Commodity Supercycles And The Role Of Luck

Increasingly, albeit anecdotally, as I don’t have an empirical way to measure this, over the past few months, I am seeing and reading way too many bullish commodity articles. Throughout 2022, investing in commodity stocks has become highly fashionable and very lucrative. As both popularity and significant short-term returns have a tendency of attracting a crowd, I want to remind readers that once a commodity cycle does stall out, the declines can be easily as breathtaking and the losses equally as spectacular as the gains. Perhaps, similar to any sector that is at or nearing a top, after a monster supercycle, sentiment and FOMO simply take over as way too many people rush in, and often at the wrong time. That said, precisely trying to time the broader market or a commodity cycle is really hard. As the saying goes, no one rings a bell at a market bottom or a market top, but given the blow-off top we have witnessed in a number of commodity stocks, it is starting to feel like this is the 8th or 9th inning of this extraordinary supercycle.

The Elephant in the Room

What is so startling is that so many of these uber-bullish articles don’t discuss the elephant in the room. The elephant in the room is the terrible Russian invasion of Ukraine. For the first time since 1945, there is a war in continental Europe.

Now there are many different commodity markets, each one has its own supply and demand, fundamentals, and outlook. It is well beyond the scope of this piece to try and discuss every commodity market. Therefore, as a proxy, let’s talk oil. Without getting into the weeds, prior to the war, Russia exported upwards of four million barrels of oil per day. On January 1, 2022, WTI was trading at $75 per barrel. The big leg up in oil prices, briefly trading north of $130 per barrel, on the front month, was arguably 90% driven by a higher risk premium due to the uncertainty of the war (and Putin), the short-term supply/demand implications of Russian barrels not being exported as former buyers stop buying on moral/ethical grounds, and momentum traders and speculators chasing prices higher.

Consider a few cracks in the bullish narrative:

If you take a step back, from January 1, 2022 – April 22nd, the 10 YR U.S. Treasury has gone from a yield of 1.51% to 2.90%. The Federal Reserve has already signaled a 50 Bps rate hike in May 2022 and Wall Street is now pricing in the strong likelihood of additional 50 Bps hikes in both the June and July 2022 meetings. And by the way, the U.S. Dollar is approaching a three-year high. As oil is priced in dollars, a strong dollar makes oil more expensive, so think more demand destruction, at least at the margin.

Next, we have many major Chinese cities on a lockdown due to Covid. If you take a step back, this means very low near-term demand for oil during the lockdown and the possibility of a recession in China due to this lockdown. In case you didn’t know, China imported over 10 million barrels per day of oil in 2021.

If you look at the stock market as a leading indicator, year to date through April 22, 2022, the NASDAQ is down about 18% and the Russell 2000 is down about 15%. Although the S&P 500 is only in correction mode, down about 10%, the relative strength of some of its largest components, as well as the larger weighted defensive companies, have insulated the S&P 500 more so than the higher beta NASDAQ or Russell 2000.

Is the market signaling a recession, driven by the highest inflation in 40 years, and therefore this forces the Fed’s hand? Forecasting recessions is way above my pay grade, but holding all things equal, it doesn’t take a rocket scientist to work out that a recession or slower economic growth leads to less demand for many commodities. So why are investors rushing into E&P stocks at this juncture?

Another angle to consider, and there is a lot of nuances and many more arguments that can be leveled, is that there is a lot of governmental pressure on the large U.S. E&P companies to increase their Capex budgets and do everything in their power to increase production. No question you can’t simply snap your fingers or click your heels and more oil magically appears, but marshaling the necessary personnel and equipment notwithstanding, one of the biggest risks to the large E&P producers is that by not increasing production, in a time of very high prices, it starts to look like profiteering from the war. Let me be clear, I am not making this argument nor am I in that camp, but at least optically, if efforts aren’t made to move the necessary pieces in place to get more production flowing, and whether a person agrees or disagrees, the profiteering argument will be waged.

Also, U.S. oil and gas production is highly fragmented compared to many other types of industries. There are inherent decline rates, and at some point, the compelling current cash on cash economics start to win out as it starts to seem crazy not to increase production in the face of markedly higher prices, the best prices since 2008.

And as all sophisticated investors/speculators know, you usually want to buy commodity stocks when valuations are rich (at or near the low of the cycle) and sell them when they look really cheap (at or near the peak of the cycle). Simply put, I am reading way too many authors citing traditional valuation metrics as their proxy for ‘strong buy’ recommendations. However, the bullish arguments often fail to incorporate the massive share price appreciation or valuation in context of normalized EBITDA power, at the midpoint of the cycle. In other words, the bulls are simply extrapolating the bumper profits, somewhat oblivious to the drivers of the underlying commodities prices, considering where we are in the commodity cycle and blissfully concluding the good times will continue to roll.

