SECTOR SCOPE by Pamela Black August 24, 1999

Natural Resources Come in from the Wilderness
Bullish scenarios are starting to make many areas of this sector more appealing

Need a dose of diversity for your portfolio? If so, maybe it's time to consider natural resources. After all, several factors are coming together nicely now to give this sector a bullish outlook. As Asia stabilizes, its recovery will create renewed demand for basic commodities, such as oil, metals, lumber, and chemicals. In addition, the market swing toward cyclical stocks -- and the slightest whiff of inflation -- are drawing some investors' attention away from blue-chip growth and high-tech stocks to more price-sensitive commodities.

Among the natural resources funds, those like Vanguard Energy (VGENX) and Invesco Energy (FSTEX) invest mostly in oil and gas stocks, and those like T. Rowe Price New Era (PRNEX) and Putnam Global Natural Resources (PNRBX) diversify among energy, paper, chemicals, and metals companies. Which fund you choose depends on whether you're more interested in exposure to general commodities or to energy. While rising oil prices, up 73% this year, are clearly driving the rebound for natural resources funds, fundamentals have improved in several nonoil commodities as well.


If Asia continues to recover, metals and chemicals could strengthen

"Diversification helps us in periods that are tough for natural resources and when there's a broad recovery," says T. Rowe Price New Era manager Charles Ober. "We tend to lag if one particular resource is doing better than the others." His fund is up 24% year to date, but it could go higher since paper products as well as oil are on the upswing. And if Asia continues to recover, metals and chemicals could strengthen.

After bottoming about a year ago, the S&P Forest Products & Paper Index is up about 30% this year. "These markets rolled over a lot earlier in the business cycle and got a lot of rationalization of production and better supply-demand balances," says Ober. Wood and building products have been running up, so Ober is looking to paper companies for greater future potential. "The key to paper price improvements is pulp, which has started to recover," he says. "So, we're seeing higher prices for coated free sheets and newsprint." Ober has been moving out of forest-products companies such as MacMillan Bleodel (MMBL) and Georgia Pacific (GPW) and into paper companies such as Champion International (CHA) and International Paper (IP).

MILD UPTICK. Metals are a dicier proposition. While Ober thinks the worst is over for gold, the precious metal has been limping along for what seems like forever. Base metals such as aluminum and nickel, used in making steel, have fairly tight supply demand fundamentals right now. Aluminum inventories are low, primarily driven more by restructuring in these companies than by commodity prices," says Murice Onyuka, an investment analyst at Clemente Capital in New York. A massive consolidation movement is under way in aluminum, with Alcoa buying Reynolds and a three-way merger of Canada's Alcan, France's Pechiney, and Switzerland's Alsuisse Lonza. That should help as should a mild uptick in demand from industrial production in Asia. Nickel, too, has a deficit, causing prices to rise 20% to 27% since the beginning of the year. That could continue in the next two quarters, says Onyuka, who doesn't think nickel has as far to run as aluminum, however.


Latin America is the chief culprit behind copper's oversupply and low prices

Copper has so far been missing out on the resurgence, although the Phelps Dodge (PD) bid on Aug. 20 for Cyprus Amax (CYM) and Asarco (AR) could spark a consolidation-led comeback. Copper's primary problem has been oversupply, in part because foreign producers, mainly in Latin America, haven't cut back. "Their currencies depreciated, and costs went down, allowing them to stay open when high-cost facilities would otherwise close," says Ober. This has kept copper inventories high and prices low.

Putnam Global Natural Resources manager Delores Bamford is a little more sanguine about copper, but she's hedging her bets. "I'm focusing on companies that can improve returns in a flat pricing environment," like copper giant Phelps Dodge and Alcoa (AA), which is about halfway through a billion-dollar cost-cutting plan. She considers these two companies to be the best-managed in the metals industry because of ceaseless efforts to improve returns. "If you're more positive on copper pricing, Phelps is an even more attractive," she says. "It has high yield, so you're getting paid a little while you wait."

A KICK FROM OIL. As for chemicals, Bamford is bullish on Dow's (DOW) acquisition of Union Carbide (UK) because Dow is cutting costs and refocusing on high-margin specialty chemicals. "No one thought they could achieve returns equal to the cost of capital at the bottom of the cycle, and they have," she says. Carbide should add to earnings if the price of ethylene (used in plastics), which is currently bottoming, turns around. Bamford's Putnam Global Natural Resources is up 29% year through the beginning of August.

If you want to get in on rising oil prices, but don't know much about basic commodities, an easy play is to buy a natural resources mutual fund that invests almost exclusively in energy stocks. These funds will give you more leverage from oil prices, says Chris Traulsen, an equity-fund analyst at Morningstar.


Oil stocks have already enjoyed a big jump, but there's likely still room to run

How much leverage depends on whether the fund invests primarily in big integrated multinationals such as Exxon and BP or smaller oil-services companies such as exploration, drilling, and production companies. For example, Fidelity Select Energy (FSESX), which emphasizes the "oil majors" has earned year-to-date returns of 50%, while Fidelity Select Energy Services (FSESX), which invests primarily in small- to mid-cap services companies, returned 76.16%. (Of course, such dramatic returns carry equal downside risk. While the former was down 15% for 1998, the latter lost almost 50%.)

Despite such runups, there's still room for oil profits to flow. "The next 18 to 24 months look very positive," says John Segner, manager of Invesco Energy (up 52% year-to- date). "You can make some very good money in this group even though the stocks have moved up from their bottoms because they were grossly oversold to begin with." (See BW Online, 8/2/99, "Oil Stocks: A Pleasant Reversal of Fortune".)

Take his biggest holding, USX-Marathon Group, an integrated oil company he bought at 20 and rode to 30. It still hasn't returned to its $40 high of a year-ago March, and it's in much better fundamental shape now. Another example: seismic data company Veritas (VTS), which Segner bought at 10 in January, and which, trading now at 17, is still dirt cheap compared with its year-ago-April high of $61 a share.

"THAT'S GRAVY." Segner favors the smaller companies right now but is not counting on crude prices alone to turn a profit. "My companies can increase earnings at $18 a barrel [instead of current prices of over $20]," he says. "If I do get an increase in prices, that's gravy."

When it comes to natural gas, which is also seeing improved fundamentals, pipeline companies are a cheap play. Segner likes companies such as Coastal (CGP), which has 18,000 miles of natural-gas pipe, and El Paso Energy (EPG) with 28,000 miles of pipe. In exploration and production companies, he likes Talisman (TLM), a Canadian company selling at a fraction of its value, and Apache (APA).

If you're still not convinced that natural resources funds deserve a look-see, consider this: These funds truly add diversification to an overall portfolio because they don't move in tandem with the S&P 500-stock index. Moreover, Lipper Analytical President Michael Lipper points out that the S&P and many funds have cut back on their energy weightings, from about 20% of assets to about 6% because so many other funds have done much better. Now he says, many investors only have either no exposure or only 1% exposure to a sector that deserves at least 10%. Dig in.

Black is a New York-based finance writer _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

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