Three major themes creating risks and opportunities: Gold, China, labour
Three key themes have emerged in the Resources & Energy sectors over the last 3-6 months. First, the recent rise in gold prices initially benefited producers over explorers, but a surge in M&A activity means this could rapidly invert. Second, fears of a global recession and the slower-than-anticipated reopening of China triggered a pullback in prices for energy stocks and EV metal, despite medium- and long-term outlooks remaining strong. And third, labour shortages continue to challenge most operations, especially in Australia and North America.
This combination of positive and negative catalysts have made for a challenging start to the year, but they are also the conditions where the investment process at Acorn Capital can flourish.
Rising gold prices: initially good for some; now good for all
Gold producers are generally the first beneficiaries of a rising gold price, because their cash flows rise while the cost base initially remains flat. But it’s not just growing margins that the market likes in a rising price environment: rapid deleveraging of a balance sheet can put a rocket under a stock’s share price.
A good example of this is Resolute Mining (ASX: RSG). In late 2022 the company was forced to raise money to reduce its debt and provide working capital for its two mines in West Africa. Strengthening gold prices in the March quarter saw the company further reduce its net-debt position by about 37 percent to US$19.9m. This deleveraging, combined with news of a potential low-capex expansion of its Syama Gold Mine, resulted in its share price gaining an impressive 110 percent in the March quarter.
In marked contrast to the gold producers, those with development or exploration projects attracted very little attention from the market in the March quarter. Bellevue Gold (ASX: BGL) is developing a large high-grade gold project in Western Australia and have quality management. Despite being well-capitalised and development remaining on schedule and within budget (post a revision in late 2022), the share price was up a modest 10 percent in the March quarter. And for the gold explorers it was a similar story of indifference from the market. Alto Metal made several positive announcements during the quarter from drilling at their exciting exploration project near Sandstone in Western Australia, but the share price was up only 9 percent.
Similarly, Chesser Resources (ASX: CHZ) was up a meagre 6 percent despite releasing some positive drilling results on their gold project in West Africa. For some investors, the poor performance of the gold developers/explorers has lured them into selling out and chasing undervalued (generally low quality) producers. However, our experience in the Resources & Energy sectors has shown that now is the time to be buying the developers and explorers rather than selling.
The disparity in performance between the producers and developer/explorers in the last 4-6 months since the gold price started to rise is part of the natural cycle in the sector. The main driver of this cycle is the producers eventually become fully valued (even at the higher metal prices) and investors are forced to look for other quality stocks with exposure to the same metal.
A second contributing factor is the producers soon realise that they can use their growing cash balances and/or well-valued scrip to acquire undervalued stocks. The result is a flurry of M&A where large premiums can be paid for quality and strategic assets. Adding fuel to the M&A fire is a weak AUD, which makes Australian companies cheap for North American acquirers. The recent takeover bid for Newcrest Mining (ASX: NCM) by Newmont (NASDAQ: NEM) is a great example of this. And we think there could be a lot more to come.
China reopening: jogging, not sprinting
In late 2022, when most of the world had emerged from COVID lockdowns, China closed its borders and locked up hundreds of millions of people. With factories shut and revenue curtailed, many Chinese companies were forced to generate cash by selling stockpiles. Fast-forward to today, and with production returning to pre-COVID levels, there was a belief among many analysts that not only would demand for metals return, but there would also be a need to rapidly rebuild the heavily depleted stockpiles. For metal producers, the ‘China reopening’ trade was expected to provide the sector with a short-term sugar- hit and thus a great start to 2023.
The metals that were expected to benefit the most from ‘China reopening’ were those hit the hardest in late 2022. These include lithium, rare earths, graphite, nickel, cobalt and copper. However, two things happened that delayed and subdued the rebound. First, the combination of rising interest rates and growing concerns about a global slowdown (and possible recession) have dampened consumer sentiment and in-turn the demand for many metals. Second, we appear to be suffering a hangover from the COVID spending spree of 2021 and early 2022. Most of us will remember the surge in demand for electronic goods when we were initially forced into lockdown. This burst in consumption drove a pronounced pull-forward in demand for the metals used in electronic goods. Although the demand for electric vehicles remains strong, the demand for electronic goods has eased, leading to a short-term oversupply of many of the key metals used in those goods.
