Multi Asset

The Heart of the Matter

The Heart of the Matter

For many developing economies, the commodities ‘super cycle’ has been both a blessing and a curse. Insight Investment’s Rodica Glavan and ARX’s Alex Gorra consider how pricing volatility has affected governments around the world. 

The flip side of stratospheric growth is abrupt decline—and for the commodity producers of the world, that’s been the story of the past couple of years. Oil led the way, falling from over US$100 a barrel in mid-2014 to just above US$26 a barrel at the start of 2016.1 But amid a global surplus of supply and low demand, the full spectrum of commodities took a drubbing— with everything from metals to soft commodities falling to levels not seen since the dark days of the global financial crisis.

Emerging market (EM) countries in many ways bore the brunt of the collapse: the Institute of International Finance estimates global investors pulled US$735bn out of emerging market bonds and equities in 2015, the worst capital flight in 15 years.2

But according to Insight EM debt manager Rodica Glavan, the popular view of emerging markets as predominantly commodity-dependent net exporters is a mistaken one. For some countries, energy is a key export; while for others (Latin America, for example) exports are predominantly soft commodities and metals. In Asia, with one or two exceptions, countries are mainly net importers, particularly of energy. Across emerging markets, just 44% of countries are net exporters, while 56% are net importers.3

For Glavan, these nuances matter. They demonstrate the importance of viewing EM not as one monolithic whole but rather as a broadly differentiated set of investment opportunities and challenges. “In our view, it is not a country’s degree of dependence on commodities but how it uses those revenues that determines long-term success or failure. In this sense, it’s hard to overemphasize the need for fiscally prudent policies. If they can put those revenues to good use, then the country will be far stronger and the investment case more compelling."

One important concept, says Glavan, is progressive taxation — that is, only taxing commodities producers what they can afford. Far too often, she says, large quasi-sovereign commodity- producing companies have been seen as cash cows which can be milked to the point of exhaustion to help pay for often politically motivated social programs. This is the case in Venezuela, where the contributions to social programs from state-owned oil company PDVSA went up by more than 72% in 2015 — even as net earnings dropped over 19% due to weaker global oil prices.4 A similar scenario played out in Mexico, where for the past two decades state-owned oil company Pemex has underwritten between 20% and 40% of the country’s federal budget.5 The long- term impact of this protracted policy of capital extraction has been devastating. Pemex’s oil production fell by 20% over the 10 years to 2013; reserves declined by a third over the same period and Mexico went from being a net exporter of energy to being a net importer.6

As a salutary lesson in how to avoid this kind of unsustainable approach, Glavan points to countries like Colombia. There, since 2000, the government has charged state-owned oil firm Ecopetrol higher taxes only when its profits reach above a predetermined level. Even in the face of precipitately declining oil prices, this has allowed the company to maintain and even increase investment and output.7

IN SEARCH OF POSITIVES

While the commodity collapse may have sparked investment outflows from emerging markets, on a country level there is evidence to suggest price volatility may have had some upsides.

Glavan notes how cheaper oil prices were a boon not just for the economies of energy importers, but also for legislators keen on reform.“Asia, which on a net basis imports more oil than it produces, is one of the regions to have experienced a windfall from cheaper energy,” she says. “But even in export countries, the collapse in oil pricing had its benfits.” She highlights Indonesia as a case in point: it used the breathing space of a plummeting oil price to scrap an expensive fuel subsidy program that in 2013 cost US$23bn, or around 20% of the state budget.8 President Joko Widodo pledged to invest the billions of dollars of savings into infrastructure projects and push for “total reform” of the aviation sector.9 Nigeria, where oil revenues account for some 90% of the federal budget and where subsidies hit a peak of US$14bn in 2011, followed suit.

