Research in action: the commodities comeback

Carolyn Bigda: From Janus Henderson Investors, this is Research in Action. A podcast series that gives investors a behind-the-scenes look at the research and analysis used to shape our understanding of markets and inform investment decisions.

On today’s episode, we discuss the dramatic and broad-based rise in commodity prices, with products such as natural gas and coal hitting all-time highs and fertilizer and wheat prices increasing by triple- and double-digit rates over the past two years.

Chris O’Malley is a research analyst who has covered commodities for more than 20 years. He says the price increases are not surprising given the mismatch in supply and demand caused by COVID-19, the conflict in Ukraine and other macroeconomic shocks. He also says structural shifts in the global economy could keep prices of some raw materials higher for longer – with important implications for investors.

Chris O’Malley: You always knew that if, for instance, copper got to a certain price, there was a stable of projects that could be developed to fulfill demand. Today, those projects just don’t exist, and that’s one of the key differentiators between this cycle and previous cycles.

Bigda: I’m Carolyn Bigda.

Matt Peron: And I’m Matt Peron, Director of Research.

Bigda: That’s today on Research in Action.

Chris, welcome to the program.

O’Malley: Thanks.

Bigda: So, by this point, we’re all very familiar with the rise in prices. We know what some of the drivers are of those price increases: The conflict between Russia and Ukraine, since those two countries are large suppliers of energy and agricultural products, and the global pandemic, which caused big swings in demand for raw materials and scrambled supply chains. Chris, in your view, how long do you think this volatility in commodity prices can last?

O’Malley: So, the Russia/Ukraine situation has disrupted commodity supplies and supply chains in many ways. It’s raised energy prices in Europe, which has resulted in plants shutting down. So, anything where energy is a large component of the manufacturing costs, such as fertilizers and aluminum, you’ve seen a reduction in capacity due to the situation we’re seeing in Russia and Ukraine. It’s also affected commodities where obviously Russia or Ukraine were material suppliers into specific markets or geographies. So, take steel, potash and titanium, as examples.

News flow out of China has also contributed to the volatility, even in the past week. We’ve seen swings in news flow around Chinese infrastructure spend, as well as COVID. And then expectations around U.S. interest rates hasn’t helped. Hopefully, much of this is just near-term noise.

Bigda: There’s also been a longer-term trend going on, which is this under-investment in commodities production. Could you maybe talk a little bit about that?

O’Malley: Yes, so one key factor that should drive prices over the longer term in metals should be this under-investment where we’ve seen capacity. See, periodically, the industry goes through extended periods where they spend capital to increase capacity and supply increases dramatically. What follows is usually a period of relatively flat capacity growth, which I think we’re entering now. After the China boom, the mining industry spent about $190 billion per year on capex [capital expenditures] in the 2011 to 2014 time period, just after the GFC [global financial crisis]. Today, they’re spending about half of that in real terms. Furthermore, in copper, for instance, the mines that are producing are seeing their ore grades decline. In other words, they’re producing less, and so companies are having to spend billions of dollars just to keep their production level. Codelco, for example, the world’s largest producer of copper, they’re going to have to spend tens-of-billions of dollars over the next 10 years just to keep their production stable. Otherwise, their production is going to fall by over 50% by 2032. And so, this is further stress on companies’ cash flows.

Bigda: So, the mines are producing less because the mines themselves are just less productive? It’s just harder to get the metals out of the ground basically at this point?

O’Malley: That’s absolutely right. So, ore bodies, deposits of copper are not uniform. And so, what typically happens is you mine the more-rich areas of ore body first. And as the mine ages, you get into those portions of the ore body that just have less copper per ton of material, halt. And so, these mines are just aging, and now we’re into the tail of those deposits, in many cases. And so, the mines either have to expand their productive capacity, i.e., their milling capacity, or they have to move underground. This is very expensive for them to do, but they have to do it just to keep their production level.

Peron: And Chris, I think it’s fair to say that net investment has declined, which exacerbates this issue, does it not?

