December Fund Performance & Market Commentary
The Delbrook Resource Opportunities Fund (the “Fund”) returned +13.8% in the month of December, bringing the 2017 net return to +25.6%. For the month, long positions drove the majority of performance, given our decision to tactically reduce short exposure in advance of the US Federal Reserve meeting on December 13th (more on this below). While Fund exposure was net long for the year, strong performance was the result of positive gross returns from both long (+25.5%) and short (+5.1%) positions.
As outlined in our November
we made a tactical decision to reduce short exposure in anticipation of the December 13th Federal Reserve meeting, believing it would mark a near term high for the US dollar, and as such, a low for precious metals. Analysis of market fundamentals, including multi-year highs in bearish sentiment for gold, trading in US treasury futures and a crowded dollar index trade led to the conclusion that a contrarian shift in allocation to precious metals was warranted. Our thesis of a
“buy the rumor, sell the news
” trade on the US dollar played out well as gold rallied 3.8% post meeting. We have harvested some of the profits from this short term trade and have been increasing short exposure, specifically within the precious metals complex, given our belief that equity valuations are likely to remain relatively stable in the short term.
Importance of Single Name Shorts
Despite the temporary shift in exposure outlined above, the Fund maintained select single name shorts which continue to perform well. The sector’s above average equity volatility, which is a direct result of swings in underlying commodity prices combined with corporate operating (and sometimes financial) leverage, provides opportunities to generate significant profit from short sales.
Garibaldi Resources (“GGI”), is a company we have advocated and positioned as a short since October. When we first examined GGI, it had a market capitalization of approximately $0.5 billion, no material exploration results and, in our view, lacked any critical evaluation from investors. Our initial short position in GGI was at C$4.50 per share, with the belief that the correct equity valuation was less than $50 million (C$0.50 share). The stock closed 2017 at C$2.46, a 45.3% mark to market gain for unitholders, but still well above its intrinsic value.
One of the Fund’s greatest competitive advantages is our access to a superior technical team focused on geologic and project evaluation. It is our belief that the market is less efficient on the short side, especially within the natural resource sector, where some investors lack technical strength and are easily distracted by misleading information or half-truths. We will continue to take advantage of opportunities where our technical expertise identifies opportunities to short securities which are misunderstood by market participants.
Zinc Inventories Tighten (again)
The current deficit in the zinc market has been well documented in our commentary throughout the year and prices have responded accordingly, rising 28.9% to US$1.50/lb (LME). Despite the rise in price, supply of new zinc concentrate has proven to be alarmingly slow to materialize. Incremental production coming online in 2018 and 2019 should barely offset the losses from curtailments seen in 2015 and 2016. Current global inventories sit at just over 10 days of consumption, half the level it stood at 24 months ago and down 80% from 2012. We forecast a continued deficit in 2018, however we note that our projected growth in demand is only +2.5% year-over-year (in line with the 5-year compound annual growth rate). Positive economic developments and/or unforeseen supply disruptions will result in significant upside pressure to prices, and with limited inventory available, we believe the perfect storm is brewing. We suspect that zinc prices could exceed US$2.00/lb in 2018.
We continue to like the larger capitalization names which benefited the Fund in 2017, including
Trevali Mining (+34.5%) and
Vedanta Resources ADR (+79.7%), however, we have begun to shift long exposure into brownfield projects and later stage exploration companies. At this point in a rising zinc price environment we see greater opportunity in higher cost producers or projects queued to come online near term. We like the prospects for
Ascendant Resources, which operates the El Mochito Mine in Peru, and have recently made a strategic investment in
Buchans Resources, a late stage exploration company with an economically attractive project in central Newfoundland.
Broad Views Across the Commodity Complex
Our outlook for 2018 favors base metals, with zinc being our favorite short term opportunity, followed by nickel and copper. The thesis for nickel and copper is similar to zinc, both having a lack of quality projects to replace depleting resources, but also incorporate the potential for greater than anticipated demand given acceleration of electrification trends. Mid-term prospects for nickel are misunderstood by the market given its importance to the growing battery market.
We are neutral on the precious metals complex, seeing gold and silver as fairly priced in the context of rising global interest rates vs. heightened geopolitical risk and desire for central banks to diversify away from US dollars. In our view, opportunities in the space need to be evaluated within the context of a flat pricing environment and therefore we are focused relative value and special situations ideas.
As always, please contact our office at 604.229.1450 with any questions you might have.