The last two years has been boom years for the energy and materials sector. Rising commodity prices have contributed to higher earnings. Global economic recovery, the emergence of China and low inventory drove prices up. The surge in oil prices and recent attempts by the Chinese government to cool the overheating Chinese economy has raised questions as to the sustainability of high commodity prices. We believe that commodity prices are likely to stay higher for longer. Investors could participate in the upside by investing in some of the stocks in the refining, base metals and petrochemical sectors.
Refining
The refining industry has finally emerged from a decade long period of disappointing returns. Since the fourth quarter of 2002, global refining margins have been on a steady uptrend as demand for gasoline and other refined products outstrip the capacity to produce them. Refineries lost a lot of money in the 1970s due to over-capacity and efforts by governments to reduce the dependence on oil after the oil crisis. In Asia, after the financial crisis in 1997, companies were reluctant to invest in new capacity. Ironically, this sowed the seeds for the upturn in the refining industry as global economies witnessed a synchronized recovery in 2002 and 2003.
The outlook for the refining industry continues to be bright for the next 12 months. Demand is expected to remain robust, driven mainly by growth in the transportation sector. The sustained trend of global outsourcing of manufacturing capacity means that more ships and trains will be required to transport goods. In addition, the emergence of budget airlines and increase in cars in emerging economies further increases the demand for transport fuel. Refineries are running at full capacity and enjoy strong margins. New investments in capacity will take three years to come on-stream. Fears of a slowing Chinese economy may be overdone as the growth in demand has been broad-based. Inventories of refined products remain low. Regions such as Europe, the US and other parts of Asia continue to experience robust demand for refined products.
We are positive on the outlook for refining companies, especially those situated in Asia excluding China. Asian refineries are relatively newer and generally of better quality. We favour shares in Shell Refining Malaysia, Singapore Petroleum Company (SPC) and S-Oil of Korea. Shell Refining is currently trading at an extremely attractive valuation of five times estimated earnings for 2005. While SPC is trading at a higher valuation of eight times earnings for 2005, there remains meaningful upside potential from its exploration projects in Vietnam and Indonesia. S-Oil is the largest refiner of the three and is currently trading at eight times earnings for 2005.
Base Metals
The outlook for materials is favourable due to a combination of economic growth, underinvestment in the mining sector, low levels of inventory and increasing concentration of producers. The world will not run of base metals, but the structural outlook for metal prices is intact.
The concentration of producers has improved in the last decade via mergers and acquisitions. Fewer players now account for a larger portion of the metals market, tilting more of the pricing power in their favor. Only recently, Xstrata has made an offer to buy WMC Resources of Australia at a more than 20% premium to the prior closing market price. This further extends the trend of consolidation in the industry and increases the pricing power of miners. Mergers and acquisitions are happening as there are few economically-viable large-scale mines left for exploration globally.
The weak dollar scenario in an environment of tight supply and demand, allows room for producers to ask for higher metal prices. Producers of metals tend to be in non-US regions such as Australia and Canada. Labour and equipment costs in these countries are largely denominated in the local currencies. As the local currencies appreciate versus the US dollar, margins of the producers will surely be squeezed. In the current environment, producers possess greater pricing power due to the tight supply/demand balance and are able to raise metal prices to regain some of the margin lost due to currency exchange.
We have a preference for bulk commodities such as iron ore and coal. China is now a dominant driver for the marginal demand growth, and aims to become more self-sufficient to mitigate the effect of rising commodity prices. China is now capable of producing sufficient capacity to meet its internal needs for aluminium and probably steel further down the road. However, lacking in natural resources such as iron ore and bauxite, it would thus have to purchase these products from external producers or buy such mines outright.
Our view is that it is practical and more rewarding to invest directly in the equities of mining companies than investments in the underlying physical commodities. The prices of commodities may not rise much more from current levels, even though they may stay at these levels for longer than the market expects. The persistence of high prices should result in upward revisions to earnings for mining companies and higher share prices.
Over the last decade, the number of mining companies has consolidated to leave a handful of large companies accounting for the bulk of commodities produced globally. BHP Billiton, Rio Tinto dominate the list of diversified miners with interests in copper, aluminium, iron ore, coal, zinc, lead, gold, platinium, among others. In addition, BHP Billiton has a sizeable exposure to petroleum. We favour BHP Billiton, which trades at 12 times earnings for 2005.
Petrochemical
The petrochemical sector has been enjoying two years of solid margin expansion but this may be coming to an end due to large-scale ethylene capacity build-up in 2005. We wish to highlight a particular sub-segment, namely paraxylene and benzene and favour shares of Aromatics of Thailand.
Prices and margins for both products have risen significantly, again due to extremely tight supply and demand conditions. Paraxylene is a raw material used in the manufacture of polyester for the textile industry. With the emergence of China and Vietnam as centres for textile manufacturing and next year's lifting of quotas on Chinese textile imports into the US, demand for paraxylene is expected exceed supply till 2006.
Benzene is used as an octane booster for gasoline as well as a feedstock for petrochemical products such as styrene monomer. Given limited refining capacity globally and increased demand for gasoline products from emerging countries such as China, the outlook for benzene is positive.
Aromatics is currently trading at six times earnings for 2005.
Conclusion
There is a growing camp of people who believe we may be witnessing a multi-year bull run for commodities. Those who work in the industry probably feel it is about time given how dismal prospects for the industry appeared a decade ago. Other investors worry about economic growth in 2005. We believe that the price increases are supported by structural factors and the cyclical outlook, while significant, will not overwhelm the structural case. Investors who feel reluctant to buy at current price levels may choose to stagger their purchases. As they say, "It's back to basics (materials)."
Nigel Tan is Portfolio Manager, ING Asia Private Bank
