Consumers expecting a break from high prices for oil, gas and other natural resources are likely to be disappointed, says Leigh Goehring, manager of the Jennison Natural Resources Fund. The 45-year old Goehring believes we are in the early stages of a bull market for commodities that could last for several years. If his prediction proves correct, he believes that stocks of certain companies involved in the production of these natural resources are poised to deliver returns well above the market averages between now and 2010.
"Historically, commodity prices tend to go through long cycles," observes Goehring, who has managed the fund for almost 13 years. "There is a lot of evidence gathering now to suggest that another bull market cycle in commodities has already begun."
If it comes to pass, a natural resource bull market would be something not seen in more than two decades. The last one started in the late 1960s and lasted until around 1980, he says. During that time, supplies increased dramatically as the former Soviet Union made massive investments in its natural resource infrastructure. When consumption in that country declined precipitously about 1990, a flood of exports increased supplies and depressed prices.
The supply-demand tide began to turn in the late 1990s, when the prices of platinum and palladium, two metals critical to the production of automobiles, started to climb. The bull market for those metals spilled over first to nickel, and later to copper. Last year, the latter metal's price spiked from $0.77 a pound to $1.05 a pound by the end of December. Stock of copper producer Phelps Dodge, which Goehring began buying in December 2002 at an average price of around $31 a share, ended the year at $75. He believes that copper, which now sells for around $1.40 a pound, could rise to more than $2.00 a pound over the next several years as demand from China and other developing countries strains supplies. The fund has about 8 % of its assets in companies that produce the metal.
The strong performance of Phelps Dodge and the other metals and mining stocks in the portfolio, which now account for about one-quarter of fund assets, helped the fund gain 37.1% last year. That performance gave it an advantage of nearly five percentage points over its Morningstar category average and put it over eight percentage points ahead of the Standard & Poor's 500 Index over the same period. Over the last five years, the fund's average annualized return of over 20% puts it ahead of 87% of its peers. It has also been well ahead of the S&P 500 Index over that period. "Our out-performance of the overall market actually started in 1999, but people were too enamored with traditional growth stocks to notice," says Goehring. "This bull market in commodities and commodity stocks began very quietly."
Lately, the quiet rally has become a lot noisier as the upturn in oil and gas prices, and stocks of companies involved in the production of those commodities, continues to intensify. The increased price of oil, which has risen from $28 a barrel to around $35 over the last year, comes as non-OPEC countries face declining hydrocarbon reserves. The rate of increase in oil production has slowed significantly, and Goehring thinks non-OPEC production could decline over the next few years. Although increased production from West Africa and the Soviet Union could help balance out the downturn, he believes that geological constraints will give OPEC countries greater leverage to increase prices. He says that while the price of oil could pull back to the low 30s in the coming months, it could pop up to the high 30s or low 40s later in the year as seasonal demand picks up.
Still, he contends that both investors and consumers need to put the well-publicized and politically contentious pain at the gas pump into perspective. "The real price of oil is still incredibly low," he says. "After you take inflation into account, it would have to go to roughly to $90 a barrel to equal its 1980 price. People should view this not as a crisis, but as a bull market."
The case for an inflationary crisis was much more compelling in the late 1970s, when long gas lines and runaway inflation sparked his interest in commodity prices. That interest led Goehring, then a the math and economics major at Hamilton College in upstate New York, to write several papers about the factors behind the ebb and flow of gas prices.
Goehring joined Prudential in 1986 after a stint as a trust officer managing general equity accounts with Bank of New York. He began managing the fund in 1991, and Mark G. DeFranco joined him as co-manager in September 2000. The fund was called the Prudential Natural Resource Fund until June 2003, when a change in branding strategy prompted the financial services giant to replace its own name with that of Jennison Associates, a subsidiary and Goehring's current employer.
Despite the name change, Goehring has stuck with an investment strategy that focuses on finding pockets of the commodity markets that are out of favor, then investing in companies that he believes are likely to benefit from any price upturns in those commodities. He occasionally buys notes and other securities whose fluctuations are linked directly to the price of underlying commodities. At 52% of assets the United States represents the fund's largest country allocation, followed by Canada at 14.3% and South Africa at 6.4%.
In addition to copper, Goehring likes the prospects for alumina, a component of aluminum, because of the scarcity of deposits and solid worldwide demand. Fund holding Alumina Inc., an Australian company, owns 40% of an Australian miner of bauxite, the main component of alumina. A scarcity of high-grade iron ore deposits also makes that metal attractive, he says. Brazil's Companhia Vale Do Rio, another fund holding, derives three-quarters of its earnings from iron ore mining.
On the other hand, he is cutting back some of his positions in gold and precious metals mining stocks, which were some of the fund's best performers in 2002 and 2003. While the price of gold rose from $258 an ounce in mid-2000 to around $420 an ounce earlier this year, he believes that gold prices will "take a rest" for the remainder of 2004. Looking over the long term, he believes that gold prices will continue to climb and plans to accumulate precious metals stocks on any short-term pricing weakness.
In the energy sector, which makes up 57.7% of assets, Goehring avoids the familiar names of the large, well known North American integrated oil and gas companies that are widely regarded as standard fund fare. He believes that their large asset bases in the North Sea and other areas with dwindling reserves will make it difficult for them to grow production effectively. Many of them will need to downsize or merge to remain competitive, he believes.
A gravitation toward small- and mid-cap names gives the fund higher-than-average volatility in a space that already bounces around more than most of the market. "Given the fund's solid long-term record, it is a decent option for more aggressive investors looking to diversify," notes Morningstar analyst Lynn Russell. "But they need to keep in mind that a fund that focuses on both cyclical commodities and smaller companies can make for an especially rough ride."
Those up to the challenge have a sizable stake in companies with small- or mid-sized market capitalizations that provide services to the drilling industry. "We're on the verge of a large global drilling boom, and these stocks will be the primary beneficiaries of increased drilling activity," says Goehring. Houston-based BJ Services, which the fund started buying six years ago at around $7 a share, specializes in pressure pumping and other extraction techniques designed to improve oil production. The shares now trade at about $41. Weatherford International, another oil services stock, specializes in improving production from mature or marginal oil wells. And Smith International, the fund's second largest holding, makes drill bits and well-related tools.
If Goehring invests in an energy producer, it must have a large reserve base or an unconventional technology to grow production. Canada's Suncor Energy, for example, extracts oil from its stake in the Althabaska Tar Sands in Alberta, where the tar sands are estimated to have oil reserves that rival nations in the Persian Gulf. Because extraction is more of a manufacturing and refining process than one involving exploration, Suncor should be able to grow production more effectively than most of its larger competitors, Goehring says.