By Chris Berry
During the second quarter of 2014, many share prices of energy metals companies struggled for direction after the dust settled from the Tesla (TSLA: NYSE) Gigafactory announcement.
Our theme of viewing the supply and demand dynamics of each energy metal individually continues to be the best course of action as the trajectories of each metal may differ. For example, lithium carbonate prices remained healthy while uranium prices fell by 8% in Q2 and are down 21% YTD.
The recent precious metals price spike did not transfer over into the industrial or base metals sector.
Though economic data continues to improve selectively, there are still too many economic headwinds in place. Therefore only those resource investments that demonstrate the ability to produce at lowest-cost quartile costs or those that have a disruptive competitive advantage should be considered at this time.
Despite nascent inflationary pressures, we are still inclined to believe that deflation (or disinflation) is the predominant threat to growth. The recent US Q1 GDP print of a 2.9% decline has many concerned that this was due to more than “the weather”.
We think that the second half of 2014 will be just as challenging as the first half for reasons we outline below.
Different Quarter, Different Catalysts
When Elon Musk announced plans to build a Gigafactory in the Western US (and has since discussed building multiple facilities), this sent select energy metals share prices into the stratosphere. Many believed this was the “turn.” The dust has since settled as market participants have started to realize the manifold challenges to this plan. Around mid–March, most of the energy metals share prices, including uranium, began a slow and sustained dive. In our proprietary database equally weighted portfolios of companies we follow generated the following returns in Q2:
After a solid performance in Q1 2014, the lack of a positive follow-on catalyst coupled with myriad negative events was responsible for the downward pressure on share prices and a continuation of the "risk off" appetite. These include continued weak growth in Western economies, Iraq’s descent into chaos, continued fighting in Ukraine, and dovish but confusing talk from global central banks.
Those negative catalysts have lit a fire under gold and silver. As we can see below, many base metals have appreciated even if associated base and energy metal share prices haven't followed suit. Though this is a welcome upturn, as I mentioned in a previous note, this is a head fake and not a definitive turn upwards.
Despite the disappointing Q1 US GDP print of -2.9%, there is selective evidence which suggests that economic growth prospects continue to slowly improve. These include PMI readings that indicate expansion. It’s clear, however, that this will not be enough to kick start the next leg up in the overall commodity cycle.
The divergent trends between growth in the West and growth in the East (one example is the trend in Industrial Production in the US and China below) are set to continue.
While Western various economic statistics are trending positive, thought not yet at escape velocity, the growth in China appears to have bottomed out. In short, things have stopped “getting worse” and this is positive news. As credit creation in China has slowed, so has economic growth. This underscores China's need to transition its growth model from investment and export-led expansion to one underpinned by internal consumption.
One of the key events we’ll be watching in the second half of this year will be the Chinese leadership’s plans to sustain economic growth and deal with their debt load.
The challenges in Western economies I mentioned above are underpinned by the glut in an expanding global labor pool, excess capacity, and cheap money. These must be addressed before a new credit cycle can commence. Western economies will have trouble achieving and maintaining “above trend” economic growth until we have faced that “music”.
Inflation vs. Deflation: Solved or Not?
The debate continues to rage between those who think inflation is a larger problem relative to deflation. We are still inclined to believe in deflation (or at least disinflation) going forward as the Federal Reserve, for all its efforts, has failed to produce the intended type of inflation it is looking for (that being wage inflation and jobs). Instead, anyone who has been to a grocery store or filled their car with gas sees a different story. How culpable and ineffective the Federal Reserve (and for that matter the central banking establishment worldwide) is for the increases in food and energy is debatable. It is possible that weather events such as severe droughts or floods have played a significant role in increased food prices.
Another ominous note: consumption in the US came in weaker than expected yesterday at half of what economists expected. The numbers from January, February, and March were revised downwards by .7% overall according to FTN. If the US consumer isn't spending, it is hard to see how growth can really reignite.
The nose dive in the velocity of money (M2, shown below) in the US lends credence to our thesis of excess liquidity keeping a lid on growth in output and wages.
Thoughts on the Second Half
Given that economic data around the globe is mixed at best, it would appear that a generally subdued environment for commodities is in store. Regardless of the market environment, opportunities will present themselves. Nickel and nickel exploration and development plays YTD are an example of this. Below I list the main events or catalysts to be aware of:
The announcement of the Tesla Gigafactory's location should re-energize select energy metals. Though I'm still somewhat skeptical of such a far-reaching plan, it is important to remember that there are numerous other companies like Hitachi, GS Yuasa, Panasonic, Johnson Controls, and LG Chem all of whom are involved in lithium ion battery manufacturing with plans on capturing market share in this growing market. This is bullish for the energy metals going forward.
Continued or increased instability in Iraq or the broader Middle East could push oil prices up to $125 per barrel. At some point this will curb consumer demand in Western economies. Oil, which many economies run on, comprises 71% of the price of gasoline. If oil spikes higher, expect to see a release from the Strategic Petroleum Reserve (SPR) as a political move to attempt to push down prices during the summer driving season. On the other hand, the US Federal Government has just approved the release of selective crude oil supplies for export.
More clarity on the hypothecation (using metal collateral for multiple loans) situation in the Chinese port of Qingdao will tell an interesting story. At issue is approximately 20,000 tonnes of copper and 100,000 tonnes of aluminum which may or may not have been pledged as collateral in multiple financings. The tonnage of metal in question is small relative to the size of the copper and aluminum markets, but should this spread to other ports some much needed volatility could result and unravel the banking system. The recent news of $15 billion of loans in China backed by falsified gold trades is more evidence of a looming problem.
Tapering of asset purchases is on course to end Quantitative Easing later this year. Can the Federal Reserve continue to prop up the US economy with only "forward guidance" and low rates "for an extended period" at their disposal? Should the US economy continue its subpar performance from Q1 throughout the remainder of 2014, the possibility of a return to QE exists and this would provide an additional boost to precious metals.
In Part II of this note, I will focus on Energy Metals, catalysts in Q2, and what to watch for in the second half of 2014.
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