money has been made. According to MacKenzie Davis and Ken Settles, who manage the $2.2 billion fund along with Andy Pilara, the best deals now aren't in the commodities themselves but in the stocks of commodity producers. U.S. News spoke recently with Davis and Settles about bubbles, "advantaged" companies, and why they don't invest in $125-a-barrel oil. Excerpts:

What's your outlook for commodities? Settles: We believe that we are in the early stages of a 10-to-20-year uptrend for commodities, driven largely by the rising costs to add new supply. As such, we don't see commodities as a speculative bubble. However, we do believe that the natural resource stocks are much more attractively priced than the commodities themselves. In fact, using long-term commodity price assumptions that are well below current spot prices, valuations for many natural resources stocks remain quite attractive. The opportunity is as good today as it was two to three years ago.

Davis: But the easy money, driven by the homogenous rise of commodities over the past five to six years, has been made. Going forward, investors will need to take a more nuanced approach when investing in the sector to reflect the expected differentiation in performance between commodities and commodity producers. We look for advantaged companies that can generate attractive returns in a much lower commodity price environment. That helps to protect our investors on the downside.

Settles: One thing that is important to realize is that there is a big difference between low-cost producers and high-cost producers. For example, there are some oil projects today that require $100 oil in order to generate a decent rate of return on the investment, and there are other projects that can generate attractive returns it at $30 to $40 oil. Rather than invest in companies that need extremely high oil prices to generate a decent rate of return, what we do is invest in companies that have the ability to reinvest in low-cost projects.

I would ask where you see the price of oil going, but I hear that you don't forecast commodity price levels. Settles: We don't spend a lot of time forecasting short-term moves in spot price, but we have pretty strong opinions about the long-term outlook. Although commodities will continue to be cyclical, we see the cost of most commodities continuing to rise, thus driving prices higher over time. If you're a longer-term investor, it's more important to pick the right company than to speculate on the near-term direction for the commodity.

What's a stock that fits your investing strategy? Settles: Denbury Resources owns a large, naturally occurring source of carbon dioxide in Mississippi, which puts it at an advantage in the Gulf Coast area. Injecting carbon dioxide into a reservoir allows previously inaccessible oil to be recovered, at very low capital costs. Finding and development costs in North America are running $20 to $30 a barrel, and we think Denbury's enhanced oil recovery projects will come in around $5 to $10 a barrel.

Davis: The CO2 deposit is a structural advantage that can't be competed away. The geology gives them a competitive advantage which can't be replicated.

Settles: We think there's very limited downside for Denbury in a multiyear period. We don't need to invest in $125 oil; we can find companies that can profitably produce at $40 a barrel.
What's a nonoil stock you like? Davis: Century Aluminum, a relatively small aluminum company based in Monterey, Calif. They have a collection of U.S.-based smelters [smelters process alumina into aluminum] which sit in the middle of the industry cost curve. Several years ago, they took on a significant project in Iceland, where they're developing a series of new smelters. Power is a key determinant of the aluminum cost curve, and in Iceland, Century has access to inexpensive hydro and geothermal power. The value of owning those assets in Iceland grows over time because of the structural challenges facing power on a global basis. They've locked up long-term power contracts at very low rates, which should allow Century to remain at the low end of a cost curve which continues to steepen.

Do you invest in renewable energy? Davis: We're focused on the economics and understanding the math behind projects. Broadly speaking, what we've seen so far in the alternative energy space is that the projects don't necessarily work without government subsidies, and the stocks don't work unless you're willing to assume very significant rates of growth over long periods of time.

However, we're looking for free options inside larger companies. For example, we have a number of coal investments that are putting significant funding toward clean coal technologies. That's a way to get access to their development without having to pay for it. We also try to follow the food chain with things like the nuclear renaissance and the water shortage, which we think we're getting closer to on a global basis. We won't necessarily invest in a General Electric, which is building a lot of the infrastructure, but we'll look at who the parts suppliers are and who's supplying alloys and metals.

How much of a portfolio should be dedicated to commodities? Davis: What's happening in commodities is probably the same thing that happened to real estate 10 to 15 years ago. Real estate went from being an optional allocation to pretty much a permanent allocation in portfolios. Whether it's a 5 percent or 15 percent allocation to commodities and natural resources varies by individual. It's also an interesting way, we think, to get exposure to the emerging economies, where much of the demand is coming from.


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