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Financial Times: On London: Tough times for resource stocks

By Chris Brown-Humes
Published: September 22 2006 18:09 | Last updated: September 22 2006 18:17

Times are tough for the bulls on oil and commodity stocks. The sharp falls in oil prices since July have coincided with fresh bouts of troubles for sector heayweights BP and Shell. That has raised doubts about one of the biggest and most successful trades of the last few years – overweight oils and miners. But the the bulls should hold on. The story is not yet over, even if the ride is going to get bumpier.

It is a call which has ramifications for the wider UK market. London has been underperforming, precisely because resources stocks have been falling and because there is a greater weighting of these in London than in other European markets. While the FTSE All Share is nearly 5 per cent below its April 21 peak, the FTSE Eurofirst 300 index was at four-month highs on Thursday. Its close yesterday was only 2.5 per cent below the five and a half year peak in May.

Resources stocks have succumbed to profit-taking after the big gains of recent years. The FTSE All Share Oil and Gas index is down 11.5 per cent since April 21 while the Mining index is down 11 per cent. The heaviest falls have taken place in the last month. Given that mining accounts for six per cent of the All Share – it was less than two per cent in 2000 – and that oil and gas is 15 per cent, it is not hard to see why London shares have been struggling to make progress. This is despite the fact that many sectors of the economy are potential beneficiaries of lower oil prices.

US oil prices have fallen 20 per cent to $61 a barrel since early August, gold is down by the same amount since its 26-year peak in May and copper has fallen 13 per cent since May. One of the main reasons for the falls is that slowing US demand has become a greater worry for markets than rising inflation now that there is clear evidence of a drop in US housing activity and that the Federal Reserve has stopped raising interest rates. If fewer new homes are built in the US, there won’t be as much need for copper piping, for example. At the same time, a US slowdown could have an impact on the wider global economy, particularly the Chinese one, because of the importance of US exports to China.

But lower oil prices are not the only reason oil and gas shares have been falling. BP has become mired in all sorts of difficulties in the US, following a blast at one of its Texas refineries; pipeline corrosion problems in Alaska; and production delays at its Thunder Horse oil field in the Gulf of Mexico. These issues are clearly taking their toll on BP’s share price, which has underperformed Exxon Mobil’s share price by 10 per cent this year. Royal Dutch Shell also faces company-specific issues, including interference by the Russian authorities in the Shell-led Sakhalin-2 project.

The question is whether oil and gas stocks are now undervalued with ABN Amro noting this week the oil and gas sector was trading at a record discount to the market. The oil and gas index price-earnings ratio is 9.11 compared with 12.87 for the FTSE All-Share. That’s probably fair if you think oil is heading back towards $40 a barrel and believe oil and gas earnings have been heavily inflated by oil price strength.

But there are many reasons for believing the oil price drop is only temporary. The US driving season is over, so demand for gasoline is lower, but soon demand for heating oil will start to increase as winter approaches. Hurricanes have been notable by their absence this year, while concerns about the Iranian nuclear programme have temporarily dissipated. It is all too easy to imagine new geopolitical tensions. As for BP’s US problems, it is far too early to say that it is out of the woods, but its share price is already probably discounting many of the problems it is experiencing there.

Mining stocks are also trading on a low price-earnings ratio of about 8.5. That suggests the market believes earnings are heading for a sharp fall as commodities prices drop. There are concerns about corporate governance at some big international mining groups that have joined the London stock exchange in the last few years.

Yet commodities demand remains robust in China and India, corporate balance sheets are strong, even if commodity prices fall further, and there is every prospect of increased dividends and further share buy-backs. Moreover there are good reasons for expecting consolidation in the mining sector to continue, because it can be cheaper to buy companies than spend money on exploration and development. Anglo-American – in which Chinese investors were this week rumoured to be building a stake – is only the latest mining company to feature in the regular consolidation gossip surrounding the sector. On balance, resources shares are attractive, providing you believe that global demand will slow rather than collapse next year.

Copyright The Financial Times Limited 2006

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