The sectors offer better long-term prospects than short-term ones, writes Maha Khan Phillips

It is a truism that in any gold rush, it is the people selling the picks and shovels that make the most money, not the ones that are actually prospecting for gold. Fund managers investing in the energy and mining sectors, where volatility makes it difficult to make short-term bets, are well aware of this.

Roberto Cominotto, fund manager of the JB Energy Transition Fund at Swiss & Global, points out that, as far as he is concerned, some of the most attractive stocks today are those of oil and gas service equipment companies, rather than the exploration companies. "These are the companies that supply the technology to find and develop remaining resources," he explains. "We do invest in oil and gas producers, but it is not one of the largest parts of our portfolio because the producers are having big challenges."

It is easy to see the long-term attractiveness of investing in resources. The world just welcomed its seven billionth human. "I'm phenomenally excited about the outlook for energy investing, whether it is over the next month, or three months, or year, or over five years, because this world is full of people - people who want a better life," enthuses Christopher Wheaton, manager of the Allianz RCM Energy Fund. "That means they consume more energy, whether it is buying a car or moving to the city or buying a fridge-freezer."

All that glisters
But the short-term outlook is really not that clear, particularly for mining. Advisory and broking service provider Davy Research is cautious about the sector, after conducting a survey of steel mills and traders in China.

Unsurprisingly, China dominates the world's commodity consumption - but Davy's survey results reveal slowing demand. Specifically, Chinese demand for steel is slowing; with 70% of respondents actually saying that demand would be down, year-on-year, over the three months from November 2011. Chinese mills are carrying higher than usual iron ore inventories, which will unwind in the coming months, they believe. This view offers some understanding about why the global iron ore price has fallen from $180/t to $126/t over the last few months, as Chinese demand dictates the price. The outlook for iron ore also affects the outlook for steel. "This is not good news for the steel companies as profitability decreases in times of declining input costs," says Davy, in a research report.
Tim Cahill, senior equity analyst at Davy, suggests that investors are too optimistic about the sector. "As austerity is kicks in, my view is that some of the numbers out there are way too optimistic. When you combine a slowing China with what I believe will be a much trickier environment in terms of construction, the end market is going to be much more subdued than people think."

Copper is also affected. In December Goldman Sachs warned that the commodities boom was probably over, with the high oil price and the economic damage caused by the Japanese earthquake and tsunami affecting demand for both copper and platinum.

However, fund managers say it is about logistics as much as anything else. "Over the past six years the supply-side has grown an average of 1% per annum," explains Sam Catalano, fund manager of the Schroder ISF Global Resources Equity fund. "This is in an environment where copper providers have been enjoying margins of 70-80%. There is no shortage of incentive to produce copper, it is just difficult to do."

The one metal that is unaffected is gold, which has proved resilient. While other metals have come under pressure because of the unresolved crisis in the euro-zone, gold has benefitted from it.

Olivier Eugène, portfolio manager of the AXA WF Framlington Natural Resources fund, points out, however, that it is gold itself that has proven to be the better investment, rather than gold-miners.

"If you buy gold, then you only have to deal with the price of gold, and it has been going up," he expains. "If you buy a company, then you have the gold price, but you also have the geopolitical issues that the world is facing in terms of cost inflation and regulations."

Energy shocks
Energy is facing different challenges. "If you talk about mining, the first thing you need to think about is China," says Pau Morilla-Giner, partner and director of equities, commodities, and alternative investments at London & Capital. "But with energy, China does not count as much. The two main energies are oil and natural gas, and when it comes to sources of energy and the demand for fossil fuels, it is really more about OECD growth, which accounts for an overwhelmingly large majority of demand."

For his part, Cominotto points out that like most sectors, the energy market has been unable to avoid recent market volatility. However, he argues that many energy stocks, which were already undervalued prior to the recent correction, are now even more attractive. He believes that investors looking to capitalise on the low valuations should focus on the structural growth themes of oil and gas technology, power grids, and liquefied natural gas (LNG). They should also consider efficient mobility companies such as Tesla, the electric car manufacturer, and efficient building technology companies like SIG, the insulation and building environment specialist.

"Power grids are important, whether they are companies that supply equipment, or software and services to expand and modernise the power grid. Another important topic is LNG, because we believe that natural gas will play a much more important role in the future in terms of the energy mix, because it is cleaner than coal and more abundant than oil," he explains.

Still, the energy sector has suffered two high-profile shocks in the last two years, putting risk management front and centre. The first was the BP Macondo spill in April 2010; the second the nuclear crisis at the Fukushima reactor in Japan a year later. Tokyo Electric Power (Tepco), which runs the plant, announced a record loss of $15bn (€10bn) in May. In the same month, Germany announced plans to pull out of nuclear energy entirely. Fund managers say neither event could have been predicted.

"You could not have gleaned any stock-specific insight from health and safety measures, because no one company stood out as relatively good, or relatively bad," says RCM's Wheaton "The frequency and severity of incidents over time has fallen over the last five years. Macondo was a one-in-thirty-year event."

In fact, he suggests, every time there is an accident or major disaster, things change. "Businesses become safer. They review all their processes and where people have got lax, and where safety needs to be focused on, then that happens."

He suggests that Germany's decision to pull out of nuclear power was more sociological, or political, than energy conscious. "Fukushima went wrong because it was a relatively old reactor design and it had not been protected against the size of tsunami that hit it. For Germany or Italy to say that nuclear power is dangerous is incorrect, because that is taking the example of a coastal nuclear station, and transferring that risk to Bavaria, which is hundreds of miles from the sea."

In fact, Wheaton argues that few of the risks actually apply to the European nuclear industry, where politicians used the event as a convenient excuse to score short-term political points.

However, the shock was absorbed because 80% of the energy sector is made up of oil-related companies. Many oil companies (with the obvious exception of BP) are cash rich.

"Energy is dominated by the big oil companies and a lot of them are quite defensive in nature," says Wheaton. "Current oil prices are generating more cash than companies can comfortably spend, so the are reducing balance-sheet debt. Some of these companies tend to pay dividends one-and-a-half to two-times the market average. This is a pretty nice source of shareholder return."

Eugène agrees: "The big players like Exxon and Shell are relatively steady in shaky environments because they are so big and diverse. If they suffer somewhere, they benefit somewhere else. They are going for these dividend policies now, because they are saying we are not just a tracker, but we also provide a little yield."

For oil companies however, the challenge will always be production. Catalano points out that demand from emerging markets took a lot of resources companies by surprise, because there was a sudden acceleration of demand after 15 to 20 years of depressed commodity prices. "Over the last seven or eight years in particular, there has been a huge crowd of people trying to fit into a small door frame," he says. "Everyone is trying to develop this, but there are only so many drilling rigs that can operate these things, and only so many mining trucks. Also, it just takes time."

And, he suggests, volatility is just part of the game. "It's just part and parcel of highly cyclical sectors. If someone is going to invest in the sector, then they need to be comfortable with volatility."