Investing in natural resources can seem daunting for those just getting started.
Whether you’re looking at lumber, oil or natural gas, the prices of these commodities can be extremely volatile. And that volatility is also reflected in the share price performance of companies that produce and process those same commodities.
So how should a novice investor approach the market of natural resources?
MoneyWise recently spoke with investing legend Rick Rule — former president and CEO of Sprott U.S. Holdings — to learn how to tackle this increasingly critical sector.
Rule thinks the raw materials space is a great place to be for the next five years due to the inflationary, interest rate and geopolitical risks the market faces. But you can’t just follow the herd.
“You're going to be a contrarian, or you're going to be a victim,” Rule says.
Let’s take a closer look at what Rule means by that.
Go against the herd
A contrarian investor deliberately goes against prevailing market trends. They buy when most investors are selling, and sell when others are buying.
It’s a strategy a lot easier said than done: When the price of an asset plunges, you simply don’t know where the floor is. But according to Rule, being contrarian is particularly important when it comes to investing in natural resources.
“The cure for low prices in commodities is always low prices,” he says, pointing to oil as an example.
When crude was trading at $20 a barrel at the onset of the COVID-19 pandemic, producer costs were roughly $50 to $60 a barrel on average. So by producing 70 million barrels a day, the industry was taking daily losses of $2 billion.
As a result, producers couldn’t even maintain sustaining capital investments while new projects were certainly out of the question.
“If you don't continually reinvest in a business, where the only guarantee is depletion, you lose the ability to produce,” Rule says.
But as we’ve clearly seen, it's those low prices that have led to constrained supply and increased demand. Oil prices are now at over $100 a barrel, translating into big profits for contrarians who loaded up on the cheap.
“Markets are messy, but markets always work.”
Pick the right bargains
Of course, not all beaten-down assets are guaranteed to turn around. Shares of embattled BlackBerry, for example, plunged from over $147 apiece in June 2008 to around $10 in 2012. Today, they're trading at $5.88.
So what should investors pick up if they want to take a contrarian approach? Rule’s answer is simple: Consider things that we can’t live without.
“You need to look at asset classes that are necessary for the maintenance of the living standards of humankind that are out of favor.”
Again, oil serves as a good example.
Rule explains that if you have a natural resource like oil, which is essential to the material well being of human beings, and that commodity is priced substantially below its cost of production, only two things can happen: The price goes up, or the commodity becomes unavailable (and the world's material standard of living goes down).
The easy money on oil was made two years ago when its price was deep in the doldrums.
Rule cautions that if the Russia-Ukraine conflict resolves, we could see “a fairly immediate and precipitous decline” in oil and gas prices.
That said, he still sees opportunity in the energy space — particularly north of the border.
“Canadian oil and gas industry is priced relative to cash flow as though the oil price was at $60, but it's at $100. In other words, a big decline is already built in the prices of the producers.”
While the significant volatility of energy stocks can make holding them uneasy, Rule advises patience.
“If you are willing to own these stocks for three or four years, the extraordinary free cash yields that they generate at lower energy prices and their current reticence to engage in too much reckless expansion, but rather, their preference for returning cash to shareholders means that the sector is particularly attractive.”
Stick with blue chips
In any sector, there are small companies, medium companies and large companies, each offering unique risk-reward profiles. When an industry is expanding, both little players and established leaders can thrive.
But for investors who are just getting started in the commodities space, Rule says it’s best to stick with blue chip names.
“I think for beginning investors, in particular, at least 75% of their natural resource-oriented portfolio should be in very large companies, where the company operates in the best quartile worldwide in terms of production costs, and historically has operated in the best quartile worldwide in terms of return on capital employed.”
“In other words, not just big companies, but big, good companies.”
This advice applies to more than just oil and gas.
Gold, for instance, is getting renewed investor attention amid spiking inflation and global unrest. The price of the yellow metal has surged to around $2,000 an ounce as of this writing.
Gold investors who are keeping it simple with big miners are indeed doing well. Shares of Barrick Gold (GOLD) are up 20% year to date, while Newmont (NEM) is up 22% over the same period.
Rule says that when generalist money comes into the precious metals market, it doesn’t go into “dreadful looking” penny stock names. “It goes to Barrick.”
The bottom line
We are already in a commodity price boom. But investors who are eager to jump into the space should be extra careful at these elevated levels.
“The cure for high prices is always high prices,” Rule cautions. “There will be a time when $110 oil is silly, it will cause people to drive less, and it will cause other people to drill more.”
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