Adam Rozencwajg: Commodities Are Radically Undervalued

Tue, Oct 22, 2019 - 4:10pm

Is there hidden value in commodities? Financial Sense Insider talked to Adam Rozencwajg of Goehring and Rozencwajg about the surprisingly low costs of commodities, how they got to these levels and what impact that could have on the market.

See Commodities At Cheapest Levels in 100 Years, Says Adam Rozencwajg for audio.

Price of Commodities

Rozencwajg focuses on value investing in the commodity space, he noted, working from the bottom up to identify unseen potential in companies that produce natural resources.

His work has revealed that commodities are radically undervalued as an asset class. The approach Rozencwajg uses is to chart the commodity price index relative to the stock market over time.

Based on his charts, commodities are as cheap as they've ever been relative to financial assets.

This chart goes back to 1917, when the Goldman Sachs Commodity Index first reported data. Additionally, Goehring and Rozencwajg tried to reconstruct that index going back to the turn of the century.

Using this methodology, Rozencwajg determined commodities are as cheap as they’ve ever been relative to financial assets, measured either by the Dow Jones or the S&P 500.

Commodities have been in a bear market for the last 10 years or so, but few realize just how cheap they now are on this relative basis. Whenever commodities have become very cheap relative to stocks, it's been a good time to be a commodity investor.

The three most striking examples occurred in 1929, 1969 and 1999—just before the Great Depression, the 1970s inflationary period and the period leading into the dot com bubble and the current era, respectively—and also right now.

“Had you chosen to invest in commodity and commodity-related equities, you would have done extremely well in these periods,” Rozencwajg said. “Obviously every cycle is a little bit different, but in the past it has always paid to look at what this ratio has been telling you.”

Oil Presents Most Attractive Valuations

Currently, the largest price dislocation relative to its underlying fundamentals exists in the oil market, Rozencwajg stated. Energy in particular has performed horrendously, he noted, with oil bottoming in February of 2016 at $27 a barrel, while related energy stocks are still making new lows.

Energy prices are too low to balance supply and demand, Rozencwajg stated. Inventory figures from both the U.S. and globally demonstrate quite clearly that the market is in deficit and has been in deficit now for the better part of the last three years, and yet investors remain incredibly bearish toward the space.

In contrast to market sentiment, Rozencwajg sees very positive fundamental developments in the demand side of the equation. Demand remains strong, with China and Indonesia holding up as India comes online as a major source of new demand.

Despite trade war fears and downward revisions in demand from the IEA, the overall picture is that of a world poised to consume more oil going forward.

On the supply side of the equation, oil prices are too low to incentivize new production, Rozencwajg noted. Outside of the U.S., non-OPEC production has declined on a conventional basis for the last 10 years, and those declines are beginning to accelerate.

This represents 45 percent of global oil supply and it's basically rolled over, he added. No new conventional sources have materialized to make up for declining production.

“Of course, what everyone likes to talk about are the shales,” Rozencwajg said. “Yes, the shales have been growing, but now we think even that growth could be on the verge of slowing dramatically. So you have everything lining up. … Non-OPEC supply outside of the U.S. is probably the story that no one's talking about, now in its tenth or eleventh year of sustained declines on a conventional basis. That leaves all of the supply-demand imbalances on the U.S. shales, and we just don't think that's going to be enough to do it. And I think you're seeing that already today.”

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Are the Shales in Trouble?

On a longer-term basis, the supply-demand fundamentals are very clear and very bullish, Rozencwajg stated. Shale supply growth has come to a halt so far in 2019, he noted, and his models reveal that shale grew 65 percent more slowly than in the same eight-month period last year.

The greatest change in the last few months has been seen in the underlying base decline rate. Shale wells have quite sharp initial production decline rates, with loses of 50 or 60 percent in their first year of production, followed by a plateau in production rates.

Drilling has increased substantially in the last 24 months, reducing the average of shale wells overall, steeping the decline rate as more shales are in their early decline period. The result is that we have to produce more every month just to stay ahead of declining production, Rozencwajg noted. Right now, it appears that declines are slightly ahead of new production.

Additionally, over the next few years, the remaining inventory of tier-one wells—the highest quality wells in shale basins—are far lower than most realize, relative to tier-two lower-quality wells.

Because of the steep decline in oil prices, producers have been forced to high-grade—essentially favoring high-quality tier-one well production—to keep turning a profit, Rozencwajg noted. The problem is, this reduces the ratio between tier-one and tier-two wells, weakening long-term production and profitability.

“We think that depletion of the best-quality acres is starting to take hold right now,” Rozencwajg said. “As producers have laid down rigs in the shale basins this year, what's been very noticeable to us is they’ve not seen a massive uptick in productivity, which is normally what we see. … I think part of the reason for that is that we're running out of those best wells faster than people realize. … Out of the three U.S. shale basins, two are basically past their prime. One is very quickly approaching its past-prime point, and there's really no next generation of other shale basins either here in the U.S. or abroad to make up the difference.”

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