This kind of reform is important for developing countries, says Glavan, since it frees up investment into more productive areas of the economy. The International Growth Centre, a UK- based think tank, estimates artificially low fuel prices cost governments around the world US$500bn each year. It says subsidies encourage wasteful energy consumption, create fiscal burdens on developing country budgets, and disproportionately benefit wealthy households.10

UPSIDES IN ADVERSITY

Alex Gorra, senior investment strategist with Brazil-focused investment boutique ARX, highlights another possible upside from the commodity price collapse. For Latin America’s second largest economy, sluggish Chinese demand and the end of the commodities super cycle exposed not only economic losers but also revealed some unexpected winners, he notes.

“When the tide went out on pricing it left a lot of companies stranded — and unquestionably that was painful. But the upside is how it also helped investors identify hitherto unrecognized areas of resilience within the economy.”

Even companies that suffered the most have benefited in unexpected ways. This is the case with Petrobras, the state- owned energy company beset by the twin challenges of falling oil prices and a national political scandal. Here, says Gorra, the previous management team’s investment plans have been pared back with a far firmer focus on core profitability.

Elsewhere, the receding tide of commodity prices helped reduce the weighting of basic materials companies in the Bovespa stock exchange, allowing the financial services, consumer and infrastructure sectors to gain prominence after being in the shadow of commodity producers for so long.

For now, says Gorra, what Brazil needs most is stability, particularly in its currency. Coupled with an ongoing reform program, this should provide a platform for a return to growth and help restore investors’ confidence in the economy.

Glavan agrees, noting the longer-term question of whether commodity prices could rebound is almost irrelevant. Far more important, she says, is a period of pricing equilibrium. “Countries and companies around the world need that breathing space,” she says. “A respite from price volatility could make all the difference — even if it’s only for a few months.”

1. CNBC: ‘US Oil Falls on Unexpectedly Large Inventory Build’, January 20, 2016.

2. Bloomberg: ‘Emerging Markets Lost $735 Billion in 2015, More to Go, IIF Says’, January 20, 2016.

3. JP Morgan: ‘EM Exposure and Vulnerability to Commodities Revisited’, March 9, 2016. 

4. Bloomberg: ‘Venezuela’s PDVSA Revenue Plunges Amid Commodity Price Collapse’, July 3, 2016.

5. The Economist: ‘Make or break for Peña Nieto’, November 23, 2013.

6. The Economist: ‘Make or break for Peña Nieto’, November 23, 2013.

7. Library of Congress Federal Research Division: ‘Colombia: A Country Study’, 2010. “In 2000 the Government Modified the Royalties System, with Variable Coefficients Based on Output and Ranging From 5 per Cent to 25 per Cent.” 

8. The New York Times: ‘Indonesia Struggles to End Fuel Subsidies’, May 2, 2013.

9. Financial Times: ‘Indonesia’s Joko Widodo pledges to accelerate reforms’, January 13, 2015.

10. International Growth Centre: ‘Low Oil Prices: An Opportunity for Fuel Subsidy Reform’, January 18, 2016. 

Risks

Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Investing in foreign denominated and/or domiciled securities involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity.  These risks generally are greater with emerging market countries. 

BNY Mellon ARX is the brand used to describe the Brazilian investment capabilities of BNY Mellon ARX Investimentos Ltda. Investment advisory services in North America are provided through four different SEC-registered investment advisers using the brand Insight Investment: Cutwater Asset Management Corp., Cutwater Investor Services Corp., Pareto New York LLC and Pareto Investment Management Limited. The Insight Investment Group includes Insight Investment Management (Global) Limited, Pareto Investment Management Limited, Insight Investment Funds Management Limited, Cutwater Asset Management Corp. and Cutwater Investor Services Corp.

Views expressed are those of the author(s)/manager(s)/advisor(s) stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. This information should not be construed as investment advice or recommendations for any particular investment. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.  ARX, Insight Investment, and MBSC Securities Corporation are subsidiaries of BNY Mellon. ©2016 MBSC Securities Corporation, 225 Liberty Street, 19th Fl., New York, NY 10281.

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