O’Malley: It does.

Peron: So, what drove that decline in investment?

O’Malley: There are a few reasons behind that. So, for one thing, producers put on a lot of capacity after the great [global] financial crisis in response to what they saw as resilient demand from China, and they took on debt to finance these projects. Through a combination of the supply build and the slowing of global economies in the years that followed, the prices of commodities plummeted. And these companies’ balance sheets were really stressed. Second, having been through that, investors have urged companies to be more conservative with their capital allocations and return capital to shareholders. But lastly, there’s just a dearth of new projects. Even as recently as the first decade of the 2000s, miners’ exploration departments were fairly full with projects [that] they could develop. You always knew that if, for instance, copper got to a certain price, there was a pretty good stable of projects that could be developed to fulfill that demand. Today, those projects just don’t exist, and that’s one of the key differentiators between this cycle and previous cycles.

Bigda: Matt, this is sounding a lot like a conversation we had earlier on one of our podcasts about oil, where there was this drop-off in demand and lack of investment. And then all of a sudden, the sector was hit with this huge rebound in demand. And so, the same thing seems to be happening in commodities. At the same time, a lot of input costs for these producers are going up. Is that contributing to, you know, the struggles that they’re having in meeting some of that demand today, the rising input costs?

O’Malley: So, in the areas like fertilizer and aluminum, it actually is. You’ve seen aluminum production and fertilizer production come down in places like Europe due to higher energy costs. In other mining areas, such as copper, which are also seeing input cost increases, you know, it’s not affecting their production. Input cost increases in rising commodity price environments are quite normal. And so, if you look at the copper miners, they are seeing cost inflation, specifically in diesel, which is obviously connected to the rise we’re seeing in oil prices, and in consumables, most acutely in explosives. Because remember, explosives and fertilizer are the same raw material, and so that’s a function of the Russia/Ukraine situation. Now on average, those miners are seeing a single-digit percent increase in their costs. And to put that into perspective, they’ve seen almost a 20% increase in copper prices over the same period. And so, you know, input costs and the commodity price should be positively correlated and should not lead to margin compression longer term. Again, this is fairly normal within cycles.

Bigda: Got it, but investors at this point are maybe overly worried about it, and that’s, is that being reflected in stock prices as well?

O’Malley: I think so. You know, what we’ve seen this earnings cycle is, you saw an initial somewhat harsh reaction to earnings numbers around those cost pressures. And this was exacerbated by news out of China. But in the days following, I think, as investors took stock and thought about those earnings, you’ve seen these companies rebound nicely.

Peron: So, Carolyn, you connected this to our energy discussion of a few weeks back, and it is the same story. There’s a structural supply/demand imbalance that really will be a tailwind that’s multiyear in duration, likely. And so, we look for that, those tailwinds; so, we think this one is durable and has some gas in the tank, so to speak.

Bigda: So, let’s dig into some of these structural tailwinds where we maybe see demand resilient throughout an economic cycle. You know, and to that point, we’ve seen some commodity prices actually ease a little bit after the Fed [Federal Reserve] recently signaled that it could hike rates more aggressively. Chris, in your view, where do you see structural dynamics that look very promising versus something that might be a bit more transitory at this point?

O’Malley: So, certainly, shorter term, one of the key risks is that the Fed does make a policy mistake. Commodities typically are positively correlated with interest rates until you hit that tipping point and things invert because the Fed’s pushed us into recession.

However, longer term, just generally speaking, you know, as the world decarbonizes through electrification – electrification means more metals, particularly copper. In a typical decade, the world adds about 4 million tons of incremental copper demand, and the industry puts on about 4 million tons of incremental supply. Decarbonization through electrification – whether that’s renewable energy or electric vehicles – this could add another 4 to 6 million tons of incremental copper demand over the next decade, or a doubling of what is considered normal incremental demand growth. Again, the most capacity the industry has ever put on in a single decade is 4 million tons. And the projects to do this just don’t exist, and what projects there are, are costlier to produce.

