At first glance, the natural resources sector looks incredibly appealing for income investors. A good bellwether for the mining sector is the £1.3 billion BlackRock World Mining trust, which yields 6.8% based on income payouts throughout 2022. In 2021, its yield was 7.2% as dividend payments soared following the economic recovery after the pandemic.
The fossil-fuel energy sector globally, as measured by the MSCI World Energy index, yields 3.6%, which is nearly double the yield from an all-stocks global shares index. In the UK, Shell (LSE:SHEL) yields 3.5% and BP (LSE:BP.) yields 3.9%.
It is therefore no surprise that commodity companies feature prominently in UK equity income portfolios, alongside shares in banking and insurance, consumer staples and utilities.
However, because commodity prices tend to rise and fall with the economic cycle, periods of high dividend payouts can be followed by sustained periods of dividend declines for investors.
And that is what we are experiencing now. An index of 24 commodities (including those closely linked to industrial activity such as oil, natural gas, copper and aluminium), has fallen about 17% since summer 2022, following a 110% rise from March 2021.
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Part of the reason is that the Chinese economy is slowing down and fighting deflation, which is impacting forecasts for global economic growth. High inflation around the world is expected to weigh on consumer spending and trigger recessions, although so far economies – and particularly the US economy – have been more resilient than expected.
So, are tempting high dividends in the natural resources sector too good to be true for investors?
Evy Hambro, manager of the BlackRock World Mining trust, says the first half of 2023 has seen markedly lower commodity prices versus both the start of the year and compared with prices from the same period last year. But he argues that current prices continue to deliver strong margins for miners and the sector will keep generating lots of cash.
Hambro says that mining dividends, based on current levels of profitability and existing payout policies, are likely to be lower and, in some cases, significantly lower in 2023 than the prior year – but investors will still pick up strong yields from the sector.
“This is to be expected but what should not be ignored is just how competitive the forecast yields continue to be versus the broader market. The benchmark index has a dividend yield of 4.1% versus the MSCI All Country World Index at 2.2%,” Hambro said.
In addition, he says that commodity inventory levels have fallen to record lows for a number of metals, meaning that when demand returns the impact on prices from restocking could be “dramatic”.
His key mining investments are in iron ore and copper, where average prices for these two commodities were lower in the first half of 2023 versus the first half of 2022, with iron ore down by 15% and copper down by 10%. This allocation includes shares in Vale SA ADR (NYSE:VALE) and Rio Tinto Registered Shares (LSE:RIO).
James Lowen, manager of the JO Hambro UK Equity Income fund, also likes mining shares for their income, despite lower payouts expected next year. He has 11% of his portfolio in “basic materials” compared with 7% for the FTSE All-Share index.
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He says that while mining firms paid supernormal dividends last year via special dividends, forecasts for payouts over the next 12 months take the sector’s yield to about 4%, which is similar to the oil sector.
Looking longer term, US fund manager PIMCO argues that commodities stand to benefit from the clean energy transition and underinvestment in new resources.
Michael Haigh, commodities and real assets economist at the firm, says history suggests that when investment is limited prior to a recession, supply constraints tend to emerge once demand growth resumes when the economy is healthier again – which would be good news for commodity prices.
“These conditions exist today, so a long-term investor may view weakness stemming from a mild recession as an opportunity to use commodities to guard against inflation,” said Haigh.
He adds that the net-zero transition, and deglobalisation could, add to inflationary risks.
“Because transitioning to a net-zero economy will be commodity-intensive, there could be unavoidable bottlenecks as commodity demand outstrips supply. This would set commodities on an upward trend in coming years,” he said.
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What about oil companies?
In contrast, oil firms cut their dividends during the pandemic and “reset” them at a lower level, meaning that yields have typically been lower than in the mining sector, but are likely to be more sustainable.
Lowen’s largest position is BP and energy is 14% of his fund compared with 11% for the FTSE All-Share Index. He prefers BP over Shell due to its role in the energy transition.
He says: “Dividend levels at BP assume a $45 oil price, but we are now at $90 for a barrel of oil. So dividends at BP are therefore very safe and it is actually generating excess cash, which will lead to steady dividend increases.”
Excess cash can be used to buy back shares, which should increase the share price and increase the dividends per share figure, according to Lowen.
Haigh says that despite macroeconomic headwinds linked to slowing economies, the oil price should be resilient.
He said: “It is remarkable that in 2022 China experienced a demand recession for oil, yet global demand grew above trend due to growth in developed markets. We expect demand in 2023 will exceed trend growth as the Chinese economy continues to emerge from its zero-Covid policy that ended last December.
“As growth and travel normalise, we expect gasoline and jet fuel to be the primary beneficiaries, supporting demand despite global manufacturing and trade-related headwinds.”
Other income shares to consider
While the income outlook for oil and mining is bright, according to fund managers, there are other investment areas that income seekers can turn to if they are worried about falling commodity prices.
Lowen points to the life insurance sector, where he holds three UK shares: Aviva, Legal & General , and Phoenix. Totalling about 9% of his portfolio, the average dividend yield on these stocks is a jaw-dropping 10%.
Normally yields this high would be a warning sign for investors, but Lowen says yields are so high not because of overly generous dividends that are not sustainable, but because share prices are so low.
Lowen says: “All three stocks have excess capital at a headline level – this has been borne out of their respective board’s prudence post the 2008 financial crisis and higher interest rates, which is a positive for this sector.
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“By our calculations, moving to the top end of target capital ranges equates to around 15% of market capitalisation. On top of this, the recent Solvency II deregulation (a Brexit dividend) will create further excess capital, as well as highlighting governmental support for the sector.”
Lowen therefore argues that the “sector is awash with excess capital”, and all three stocks also have strong growth dynamics.
“Pension fund buyouts are exploding post the rise in interest rates. With our three holdings dominating this market, they have a unique position in a market that will see strong growth for the next four to five years, a supply and demand imbalance and sturdy margins,” he said.
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