Natural resources – not just another supercycle
In this Q&A, portfolio managers Tal Lomnitzer and Tim Gerrard respond to some key questions from investors on the natural resources sector.
- Commodities are benefiting from a post-pandemic tailwind as a result of the global recovery, as well as more broad-based demand from the secular shift towards decarbonisation.
- Over both the medium and long term, carbon reduction represents a significant source of new demand and sustained growth for many natural resource companies.
- Active management enables the identification of well-managed businesses and those on the correct pathway towards ‘net zero’.
Q. How has COVID-19 impacted commodities?
Interestingly, in many ways. Copper demand remained strong at a time when supply was being restricted, especially in Chile, Peru and the US, due to COVID prevention measures, with global stock levels already low at the start of the pandemic. After the initial shock of the pandemic, copper prices fell to around US$2/lb, then fairly quickly made a recovery, and are currently (early September) in excess of US$4/lb, exceeding pre-pandemic levels as global growth accelerates.
Post-pandemic government stimulus in China really kicked up the demand for steel, of which iron ore is a key raw material. This fed into the iron ore market, which was struggling with supply disruptions from Vale, the world’s largest producer. As a result, we saw a once-in-a-generation lift in iron prices from US$70–80/tonne pre-pandemic to more than US$200/tonne. While there has been a rise in exploration expenditures in the sector, we have not seen a significant increase in new capital projects. First, it can take seven to ten years from the discovery phase to developing a new mine, and second, many resource companies continue to be debt averse and are looking to reward shareholders from strong cash flow generation.
Q. Is rising inflation generated by the economic recovery and stimulus causing another commodity supercycle, or are we experiencing a sustained period of rising demand?
By its very nature, the resources sector is cyclical; fluctuating levels of demand occur at various stages of excess or restricted supply. As such commodity prices can be extremely volatile. We are now in a period where post-pandemic demand is strong, supply is tight and prices are high. Over time, high prices should encourage new supply, and the cycle starts again. However, this could be some years away. Whereas the urbanisation and modernisation of China led to strong demand and a prolonged period of higher prices for many commodities in the early 2000s (the last ‘supercycle’), this time the recovery in demand is much more broad-based. This in part reflects a structural change as countries are making efforts to decarbonise to meet Paris Agreement climate change commitments.
Over both the medium and long term, the move towards decarbonisation represents a significant source of new demand and sustained growth for many natural resource companies. This is a tailwind, not just for raw materials, but also across the natural resources supply chain, including logistics and labour.
Q. Describe the role of resource companies and active managers in decarbonisation
While certain areas of the natural resource sector are far from being carbon neutral, they have a unique opportunity to enable carbon reduction. Through company engagement with stakeholders and investors, many natural resource companies are actively seeking to reduce their carbon footprint. Share price performance, all else being equal, is likely to reflect a company's progress along the decarbonisation path. Given the paucity of accurate data there is a solid argument for active management when it comes to resource investing. Experienced investors should be able to identify businesses that are on the correct pathway, evidenced by company commitments allied to capital investment, declining emissions reports, gains from new technology and collaborative news flow between companies, signatories, and investors.
Q. What are the key risks for investors within the resources sector at present?
As inflationary pressures build, investors typically seek out precious metals and commodity companies or other cyclical companies that are sensitive to changes in economic conditions. There are some attractive valuations to be found here at present. However, concerns exist. As an example, due to competition between China, Europe and the US, there are security of supply concerns for copper and lithium. There is a probability that the demand for these metals from manufacturers of electric vehicles or renewable energy equipment may not be readily met, which also comes with broader market implications.
Electric vehicles: demand growth for metals 2019 to 2030
Source: Janus Henderson Investors, Visual Capitalist as at 1 February 2021.
Companies that can be classified as ‘decarbonisation enablers’, ie. those that provide raw materials to facilitate carbon reduction, are operating in a backdrop where new commodity supply is limited. As alluded to earlier, for a world class new copper development there may be a decade or more between the time of discovery and first production.
More broadly, resource companies in particular are facing increasing pressure in terms of their environmental, social and governance responsibilities as stakeholder demands rise. In response, mining companies and oil and gas businesses are making efforts to reduce carbon emissions and energy usage. For example, some are using renewables such as solar power as a cost-effective alternative to diesel fuel, and carbon sinks such as planting huge areas with trees aiming to reduce the concentration of greenhouse gasses in the atmosphere.
Given the multitude of factors involved, encompassing regulation, local community needs, supply issues, technology, required expertise, and environmental constraints, among others, the path towards ‘net zero’ is both an exciting and challenging one.
Q. How can investors navigate the risks and capitalise on the key opportunities within the sector?
A sensible approach may be one that focuses on high-quality assets and companies that provide meaningful diversification across commodity type, geography, and sector. Commodity diversification is important since it is hard to predict commodity price moves, while geographical diversification helps to moderate geopolitical risk. Investors also need to be valuation-aware, with some renewable energy companies trading at extreme valuations. While resources investing can be classified as speculative, taking a long-term view is prudent.
Q. What does the broader outlook for commodities look like?
We have seen prices for commodities rise as the global economy recovers and consequently select resource company shares have looked attractive to investors looking to diversify their portfolios.
Agricultural commodities such as fertilisers are benefiting from higher farming returns and increased application rates as farmers seek to maximise yields and benefit from high crop prices. Energy prices have recovered strongly as the ‘health’ of the global economy improves. Meanwhile, reduced levels of capital expenditure in the oil and gas sector and stronger demand may lift prices substantially higher than the current circa US$70/barrel.
The multi-year outlook appears constructive for the sector. There is potential for resource companies to continue to outperform commodity price moves. Well-managed companies are suitably positioned to meet the increase in demand by identifying new business opportunities, extending mine life (extraction period in years for proved and probable reserves), realising operating and efficiency gains, and making new exploration discoveries. Importantly, decarbonisation is providing a sustained tailwind for many companies within the asset class.