Low cost commodity producers offer value

LONDON (Reuters) - Commodity producing companies with low-cost operations are undervalued and offer potential for high returns even if commodity prices stay low, a U.S.-based fund manager said on Wednesday.

Mackenzie Davis, a co-portfolio manager of the RS Global Natural Resources Fund, said investors don't need a view on the direction of prices to find good investment opportunities among companies in the natural resources sector.

"Companies that can and do create value are those which own large low costs assets," Davis told Reuters, adding investors did not have to bet on volatile underlying futures.

One of the fund's largest investments is mining giant BHP Billiton (BLT.L), which Davis said is well positioned in the mining sector because it has good low-cost assets and many reinvestment opportunities.

"We don't have to bet on what this year's iron ore price settlement is going to be, we know BHP is going to earn returns above its cost of capital."

BHP Billiton is down about 50 percent since a record high above 22 pounds in May 2008. That compares with a drop of 76 percent for rival Rio Tinto (RIO.L), which touched a record above 71 pounds in the same month.

Part of the reason behind the losses in the second half of last year was collapsing prices of industrial metals as markets priced in recession and collapsing demand.

"Certainly 2008 was characterised by (commodity) stocks tracking commodity prices," Ken Settles, who manages the natural resources fund with Davis, said.

"But over the long term stocks don't track commodity prices, they track returns on capital."

TROUGH-TO-TROUGH

The RS Natural Resources Fund with assets of nearly $900 million (637.6 million pounds) was launched in November 1995. It lost about 45 percent last year and is down around 10 percent so far this year.

However, Davis said investors should look at the fund's annualised returns of between 13 and 14 percent over a seven- to 10-year period.

"Commodities are very cyclical, we try to think in terms of trough-to-trough or peak-to-peak -- about seven years," he said.

"That is more relevant for long-term performance."

Other companies in the fund's top 10 holdings include Toronto-listed Goldcorp (G.TO), Kinross Gold (K.TO), New York-listed Occidental Petroleum (OXY.N) and U.S. oil and gas producer XTO Energy XTO.N.

"XTO is a company that has materially outperformed other high cost producers," Settles said, adding the fund had owned XTO shares for some time.

"XTO Energy is an independent oil and gas company with roughly 80 percent of its production coming from onshore natural gas wells in the U.S."

Its shares have tumbled about 60 percent since last June when they hit all-time highs above $73.

"Our investment in XTO Energy is premised more on our view that the company will be able to reinvest in high return oil and gas projects, even in less favourable price environments, by virtue of its low-cost asset base," Davis said.

"There is a big difference between low cost and high cost producers ... Companies with large low cost reserves are able to create value in any commodity price environment."

(Editing by Sue Thomas)