Friday, 15 September 2023

By James Cooper Editor, Fat Tail Commodities

[6 min read]

Dear Reader,

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You’d be hard-pressed to find anyone who’s bullish on commodities right now.

But that’s exactly why you should be taking notice.

Negative sentiment is opening up colossal buying opportunities…that’s because, relative to US equities, the sector hasn’t been this cheap in more than 50 years!

Just take a look at the graph from Benchmark Intelligence below, comparing the GSCI Commodity Index against the S&P 500.

Now, note the two major lows to the left of the graph…the 1970s and late 1990s (circled).

Each period marked a major cyclical bottom for commodity markets.

From there, stocks embarked on a multi-year boom that extended across numerous commodities.

Now, switch your attention to the far right.

As you can see, commodities have been languishing at record low levels for years.

A monumental shift in global asset allocation is coming…

Despite mining stocks failing to ignite in 2023, you can’t ignore the massive opportunity here.

Imagine buying US tech stocks back in 2013…just prior to the record-breaking decade of outperformance.

This could be the set-up that’s brewing for commodities as they hover around record-low valuations.

And I’m not the only one peddling this narrative.

According to research released by Goehring & Rozencwajg, commodities are now at their most undervalued levels in 120 years!

The only times we came close was back in 1929, 1969, and 1999.

Each of these periods was followed by a multi-year secular bull market that dramatically outperformed all other asset classes.

According to Goehring & Rozencwajg, this cycle will be no different.

But as investment trickles back into the industry, one sector of the market requires a major injection of capital…

Mineral discovery.

Exploration is a high-risk, capital-intensive business with a low probability of success.

That’s why investors are reluctant to get on board with the explorers.

But ending a 100-year reliance on fossil fuels requires major investment in new discovery.

Existing mines do not have the capacity to meet future demand.

The mismatch between exploration activity and stock valuations

No doubt you’ve seen exploration stocks take a nosedive in recent weeks. The junior mining sector is hovering around multi-year lows.

That’s despite the critical role this segment plays in boosting future supply.

Yet despite depressed valuations…remarkably, activity is booming!

According to the latest data from Geoscience Australia, expenditure reached a record $4.05 billion last year.

It contributed to the highest-ever annual drill volume of 11.7 million metres in 2022.

That’s a record for the industry that’s even surpassed the peak from the last mining boom in 2011.

See for yourself:

So herein lies the confusion…

If exploration activity is hitting new highs, why are the explorers trading at all-time lows?

Has the industry already peaked and entered a secular bear market?

It seems unlikely.

It doesn’t align with Goehring & Rozencwajg’s findings that commodities are the most undervalued in 120 years…

Nor does it align with Benchmark Intelligence’s data that shows commodities trading around historical lows relative to US equities.

There’s a discrepancy between valuation versus activity on the ground.

In booms gone by, rising stock prices aligned closely with higher rates of drilling.

But that’s not happening in today’s market.

So, what’s going on?

Deposits are becoming harder to find

Spending on exploration is delivering far less payback for the junior mining sector. The business of finding deposits is becoming harder and more capital intensive.

The research firm at Market Intelligence tends to agree…in 2020, there were just 52 new greenfield and brownfield resource upgrades — compared to 175 in 2012.

2020 was also well below the historical mean of ‘91.

Despite surging exploration activity in 2022 and 2023, we haven’t seen a major discovery in Australia.

All this data offers two key takeaways…

Explorers face an uphill battle in finding new ore.

That’s despite deploying record levels of capital last year.

It means vast capital investment is still needed to bring in more supply…ultimately, that can only arrive via higher commodity prices.

So, how should you position yourself for this enormous come-back opportunity?

Obviously, the odds of picking a successful explorer are becoming more difficult.

Discovering ore has always been like finding a needle in a haystack…except that needle has now been eroded, redeposited, and then buried again under hundreds of metres of sediment.

In other words, this is becoming a seemingly impossible task across several important metals.

Innovative technologies will certainly help, but major challenges await the industry.

It’s why you must be selective if you’re to have any chance of getting ahead in the minefield of exploration stock picking.

Focusing on stocks with prospective ground, led by management with a proven track record of discovery, certainly narrows down the list.

But there is another strategy.

Investing in developers already holding quality assets…that’s been one of our tactics at Diggers and Drillers.

It eliminates discovery risk.

But that also comes with a premium.

Even then, developers face their own unique challenges…building downstream processing facilities is capital- and labour-intensive.

It can take years to secure institutional investors willing to back a $500,000 million development project.

So, why not step up the mining lifecycle and focus on producers?

We have some exposure here, too…except mines are a depleting asset.

As thousands of tonnes of ore get extracted each year, the deposit shrinks…so does its usable mine life.

To avoid this slow death, miners must stay on the hunt for replacement reserves.

This often comes via acquisition.

But with rising commodity prices…the premium on these acquisitions goes up.

Producers also face daily challenges associated with operations…any number of risks can break the company’s output guidance.

A miss here, and the stock prices get slashed.

Mining and exploration is a risky business even at the best of times!

But what if we could capture future upside without taking on all these risks?

Sure, you could invest in an ETF.

This gives you broad exposure by investing in a group of mining stocks tied to a certain metal.

A low-risk strategy that averages out success among the miners who overall should rise in line with the underlying commodity.

Otherwise, you could invest in the commodity itself via a metal-specific ETF.

These are low-risk strategies.

But they also deleverage your potential upside compared to investing in companies directly.

An ETF could double in value over the course of a mining boom.

Individual stocks, though, have the potential to gain multiples in price during the upswing years.

Of course, not all companies will achieve this outcome.

But the probabilities of success are enhanced through an understanding of the industry and the geology…the principal asset for any exploration or mining company.

But on rare occasions, another component can lead to success…

The company’s core business.

And I’ve uncovered a stock with a winning business model…it virtually guarantees revenue growth if commodity prices rise in the years ahead.

That’s certainly not something we can say for explorers or producers...

You’ll have to become a member of my service Diggers and Drillers for the full run down of this stock.

Regards,

James Cooper,
Editor, Fat Tail Commodities

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