In March and April, several companies provided evidence for the post-COVID metals hangover. Jervois noted the sharp fall in cobalt prices from their peak just under US$40/lb in April 2022 to about US$16/lb in March this year. Syrah announced in April that demand for graphite had also eased significantly and that they were unable to find buyers (at a reasonable price) for some of their concentrate. The good news is that the medium- and long-term outlook for both commodities remains strong, so we don’t expect the low prices to persist. Thus, the short-term volatility has been frustrating but for several companies has provided some great buying opportunities.
Ongoing labour shortages
Border closures, particularly by Western Australia, made it very difficult to get people with the right skills to site at many of the mines. This resulted in delays and major disruptions to productivity. For example, a lack of truck drivers meant companies were forced to modify mine plans to ensure they could feed their processing plants.
While the change in plan kept the processing plant running, the ore grades were commonly lower and the amount of waste rock that had to be moved only grew larger and larger with time. In early 2023, almost a year after the last of the border closures were lifted in Australia, many people thought labour shortages were over and that productivity would improve. Unfortunately, some issues are still lingering.
While the good news is the worst of the labour shortages have passed, there are still some isolated challenges. For example, Bowen Coking Coal (ASX: BCB) has operations in Queensland and staff shortages led to slower-than- forecast refurbishment of a processing plant that in-turn led to delays in ramp-up and thus revenues. For companies getting into production these delays can put pressure on working capital, so active monitoring is essential to identify the risks and, just as importantly, the opportunities for investing.
The outlook
Although volatility remains in the market, conditions have stabilised from the extreme swings that the Resources & Energy sectors experienced between May 2022 and February 2023. This relative stability is better suited to the investment process used by Acorn Capital, because performance can be gained from active stock selection rather than an overweight position in a particular commodity. Moreover, the sell-off has created a great opportunity to get set in several high-quality companies that are attractive to investors and companies with an appetite for M&A.
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Rick Squire has responsibility for the Energy and Materials – Resources sectors. He is a geologist with over 25 years of experience in the resources industry, including 9 years in mining finance and investment. Rick joined Acorn Capital 4 years ago after working at Deutsche Bank and Trail Stone Group. Prior to this, Rick was a Research Fellow at The University of Melbourne and Monash University where he held industry-sponsored positions investigating the genesis of world-class gold and base-metal deposits. Rick holds a B.Sc (Hons) from Monash University and a PhD (Geology) from The University of Tasmania.
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The information in this article is general information only and does not take into account the financial objectives, situation or needs of any particular investor. Nothing in this article contains a recommendation to buy or dispose of any of the stocks noted. Any examples or information provided in this article are for illustrative and discussion purposes only and do not represent a recommendation or view on future events, and in no way bind the publisher of this website or its related parties. The publisher of this article is Australian Microcap Investments Pty Ltd ACN 127 745 395 (AMI). AMI is a wholly owned subsidiary of Acorn Capital Limited ABN 51 082 694 531 AFSL 227605. AMI is a Corporate Authorised Representative of Australian Unity Funds Management Limited ABN 60 071 497 115; AFSL 234454 (AUFM). The kind of financial service AMI provides as a Corporate Authorised Representative of AUFM is general financial product advice to retail and wholesale clients in relation to securities. None of AMI, AUFM, any employee or director of AMI or AUFM, or any associate of any of the above will receive any remuneration in respect of, or that is attributable to, the general advice given on this website. Neither AMI nor AUFM consider that there are any associations or relationships between them, and the issuers of any financial products referred to in this article.
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Rick Squire has responsibility for the Energy and Materials – Resources sectors. He is a geologist with over 25 years of experience in the resources industry, including 9 years in mining finance and investment. Rick joined Acorn Capital 4 years...
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Rick Squire has responsibility for the Energy and Materials – Resources sectors. He is a geologist with over 25 years of experience in the resources industry, including 9 years in mining finance and investment. Rick joined Acorn Capital 4 years...
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