The catalyst
The impact of the war in Ukraine has had major implications, particularly to global energy markets, but also as a catalyst for driving government packages focused on driving an energy transition. Russian oil, trading at a $25 discount to international oil, is helping to suppress the rise in the oil price, which has steadily been falling from its early invasion peaks, despite OPEC cuts. For China and India who continue to be the primary purchasers, this is delivering a cheap energy boon. Tempering the profits from Russian oil, whilst not exacerbating energy price inflation, being the main result of ‘Western’ sanctions.
Longer-term, the most significant implication resulting from the war is the recognition by governments around the world that they need to achieve a higher level of energy security. As a result, major fiscal programmes are being directed towards this whilst incorporating the necessity to transition away from a carbon economy. The Inflation Reduction Act in the US as well as the European Union’s Recovery fund and EU Green Deal Industrial Plan are results of governments seeking to achieve greater energy independence, but in a cleaner form that has been the case since the Industrial Revolution.
Whilst the early year enthusiasm that buoyed commodity prices, such as copper, stemmed from the high expectations surrounding a strong rebound in the Chinese economy, following its reopening from COVID lockdowns. The China ‘reopening’ boom now looks disappointing which, in turn, has impacted commodity prices through the course of the year, but some longer-term tailwinds remain, justifying their continued inclusion in some higher risk/reward portfolios.
Supply…Better management, better future
From the supply side, inventories have been drifting lower across multiple commodities, for example according to JPM Asset Management, copper inventories have fallen from their peaks in late 2017 of 900,000 tonnes to around 250,000. Inventory levels have been falling for the last decade at a time when we need more copper due to the energy transition. It isn’t just copper, London Metal Exchange inventories across almost every base metal are at lows helping to support prices. With the supply bottlenecks created by having to source, mine, refine and transport commodities, the lead in times to generating more production present an obvious obstacle. Lead times in bringing new commodity supply is measure in years, not days, weeks or months.
Capital investment levels from the major mining and energy companies have fallen from their peaks early in the previous decade when the clamour for new projects came at the expense of capital discipline, leading to weak share price performance for the rest of the decade. Corporate debt levels are now much lower in aggregate and the focus shifted to shareholder friendly dividends and buybacks. All good news from a corporate health perspective.
There is a ‘but’.
Underinvestment in capital expenditure and increased capital discipline in boardrooms, has been running alongside the increasingly pressured long-term outlook for traditional energy sources, oil and gas. The net result being significant reductions of capital expenditure in traditional oil and gas projects and, whilst there has been growing investment in renewable energy sources, overall investment in global energy supply has been falling since the middle of the last decade.
…and Demand – The essentials needed for the energy transition
Society is evolving and developing the technologies to move to a lower carbon future. Both sentiment within society has shifted to recognise the need for the sustainable use of the resources our planet offers up. Importantly, this coincides with, first, the ability to scale up the shift away from fossil fuel reliance and, second, the political will to support the transition under the need to ensure more secure energy supplies. The costs of solar and wind power have fallen dramatically to already make it an economically more attractive option than traditional fossil fuels, and as the pace of the renewable energy transition continues, delivering energy from renewable energy sources will make economic sense. Earlier in the year, according to National Grid, the UK generated its trillionth kilowatt hour of renewable energy. Whilst it took 50 years to reach that landmark, their forecast is for the next trillionth kilowatt hour of renwable energy to be generated in just the next 5 years.
Transitioning away from a carbon economy, whether it is achieved through increased solar or wind generation is going to need plentiful other resources, whether that be copper or rare earth’s minerals. For example, electric vehicles are 4 or 5x more copper intensive than a conventional car. A wind turbine contains approximately a tonne of rare earth metals.
This energy transition will form a strong backdrop of demand for commodities in years to come.
Inflation Friendly
We’ve written in previous quarterlies that the decade or so since the Global Financial Crisis saw central banks keeping interest rates at lows, and then ultra-lows as the pandemic struck, in an attempt to meet their inflation targets. Looking forward, we’d argue inflation is likely to trend down from the current highs but hover slightly higher than the policy targets of the major central banks. This will promote a shift mentality in central banks to constantly ‘tap the brakes’ with rate rises to keep inflation suppressed, rather than ‘foot to the floor’ to try and push inflation higher. In that environment, the positive relationship between commodities and inflation should be maintained. Either way, the prospect of a deflationary episode, which would be a headwind for commodities, seems some way distant. Whilst the inflation argument isn’t, in our view, the primary reason for holding, it does serve as a useful ‘back-pocket’ reason.
Conclusion
The short-term outlook remains challenging for commodity markets. A slowing global economy tends not to serve as a warm backdrop. However, look through the near term and the outlook becomes more positive for a variety of reasons. The demand/supply dynamic as we transition our energy production and supply to a cleaner, low-carbon option will demand huge number of resources. The corporate management of resource companies has also become more shareholder friendly and less capital destructive than it was during parts of the previous decade. Finally, should inflation remain higher than it has since the Financial Crisis, commodities relationship with inflation could be helpful.
We are moving into a period where demand for commodities is likely to be turbocharged by the push from governments to transition their economies to a cleaner energy future. The need for transitioning away from a dirty carbon economy has been known for some time, but the sharp focus delivered by the war in Ukraine on governments and their need to achieve energy security has delivered the motivation and fiscal push to deliver. The European Union’s Recovery Fund, The US Inflation Reduction Act and the EU’s Green Deal Industrial plan will help drive the demand for this energy transition, both from the need for energy security, but also from the desire for their economies to be the winners in this new energy cycle. Investing in the companies that supply some of the critical materials to enable that global transition makes long-term sense.