Bigda: Right, so the demand for copper is because, basically, copper is the conductor of electricity. And so, as we electrify our economy, that’s where this surge in demand is coming from. Is that correct?

O’Malley: That is correct. And as you move, you know, from things like internal combustion engines to electric vehicles (EVs), the amount of copper in a vehicle goes up fourfold. As you move from coal-generated or gas-generated power to offshore wind, the amount of copper goes up eightfold. And so, all of these are just much, much more metals-intensive, just generally speaking, than the predecessor technology.

Peron: And I would add that, that point, I don’t think, is well understood around the transmission investment required as we move to renewable fuels, such as solar and wind. The investment in transmission lines that will be required is massive and, I think, generally underappreciated. So, to Chris’s point, that’s a huge structural tailwind.

Bigda: And we are asking an industry to produce levels of copper that we’ve never seen in the past before.

O’Malley: That’s correct.

Bigda: I think the interesting thing right now, though, is that copper prices have already hit pretty high levels, if not all-time high levels. Is that correct?

O’Malley: That is. You know, surely some commodities have reached historic levels, including copper. So, prices are quite high, and there’s convincing evidence that these levels of price could be sustainable.

Bigda: And that evidence is this renewable-energy transition that we were just talking about, correct? Because we haven’t even really started down that road yet, but there could be a lot more demand coming on that could potentially lift copper prices higher from here?

O’Malley: So, it’s both demand and supply. So, we’ve already talked about that demand-pull from renewables, and certainly that’s going to help in the years to come. And the lack of new supply and the disruptions we’re seeing around the world due to Russia/Ukraine, all of these factors, are exacerbating supply issues.

But there are other reasons as well. There’s very convincing evidence, actually, that these high levels of price could be sustainable. First, markets are just very tight, even at current demand levels. Exiting past recessionary shocks, LME [London Metal Exchange] copper inventories would be at levels of a million tons or so. Today, LME inventories are around 100,000 tons, and the direction of travel the last several years has been lower. Today, there sits about three days of visible inventory on exchanges around the world. So, as you can see, the situation is quite tight and it’s certainly tighter than any other post-recessionary period that we’ve seen in history.

Bigda: Right, so inventories are at about 10% of their historical levels coming out of a recession.

O’Malley: That’s correct.

Bigda: That’s dramatically lower, yes.

O’Malley: Dramatically lower. The other thing that is going on is that capital costs are rising. Mines are needing to desalinate seawater and pump it up mountains for their operations. New mines have lower ore grades than mines that have developed in prior decades, and governments in places like Chile and Peru are trying to impose more costs on miners in the form of taxes, royalties and expenses around ESG [environmental, social and governance]-related issues. And so, the cost per unit of production is also going up. And prices over time, that is commodity prices, tend to be highly correlated to capital costs.

Bigda: So, is there any hope of relief? Like what could bring some relief to these supply pressures right now, or in going into the future, too?

O’Malley: There’s certainly nothing on the horizon. There are a few technologies that seem to have somewhat limited application to waste material that’s already been mined. But it seems that that technology will only work in very specific situations. In terms of the capital costs of mines, there doesn’t seem to be. For instance, a new mine today, such as QB2 or Cobre Panama, may have an ore grade rate of 0.4. That compares with the last vintage of mines, mines such as Escondida, that have ore grades of 1%. And so, for a Cobre Panama or QB2 to mine as much material as an Escondida, you need to put in twice as much capital. And the water issues in Chile are certainly getting worse, not better, as is the ESG situation. And so, these mines are just, you know, becoming harder to build, costlier to build and are taking longer to build. And even if, you know, you had the mine projects in the exploration department ready to go, it would still take you 10 years to actually have that mine produce metal.

Bigda: And I just want to follow up, you said the ESG situation, meaning that the miners have to meet certain environmental hurdles these days in order to operate?