A Few Bullish Commodity Calls Shared on SA That Worked Well:

Notwithstanding this past week’s nasty correction, in a number of high-flying commodity stocks, I’m sure many readers will be inclined to simply dismiss my warning as ridiculous. Others might suggest I have no idea what I am talking about as they don’t want to hear this point of view.

Lo and behold, I have been reading about, speculating, and investing in commodity stocks in the mid-2000s. So, before you consider me as some muppet, let me share a few articles that I wrote, right here exclusively on SA, about commodity stocks that happen to do well. This might give you some perspective.

Anglo American: My Best Long Idea For 2016:

For example, as part of Seeking Alpha then best idea contest, in late December 2015, I called Anglo American (OTCQX:NGLOY) (OTCQX:AAUKF): My Best Long Idea For 2016. At that time, sentiment was extremely bearish, and the market was myopically focused on Anglo’s big CAPEX overruns and lack of discipline. With a somewhat leveraged balance sheet and commodity cycle turning downwards, shares of Anglo American got hammered. Lo and behold, Anglo was able to pivot as the quality of its asset enabled the company to thrive once the commodity rebounded. As it turns out, Anglo American did really well in 2016, more than a three-bagger, and has continued to do well since then. This isn’t surprising given the commodity supercycle of 2022. Despite a big pullback from its all-time high, set on April 18, 2022, Anglo American shares are up 1,173% from when I wrote that article. Also, that 1,173% return excludes a number of dividends that cumulatively far exceed the original purchase price. Just to be clear, I sold Anglo American shares after a double, in 2016.

Antero Resources and Range Resources (Q2 2020)

Back in Q2 2020, shares of Antero Resources (AR) were trading under the $1. The company had a wall of debt to roll over, natural gas prices were really low, and oil prices and NGLs were also really low. Antero’s bonds were trading in the high $60s to low $70s. Most of the sell-side was extremely bearish and the conventional wisdom was Antero would go bankrupt. What the market missed was the Antero was well hedged, at least on the natural gas side, so its cash flows were somewhat protected. As it happens, the cycle turned, credit markets unfroze, and the company rolled over its debt. Since then, natural gas prices and oil prices have skyrocketed and now I am reading articles to bet aggressively on Antero in the low $30s. It is amazing to me how quickly things change and how sentiment swings so widely in less than two years. That said, I have no idea who is buying Antero shares in the low $30s.

Lo and behold, as so often timing is everything when it comes to investing/speculating in commodity stocks, if you happen to read my April 7, 2020 article: A Potential 5-Bagger Or A Zero, Antero shares are up 3,250% from the time of publication. That is a 32-bagger for anyone with perfect timing. Just to be clear, I had a very outsized position in Antero shares at an average cost of $2, as I was aggressively buying it in the mid-$1s and all the way down to sub-$1 per share. That said, if natural gas prices did stay very depressed for another year or so, it is possible that Antero’s equity could have been wiped out. Just to be clear, I was 100% out of my Antero between $5 and $7 and owned some shares as I have followed Antero closely since 2016. This legacy knowledge was a big advantage at the depths of the cycle. Again, though, at current prices, I don’t want to own Antero near the top of the cycle.

Range Resources (RRC) is a very similar story, although the market wasn’t as bearish on its equity and was pricing in lower bankruptcy risk. That said, the market was definitely bearish, just more bearish on Antero’s equity than Range. If you got back and read sell-side reports, when running their NPV models, they were using a long-term price for natural gas of only $2.25 to $2.50. With gas prices recently trading north of $7 MMBtu, boy, how fast things change in the commodity world. The biggest thing the sell-side missed was how quickly Range was taking out costs and being disciplined with its CAPEX. Also, most importantly, Range’s bank line was affirmed in March 2020, and the street ignored how bullish that was for Range’s equity, as it was then (almost) priced for bankruptcy. Incidentally, I had a few fantastic and in-depth conversations with the folks at Range, during 2019 and the first half of 2020 and one of their analysts absolutely nailed the LNG demand story. Similar to Antero, I had been following Range closely since 2016. And just to be clear, I sold all my Range shares just shy of $10.

