The Case for Commodities: Greenflation and Copper as the new Crude
If the shockwaves that commodities have sent through the economy are now self evident, then what’s less known is how supply shortages in raw materials came to pass in the first instance. Whilst software as a service companies were garlanded by investors throughout the ‘teenies’, read: 2011 to 2020, commodities and mining companies of all stripes were certainly not, yet recent months have seen a dramatic reversal of fortunes.
Decade Long Underperformance
As interest rates fell, and quantitative easing pushed up equity markets in recent years, commodities did not move in tandem.
Without retelling recent history, COVID brought an unprecedented collapse in global economies, as the world was abruptly ‘turned off’ in attempt to stem the transmission of the novel Coronavirus. The untold story of commodities was in March 2020, the biggest liquidation or selling of commodity futures and positions ever held by investors, (known as open interest in the industry). So at the tail end of a 9 year bear market in resources, where commodity related capital expenditure had been remorselessly cut for over half a decade, commodities faced a record price collapse. March 2020 meant limited inventories and supply in decline – the tinder in search of a match.
Crude Awakening: Lighting the touch paper
That spark took the form of the unprecedented monetary and fiscal response from governments globally. At a time of limited commodity capacity, no new wells, no new mines, consumers having been locked down, many countries were drowned in government sponsored benevolence, and tellingly the stimulus checks sent to households, could not physically be spent on experiences – only on ‘things’. Huge stimulus demanded raw material inputs from commodity markets characterised by limited productive capacity and historically low inventories.
Of course, whilst many commodities began to bounce, energy prices did not necessarily respond as travel itineraries were shelved. Only two years on are we seeing commercial air travel return to capacity. By the third quarter of 2021 oil and fuel, which had faced structurally depressed demand and whose performance had lagged other raw materials, was joining the commodity bull market. Coinciding with the economic re-opening bounce, Europe sought to instigate its transition towards greener energies, which are typically less reliable as base loads for electricity needs. If that was not sufficient a tailwind, within a few short months, Russia has launched its invasion of Ukraine, meaning a reluctance on the part of many to buy Russian crude oil, which hence in practice has removed further supply from the market. Its perhaps more than coincidence that Vladimir Putin chose to launch a long planned military campaign to achieve his imperialist ambitions, at a time when Europe was already witnessing energy shortages.
Changing the nature of power production
The energy transition is a fait accompli. Politically we have set sail for a greener, cleaner, energy future, of which some of the consequences are just beginning to be borne. Globally we are attempting to transition from liquids based transportation to a power based one – from oil to power calories, all at a time of historic underinvestment in our current energy infrastructure. In retrospect, when we consider all of the foregoing, it is hardly surprising that the seeds of big commodity bull market have been sown.
The Calorie Cost of Productivity
Whilst over time we will improve our ability to thrift and substitute certain raw materials, for the time being energy efficiency has been relegated to a secondary matter, meaning reducing carbon footprints are the global priority almost at any cost. For the foreseeable future, this will drive ‘greenflation’, as the calorie cost of productivity, (or energy), is higher than it would be, should the priorities still be optimising the cost of energy.
As we seek to electrify our entire power networks and arrive at one that offers uninterruptable energy with the storage to support it, be that fossil fuels or greener alternatives such as biomass, ethanol or biodiesel, energy will remain in a bull market. Moreover, as societies we will need to become much more ‘miner friendly’, given the massive investment in material metals needed to build new energy infrastructure.
Copper is the new Crude
Copper is omnipotent – its demand driven by homebuilding, construction, manufacturing, power generation, electronics and transportation. Unsurprisingly then, ‘Dr Copper’ is often viewed as a barometer for global economic growth. Chinese inventories are at their lowest levels in four years, as are those of the London Metal Exchange.
In short, the demand growth on account of electrical infrastructure, renewable energy and EV’s is now outstripping supply growth. Chile is the world’s largest producer, at almost 28% of global supply and holding the world’s biggest reserves, but historically has politically been less than reliable. A left leaning government had stoked fears around resource nationalisation, but as yet, they are unfounded although emerging economies often do present greater supply risks than their Western counterparts.
Copper is a transition metal with certain properties including ductility, electrical conductivity, thermal conductivity and low reactivity that make is an affordable option for cables, batteries, transistors and invertors, all key for the energy transition. Goldman Sachs predicts that by 2030 copper demand could rise by nearly 900%, where the world witnesses widespread adoption of green technologies. Currently the investment bank believes 3% of global production is utilised for green technologies – a number which will rise to 14% of global copper demand by 2030 – a necessary increase in production of 14.5mn tonnes.
Institutional Under Investment:
Many institutions, on account of ESG concerns are limited in their commodity exposure. Alternative asset classes to traditional equity and bond markets, such as digital assets, are not deep enough to absorb such allocations and many compliance departments are yet to be green light them..
So at a time when alternatives are sorely needed – witness recent simultaneous falls in both equities and bonds, options are few. China is currently in an ‘easing mode’, and therefore in prospect at least its government bonds should outperform those Western counterparts. However, domestic policy changes and the threat of sanctions such as those imposed on China, mean such exposure is off limits to many. So commodities, with their positive correlation with inflation can provide welcome diversification to institutional portfolios, but environment restrictions in their mandates mean they may be restricted in providing much needed capital to the sector.
JP Morgan’s research shows that institutions currently only hold 1% in commodities. However, it’s not a simple fix.
Gold perhaps could ultimately become a via alternative to bonds, yet is does not generate income streams of course. Ultimately, after years of above average returns, real money investors may have to accept that a higher inflation regime requires investors to accept lower returns going forwards. After the strongest 10 year return in over 60 years for the 60/40 equity / bond mix, that might just be a fate many investors have few options but to accept.
The foregoing is just some of the rationale we believe underlines the importance for investors to have exposure to commodities in portfolios. In many respects, a perfect storm has been created to support prices for years to come.
Where to Invest?
The net zero transition combined with aging infrastructure globally has set the macro stage. Even China without any political obstacles has committed to meet carbon neutrality by 2060, and peak carbon emissions by 2030.
There a multitude of investing implications. EVs, energy, storage, wind and solar will see massive top line growth. However, some commentators would suggest that they are very interest rate sensitive and some of the valuations are already very lofty indeed.
Beyond that raw material and component suppliers are attractive – suppliers to these front line candidates. We are on the cusp of a huge capex cycles as we replace 55 – 60 percent of global power generation, upgrade manufacturing facilities, move to the production of nearly 100mn EV’s globally. This will drive demand for copper, lithium, aluminum and inevitably steel.
Shipping is another interesting thematic. With the prospect of the IMO 2020 regulations, companies were unable to invest at all in new tonnage for the last 5 years given the lack of visibility. Even now there are competing technologies and no clear carbon reduction path. Supply chain shortages also reflect the lack of shipping capacity the world currently has. For example, in order to meet emissions targets, one means of doing so is ‘slow steaming’, which reduces the average speed of vessels to reduce emissions. It also increases voyage times by 10% equating to a de facto 10% reduction in shipping capacity. That is significant in an industry, where like all commodities, prices are set at the margin.
How To Invest?
ARIA’s Global Impact Income Fund (GIIF) exposure to the upswing in commodities, through targeting companies that will benefit from energy transition and energy security policies. As the world electrifies, there are many bottlenecks that appear and its possible to identify companies which reside within supply chains where there are shortages and are well placed to benefit. Not only do these companies offer attractive and rising margins, but also their earnings are often positively correlated to rising inflation. GIIF targets a 5.5% income yield whilst bringing a means to benefit from the unparalleled and very necessary energy transition the world is undertaking this decade.
