Bullish on natural resources

Low valuations caused by typical boom-bust market cycles can occur concurrently with other factors, in a perfect storm scenario creating exceptional opportunities for investment. This appears to be just the case developing in the natural resources sector globally.

The period between 1979 and 1999, marked a long drawn out bear market in commodities resulting in restricted exploration and development expenditures that impacted the future supply of resources. Like today, resource commodities were trading at prices close to or lower than their marginal cost of production.

A period of under-investment in infrastructure and extractive industries left the commodities sector grossly under-prepared for the economic and resource intensive resurgence that followed from 1998-2008.

The result was a phenomenal rise in commodity prices as supply struggled to keep up with burgeoning demand.

When prices are subdued and close to the bottom of the market, investor apathy invariably leads to structural problems as projects start to become unviable and it becomes difficult to attract and raise capital.

The recent credit crisis has meant that the supply of capital, for small and mid-cap resource companies, has virtually evaporated. Meanwhile larger resource-focused companies have tended to focus primarily on their core portfolio assets, leading to a situation of industry consolidation, with less attention and finance provided for new projects.

This year, the International Energy Agency (IEA) Chief Economist, Fatih Birol, predicted a significant investment decline in the global energy sector. He went on to reiterate that oil prices could surge back to the record highs seen in the summer of 2008 once the global economy recovers and energy demand increases, leading to supply lags as a result of insufficient capacity.

Global demand

In May this year, at the Gastech 2009 conference in Abu Dhabi, the CEO of state-owned Adnoc described the effect low energy prices and the credit crunch were having on the oil and gas sector, with the financial crisis weakening world demand for energy.

Lower oil prices in turn lead to problems in expansion and execution of all associated projects.

Energy, like every other heavy industry, needs time to build capacity. Low demand has created what appears to be spare capacity in the natural resource industry.

However, this is likely to turn out to be an illusion that will only painfully manifest itself when the commodity curve steepens in anticipation of future demand and supply imbalances. History may just repeat itself in a similar way to the decade that followed the 1979-1999 commodities bear market.

The opportunity has already got the attention of investors globally. Sophisticated institutional investors in the Gulf Cooperation Council have began to take a closer look at building a portfolio of long-term ‘hard assets' and one of the best avenues, aside from real estate, is in natural resource properties.

Dundee Corporation of Canada, one of the world's leading resource investment managers and merchant bankers, has recognised the significance of this trend and has embarked on setting up a local subsidiary in the UAE to bring its expertise closer to the region's investors.

Confidence

By launching a $1 billion (Dh3.67 billion) limited partnership dedicated to investing in global natural resource projects, with $200 million committed from its own capital, the business is making a strong statement of its confidence in the resources sector.

Another consequence of a long run secular bull market for commodities is the significant amount of new infrastructure development proposed as part of national stimulus plans over the next decade or so.

In the US, the $787-billion American Recovery and Reinvestment Act allocates $140 billion for infrastructure projects. China plans to pump $587 billion into similar projects. Here in the Gulf Cooperation Council, work has also begun on a wide range of economic development proposals.

Abu Dhabi's long-term economic vision is expected to result in infrastructure spending of over $200 billion-$300 billion over the next decade or so. Saudi Arabia is slated to spend $400 billion over the next five years.

China and India, each with a population of over a billion people, are both undergoing an epic level of wealth creation as their people become more prosperous and strive to uplift their living standards.

Their demand for a wide variety of goods and products, and the energy to fuel them will dwarf anything the modern world has seen to date. The demand for commodities to meet these needs will be incredible.

Supply bottlenecks and the absence of substantive and suitable substitutes, will lead to an upward spiral in the price of commodities and energy that will last for a long time to come.

There are a number of challenges. Many commodity industries are heavily capital dependent with high barriers to entry which some countries might find hard to exploit. In addition, some resource rich countries have complicated socio-political systems which can limit their ability to exploit their resources efficiently and effectively.

Finally, while the opportunities in the sector are obvious, there are a limited number of global players with the right combination of experience, technical expertise, relationships (both company management and political) and the financial wherewithal to be successful.

Investment climate

Each country has a unique investment climate requiring a specific set of skills and knowledge to succeed. An increasing number of projects are in developing countries which have shifting legal and political frameworks.

Succeeding as a foreign investor requires a full range of highly specialised project management skills. An ability to continually adapt to changing conditions, understanding local partnerships and diversification by commodity and country are keys essential for success.

Commodity prices are currently undergoing a cyclical downturn or correction, but this should be seen within the context of a much larger and long run secular uptrend that has barely run half its course.

There is a lot more upside in store. Time will tell, but we should be confident that the next great bull market will be in commodities and energy.

Domluke Da Silva is a member of the CFA Emirates Society and Chief Operating Officer of Arabia-Asia Capital Alliance.