For a more recent example, on March 14, 2021, I wrote: CVR Partners, LP: My Best Current Commodity Idea. Shares of CVR Partners, LP (UAN) are up 433%, including $9.89 of cumulative paid distributions since the time of publication. I actually bought a large-sized position in UAN at $27.50. However, I sold all of my shares in the mid-$50s, after a quick double. The big second leg up, in UAN shares, after the initial double, was driven by natural gas prices going parabolic in Europe. As natural gas is a big input in the production of ammonia (I covered this in my article), nitrogen fertilizer was shut in, in Europe, as gas needed to be saved and reserved for use in heating. This created a supply shortage and was a huge structural advantage to the non-European producers. With the terrible events in Ukraine, as Russia is a big fertilizer producer, the supply shortage has become more acute. I would argue that had the war not occurred in Ukraine, there is a very good chance UAN shares would be trading between $80 and $105 and would have never traded up to $180 (on April 20, 2022).

And lastly, although I never got around to sharing any of my work on Alpha Metallurgical Resources, Inc. (AMR), then called Conterra Energy, on the free site, AMR was one of my then top three best ideas to my Second Wind Capital group, when I launched the marketplace service, back in May 2020. AMR is the largest met coal producer in the United States, almost a pure play way to play met coal. Although back in May 2020, the company had about $600 million of debt, they took a ton of costs of its structure and managed to survive the depths of the down cycle. Since Q4 2021, there has been a huge leg up in met coal prices, and given AMR’s large production and huge operating leverage to higher seaborne met coal (and domestic met coal) prices, shares have exploded higher.

Before the big pullback, last week, AMR shares recently hit $165. If you had perfect timing and bought AMR shares at the time of my original recommendation, at $4, and held on and miraculously high ticked it, by selling it at $165, that would have been a 40 bagger. No one ever has perfect timing, but $4 to $129.24 (this past Friday’s closing price) is a 31-bagger. Again, this assumes perfect timing, both buying at the time of publication and holding on. It is a long story, but I wasn’t able to capitalize on this monster move in Air shares.

So, what’s my long-winded point?

My long-winded point is that I have been an off-and-on commodities stock investor/speculator since the early 2000s. At the recommendation of a buy-side friend, I read Jim Rogers’ book, Hot Commodities, in early 2005, soon after its first publication. Incidentally, I was long shares of Wheaton Precious Metals (WPM), then called Silver Wheaton, back in the 2004. If you want to see a boom-bust cycle, take a look at WPM’s stock chart. The stock got as high as the high $19s, in March 2008, only to crash into the low $2s, by November 2008. That is a 90% drop in less than a year! People have short memories when the cycle is strong, and they are riding big winners.

A few years later, after the crash of late 2008 in WPM shares, fast forward to the first half of 2011, and silver went on an epic run. This was a run that would have made the Hunt Brothers blush. Lo and behold, WPM shares moved from $2.50 to the high $40s. Incidentally, my father-in-law, also long a bunch of WPM shares, had a wealthy friend visiting him for Thanksgiving, November 2008. That friend ended up buying 20,000 shares of WPM, around $3 per share, and ended up cashing out in the low $30s for a sweet 10 bagger in a few short years’ time. Timing is everything when it comes to commodities and commodity stock!

Wheaton Precious Metals Corp.’s Chart

Putting It All Together

One of my biggest frustrations when reading free site articles or fielding comments within my free site articles, and this isn’t unique to SA, is that far too many people seem to mostly focus on outcome and not thought process. If you are on the buy-side and get paid to synthesize, this means trying to figure out companies and sectors and then make actionable recommendations based upon facts, logic, and reason. That is how you are judged, as an analyst. The reason is that there very often can be an element of luck, both bad luck and good luck, and that is hard to disentangle luck’s role in the outcome.

Since we are talking about commodities and commodity stocks, albeit at a very high level, as this is a very complex topic that could deserve multiple articles to dive deeper, I would argue that the big blow-off top, in oil and many other commodities impacted by Russia’s actions, was largely attributed to luck. Let’s keep it intellectually honest, how many analysts, on January 1, 2022, decided to recommend a (or remain) super overweight allocation to a basket of commodity stocks on the thinking that Putin would go on an all-out offensive and invade Ukraine?

Depending on both the level of reader interest and (thoughtful) engagement, I may explore this topic much further. Either way, if your goal is to become a better investor, and you work and strive towards that goal week in and week out, then I would strongly urge readers to focus on authors that have the best thought processes as opposed to the author’s that might have been right and gotten lucky. Also, even the best analysts can look silly during nasty bear markets. The cycles always look so scary at the trough and amazing at or near the peak.

Lastly, as someone who has been investing/speculating in commodity stocks since the mid-2000s, and I even made a few good calls that are a matter of public record, here in SA, my sense is we are at or approaching the top of the 8th inning in this commodities supercycle. I could, of course, be wrong. It wouldn’t be the first nor the last time.