O’Malley: That’s correct. So that’s one aspect of it. That would be the E. And environmental permitting is just becoming more cumbersome and longer to play out. But there’s also an S factor, a social factor going on here. In Chile and Peru, you’ve had leftist governments elected, and those governments, in Chile’s case, are seeking to rewrite the constitution and are looking for higher taxes and royalties from mining companies. And in Peru, you’ve also had a leftist government elected, and they’re also looking to increase taxes and royalties. And you’ve also seen just more sympathy around communities’ views towards mines, with mine charters being revoked and mines being shut periodically by protests, you know, from the surrounding communities. So, it’s both becoming harder to permit and develop and also harder to operate on a daily basis in these geographies.

Bigda: So, it’s a complex situation and yet, there is potentially a long-term investment opportunity here just given the role that copper seems to need to play in the energy transition. Chris, what could get producers investing more again and production going more in the years to come?

O’Malley: Yes, so certainly, we will need higher prices. However, the problem is even with higher prices, the reality is due to the scarcity of new projects and the complexities around developing resources, even with higher prices, it’s going to take years for this to happen. Generally speaking, you get to take well over 10 years from discovery to development for a project to actually produce metal.

Peron: Chris, you’ve been talking about this for over a year. At that time, it was less understood by the market. Now it’s becoming more and more understood. How are valuations looking?

O’Malley: So, I think you’re right that it is becoming more well understood by the market. We do, however, seem to be in the early innings of the cycle. Valuations still look quite attractive. A free-cash-flow yield for many of these companies are in the double-digit range. And what’s more, management teams are just beginning to return excess cash to shareholders, providing another leg to investment returns.

Bigda: So, maybe if we can just take a step back here and look at this from an overall asset allocation perspective, because it sounds like with the supply/demand imbalance, that there could be a lot of potential for commodities to grow from here. And so, as an investor, how should I be thinking about commodities today as part of my overall asset allocation?

Peron: Yes, as an asset allocator, I’m always a bit hesitant to add commodities as a structural part of the portfolio, meaning I’m always going to be structurally overweight commodities. It is a good diversifier in that respect, but as Chris alluded to earlier, prices generally revert back to the marginal cost of production. However…

Bigda: What do you mean by marginal cost of production, just for those of us who don’t know that term?

Peron: Sorry, the incremental cost of mining the next, you know, unit of copper for example, the prices will converge to that.

Bigda: Got it.

Peron: And so, as a result, there’s no long-term structural economic rent to be earned from these. And that’s the theory, and in practice, over the long span of time, that’s generally true. But as Chris has pointed out, A) these cycles can be quite long and this one has a little bit more to it given the energy transition and other demand factors we talked about, that it actually could be longer than your typical cycle.

So, what do I mean by a long time? The last cycle was 15 years. The bottom of the relative performance of the commodity sector relative to the S&P 500 was in 2000. It then was an outperformer for about 14 or 15 years before it then became an underperformer again. So, we’re right back to levels where we were on a relative basis at 2000. It looks to me like we’re at the beginning of a, you know, at least a decade-long super-cycle here.

O’Malley: It would certainly seem like many of the pieces are in place for a super-cycle to hit decarbonization goals. You’re going to see a step-function increase in demand for these commodities, and the supply side just isn’t ready for this. The supply base is exhibiting stress at even current levels of demand.

Peron: Coming back to your question, as an asset allocator I would recommend a tactical intermediate-term overweight to the sector. But understand the longer-term dynamics; at some point the investment will come, and the cycle will turn. But we’re probably years away from that.

Bigda: And there can also be some near-term volatility to be prepared for.

Peron: Always, it’s a highly volatile sector, always.

Bigda: Well, thank you both for taking us through this commodities discussion today, and the volatility and potential opportunities that might be ahead. It’s been a pleasure, Chris, having you on the show, and thanks to our listeners for joining. Next month, we’ll explore the state of one major end market for commodities, which is electric vehicles. We hope you’ll tune in.

Until then, I’m Carolyn Bigda.

Peron: And I’m Matt Peron.

Bigda: You’ve been listening to Research in Action.