The global boom in commodities is a long term story

But there will be plenty of risks and challenges along the way

INVESTING in natural resources offers the potential for high returns for investors, but risks are ever present. Both the demand and supply sides need to be assessed. What are the main challenges for resource companies at this moment and how best should the accompanying risks be negotiated?

Economic principles dictate that prices are set at a point that supply satisfies demand. The demand case for commodities is well known with the emerging nations of the world consuming more materials as their economies gather pace. We are very aware, especially after the global financial crisis of 2008, that this will not be in a straight line, but over a reasonable timescale this upward trend should continue as urbanisation proliferates.

The supply side of the equation is extremely challenging, and we see this across such diverse commodities from copper, coal and uranium to palm oil.

Increased political risks and growing resource nationalism, a lack of skilled workers and declining grades, rising capital costs and increasing requirements in permitting, are just some of the factors conspiring to make meaningful supply growth elusive and more expensive.

Political instability within emerging nations and new democracies is not new, but Africa alone in the last two years has witnessed the Arab Spring, disputed elections in Cote d’Ivoire, and coups in Mali and Guinea Bissau. Because a new mining project is often a large capital commitment requiring a long payback time, companies crave stability and investment decisions are often deferred or postponed until an acceptable degree of stability returns.

Resource nationalism is also on the rise, and not just in the developing nations. Australia recently imposed a resources rent tax. Royalties are under upward pressure across the globe as governments seek greater participation in projects.

The recent expropriation of 51 per cent of YPF by the Argentinean government is an extreme example of resource nationalism and will probably not have the desired effect of increasing domestic oil and gas production. Such a dramatic move can only deter the foreign capital and skills required to unlock the undoubted potential of the shales of the Neuquen basin.

One certainty in this uncertain world is that the average grade of copper mined is declining, possibly to as little as 0.6 grams of copper per tonne of ore extracted. This is true of gold, silver and most other metals, and this only raises the cost and difficulty of increasing supply.

Resource investors cannot avoid such risks and challenges entirely, but I believe the best way to mitigate them is by using a portfolio approach, diversifying investments across a number of countries and minimising exposure to single asset companies. At City Natural Resources, we focus on growth companies across the resources sector as we feel that these companies offer the best value and performance. Another way to help mitigate some risks is by backing management teams which have had previous success.

Our belief in the long term story of commodity strength is driven as much on the problems of the supply side as it is on the headline grabbing demand side. Diversifying investments through a portfolio approach is, we think, the most efficient way to mitigate the ever present risks while taking advantage of this global boom in commodities.

Will Smith is senior fund manager for City Natural Resources High Yield Trust