Stock Market Smarts: Commodities – A Falling Knife

Gordon Pape | August 3rd, 2015

Resource stocks look cheap right now. But don’t rush to buy– they may be even cheaper next week.

A little over a year ago, a financial professional suggested to me that it was time to start buying commodity stocks.

His rationale was very clear. The general consensus among economists at that point was that we were finally emerging from the after-effects of the Great Recession. World GDP growth was accelerating, led by the United States, which was seen to be undergoing a kind of economic renaissance. A return to normal growth patterns would lift moribund commodity prices and the shares of producer companies would follow suit. Get them while they’re still cheap, he advised.

I was skeptical and told him so. The so-called recovery looked very fragile and there were signs that China was slowing down. It didn’t seem like the kind of climate to fuel a commodities boom. As it turned out, it wasn’t.

Commodity stocks are highly cyclical. When growth is strong, demand for raw materials rises, squeezing supply and driving prices higher. Producing companies see margins widen and their bottom lines fatten up. Stock prices soar accordingly.

The profits can be mind-boggling, even from blue-chip companies. So can the losses, if you buy and sell at the wrong time. Take a look at the history of Teck Resources (TSX: TCK.B, NYSE: TCK), Canada’s largest diversified mining company and a major global producer of copper, zinc, and metallurgical coal. In July 2000, in the midst of the tech crash, its shares traded as low as $4.38 on the TSX. Eight years later, in June 2008, they hit a high of $51.24, a gain of 1,070 per cent!

Then came the credit crunch and the shares plunged again, falling as low as $3.50 in February 2009. That was followed by yet another huge rebound, to $62 in December 2010 for an advance of 1,671 per cent in less than two years. Now we’re back in another long downward slide with the share price slipping below $10 last week.

Commodities stocks may look cheap at this level but don’t be fooled – this is likely a case of falling knife syndrome. We saw it during the crash of 2008 when the share prices of many well-known U.S. financial companies like Wachovia Bank, Washington Mutual, and American International Group fell off a cliff. Many people didn’t believe they could fail so they snapped up the shares at what seemed like bargain-basement levels. Sadly, prices continued to fall until the companies went under or were taken over at fire-sale valuations.

We’re likely seeing the same phenomenon in the commodities sector right now. Prices are cheap but are likely to get cheaper.

The management of Teck Resources signalled as much with the release last month of the company’s second-quarter results. After noting that current markets are “challenging” and that the prices for some of its products have declined, the company issued this warning:

“Commodity markets have historically been volatile, prices can change rapidly and customers can alter shipment plans. This can have a substantial effect on our business. Demand for coal, particularly in China, has weakened substantially. Increased supply from Australian mines has also put downward pressure on coal prices. The weakness in some of these markets may persist for some time and, if of a long-term nature, could affect the fair value of our operating assets, which could require adjustments to company values.”

That last statement is worrisome. “Adjustments to company values” could involve writing down the valuations of some of Teck’s assets. The balance sheet released with the second-quarter results shows almost $30 billion worth of property, plant, and equipment assets. The company regularly performs impairment tests for all major assets and did not find anything of significance this time. But that could change quickly if conditions don’t improve.

Ironically, Teck reported year-over-year production increases in zinc, copper, and coal despite significant price declines in the latter two commodities. Copper production was up almost 7 per cent over the second quarter of 2014 even though the realized price per pound dropped 10 per cent from US$3.07 to US$2.76. Coal production rose 3 per cent while the price fell from US$111 per tonne to US$95.

This is consistent with what we are seeing from many other commodity producers, from big oil companies to precious metals firms like Silver Wheaton. They’re maintaining or increasing output to protect market share, even though they’re receiving much less money for their products. The effect when taken against a backdrop of weak demand is to increase supply, thereby driving prices even lower.

That vicious circle leads me to the conclusion that we still have a way to go before we reach the bottom of this phase of the commodities cycle. As in the past there will be big profits to be made in these companies. Just not yet.