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Opalesque Exclusive: Galena on metals and energy sectors; sees alpha year in mining, remains short crude, Special Sits fund +28.26% YTD

Posted on 29 April 2009

Benedicte Gravrand, Opalesque London: Cedric Chone, the Geneva-based lead portfolio manager of the Galena Special Situations Fund, gives his outlook for the metals and energy sectors:
Case for investing in Metals
There are two key themes today and in coming months that support the case for metal investing: restocking and inflation.

- Restocking
A normal down cycle in mining would see mines continue to produce at a loss, with banks willing to lend money to producers, secured by the minerals they have in the ground. However, due to the financial crisis, this has not happened during this cycle and as the expectation of recovery has been pushed back further, we are seeing more and more production cuts:

If you take Nickel for example: We have already lost 25% of nickel production and given the recent news of the closure of all Australian production by one of the world’s largest Nickel producers, we could see production falling to 30% or perhaps even as low as 40%.

We are going to have a recovery, at some stage. Once production cycles start to pick up and demand starts to show the first signs of recovery, then we will be caught in a precarious situation.

Manufacturers have run down stocks to previously unseen levels, while producers have cut back production and pushed out or cancelled new projects. Together this sets the stage for the start of another super cycle.

We do not know when the rebound will occur but the recent manufacturing data in China (i.e. recent PMI numbers up to 52.4) suggests it is closer than many believe.

We have already started to see this in Q1 with equity markets looking ahead to an expectation of some stability. Europe saw a marked increase in auto production which could lead to its own restocking cycle.

- Inflation
We have seen some huge stimulus packages across the world to kick-start the economies. These measures are inflationary, will benefit commodities and push prices higher in the medium to longer term.

Opportunities in Mining

The mining sector sold off aggressively last year as the investment community saw unprecedented redemptions. The overshoot that this forced selling has created, leaves a lot of projects and companies trading below their cash backing and/or at very distressed levels. This creates a unique opportunity to invest at this time of the cycle.

A lot of money has been sitting on the sidelines and is not investing at a time when we believe we have seen the bottom.

As a specialist fund focused on mining opportunities, we are very happy to invest at this stage of the cycle and despite the recent equity market weakness, in the first two months, we outperformed the markets.

We see good opportunities in projects and assets and expect this to be a big alpha year. Last year was a beta year with not a lot of liquidity around.

We are already observing a dramatic pick-up in interest in cash rich commodity companies. The key will be to invest selectively. In previous years, the rising tide floated all boats and there were plenty of investors willing to invest in weak projects. This year, there is a better allocation of resources and capital because less money will be invested.

Companies looking to raise money this year are finding it very difficult. This will create even more opportunities, especially in the small and mid cap market. Small caps have been devastated, with investors flocking to the security and liquidity of larger cap stocks.

At the height of the crisis in September and October last year, people bought gold and, to raise cash, they sold gold stocks; so gold started to shine again. During Q1, gold companies have issued a lot of equity funds that were previously underinvested during the last few weeks. The gold market went from $750 to $950.

Once the economic recovery is underway, investments in the Gold sector will shift to base metals which will create an influx of capital. There are signs of this happening already, with a number or large equity raisings by copper producers in the last few days.

We favour smaller gold companies to larger cap stocks that have been overvalued, in this sector as we expect gold to lose its shine as the market recovers. We have invested in around four excellent undervalued projects with discoveries that could be very profitable irrespective of the gold price.

Outlook for the energy sector

The oil price has fallen to $40 as demand collapsed during the last year and even with all the OPEC cuts the world is still swimming in oil. Our preferred way of investing in the oil market at these levels is to be long production and exploration companies against a short crude position, based on the relative undervaluation of the companies. This trade makes even more sense in the current environment where we see huge contangos in the forward prices. Few funds can trade this compelling trade through cash equities and oil futures, which insulates Galena Special Situations Fund from ‘crowded trades’.

- The next rally will see 3 phases:
The fund has been positioning itself at a time when the majority of participants were sitting on the sidelines holding cash. We believe the next rally will see 3 phases, phase one has already started to play itself out during the last couple of weeks.

- Cheap restocking by China. China drastically cut high cost mines and production and is restocking its own depleted stocks with cheap metals from the west. This will leave the West very short commodities (Chinese data saw strong imports; PMI up 14.1% YoY to 52.4%.)

- The second leg of the rally is expected once some of the physical measures start to take effect and manufacturers are forced back into the market to rebuild the inventories that have been sold off. Europe has seen new car registrations leap by 40% in March, while in the US, new car sales appear to have stabilised.

- The third leg up will be provided by reflationary effects of the quantitative easing.

Galena’s Special Situations Fund is a multi-strategy commodity fund investing in the mining and energy sectors. The core investment strategy is to invest in listed projects at a development stage. The Fund also trades commodity-related equities and underlying derivative markets, in order to leverage market opportunities and hedge against adverse market conditions. The Fund is up +28.26% YTD (net estimate, as of 13 April) and currently manages $110m. The fund returned almost 26% in 2007 and -31.07% in 2008.

See our 16-Dec-2008 Opalesque Exclusive:
Galena`s fund at ease with metals, (+5.25% in November, 16.17% YTD) as market is in contango Source

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