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BFI Perspectives 

  • Dirk Steinhoff

Commodities: A Tectonic Shift Underway

The last decade has presented excellent opportunities and considerable gains for equity investors, as the longest bull market in history, starting in March 2009, created a “tide” that lifted almost all sectors. In the commodity sector, however, the conditions were entirely different. Weak commodity prices led to both weak prices of commodity related stocks and a widespread underinvestment in this sector. Now, this may all be about to change.


As we’ll examine in greater detail in this analysis, all four commodity types we’ll look at appear to have strong drivers in place that support a very optimistic outlook for the months and years to come. These sectors, namely agriculture, base metals, energy and precious metals, differ in their nature and there are forces that are unique and specific to each one. However, there are certain common denominators that largely underlie commodities as a whole.


First of all, the “lower-for-longer” price environment has brought about significant underinvestment in most commodity sectors. While capital expenditure in general has seen a steep and steady decline over the last decade, this has particularly impacted metals and energy, as the underinvestment in mining and exploration projects has been especially pronounced.

In the commodity sector, a highly cyclical one, there is an age-old adage that still holds true: “the cure for low prices is low prices”, meaning that weak prices lead to underinvestment, which leads to supply contraction, which eventually leads to higher prices. Contrary to many other sectors, i.e. technology or industrials, in the commodity sector, it may take years to increase the supply, leaving demand unmatched for much longer and thereby pushing and keeping prices higher for a long time.


Secondly, inflation expectations have been substantially increased since the onset of the covid crisis, as a result of the monetary and fiscal responses to it. These expectations were recently reinforced by the landmark policy shift unveiled by the Federal Reserve, that will allow inflation to rise above the 2% target “for some time”, while keeping interest rates at ultra-low levels for the foreseeable future. This should provide a remarkable boost to commodities, as historically, there is a significant positive correlation between consumer price inflation and commodity prices.


Last, but certainly not least, the fiscal policy landscape is looking increasingly supportive as well. The coronavirus relief packages have already marked an important sea change in policy direction, which is expected to persist and likely intensify, as the damage caused by the lockdowns and the shutdowns continues to pose a serious threat to the global economy. This aggressive spending approach is likely to provide support particularly for the energy sector and for base metals. Specific metals like copper and nickel are bound to benefit the most, as they are also very well positioned in reference to the wider trend toward “green” energy and renewables.


Agriculture


Overall, the last decade was challenging for agricultural commodities, a sector that is extremely diverse and notoriously volatile even during the best of times. As measured by the Bloomberg Agriculture Sub-index (BCOMAG), agricultural commodity prices have been on a steep long-term downtrend since 2011 and have only risen in one year out of the last seven. However, a few months ago, the index began to show early signs of a possible reversal on the way.


The covid shock had a severe impact on soft commodities like cocoa and coffee, but that was very quickly replaced by a strong rally, buoyed by weather concerns and a weaker dollar. More recently, grains have seen impressive price gains, as China boosted its imports of U.S. crops, something that is expected to continue, despite the trade tensions, as part of the “phase one” trade deal.


As general rule, it is ill-advised to make blanket statements and predictions for agricultural commodities as whole. The sector encompasses a very wide range of commodities, each representing a market with particular and often unique drivers, ranging from specific weather conditions, to geopolitics and local regulatory changes. Looking at the bigger picture, however, what we can safely say is that agricultural commodities do stand to benefit from the emerging inflation theme and this supports the sector’s mid- and long-term outlook.


Additional support is found in global demographic trends. The growing world population, expected to hit 9.7 billion by 2050, according to UN projections, and more specifically, the growing global middle class, combined with a strong urbanization trend, present challenges to the future of global food production and supply. This is already evident in China. As reported by Reuters, a recent report by a Chinese government think tank sounded the alarm over a food supply gap by 2025, as “within five years, the proportion of the population living in urban areas is expected to hit 65.5 percent of China’s total, up from 60.6 percent by the end of last year, with around 80 million rural residents moving into the cities”.

The purest way to gain exposure to agricultural commodities would be through a commodity ETF tracking the entire sector, which would limit the impact of the various idiosyncrasies of individual commodities and their short-term volatility that can be at times extreme. As there are many pitfalls associated with futures-based commodities, investors should be very careful.


Energy


While the first half of 2020 was particularly disastrous for oil and gas causing many analysts to declare an absolute bottom in the sector, it came after many consistently challenging years. Historically weak prices have translated into chronic underinvestment, which was further exacerbated by the record price lows brought about by the covid crisis. According to the International Energy Agency’s latest projections, capital spending in the oil and gas sector is set to fall by one-third in 2020, highlighting that “pre-crisis expectations of modest growth have turned into the largest fall in global energy investment on record”.


Given the multi-year lead time of new oil and gas projects and the scale of these expenditure cuts, it is very likely that the resulting slump in supply will be significantly disproportional to the demand shock caused by the pandemic. Should demand pick up faster and stronger than initially expected, for which there are some solid indicators out of China that has already recovered more than 90% of its pre-crisis demand levels, we could see prices surge. This is further supported by the fact that investment trends were already poorly aligned with the projected global demand, even before the covid crisis.


There are, of course, additional drivers that support the case for a strong reversal over the coming months and years. The covid shock may have wreaked havoc in the energy sector in many ways, but the extreme pressures it introduced also forced some important changes and re-evaluations, especially in the U.S. shale oil business. Many companies that have been in dire financial straits for years, saddled with dangerously high levels of debt, may have found this crisis to be a blessing in disguise. These companies face the necessity to bring down costs, resort to mass layoffs, cut dividends and management compensation, to write off or sell unproductive assets.

This situation can help them emerge leaner and stronger from this crisis and with a healthier balance sheet. A recent example of this was Whiting Petroleum, which exited Chapter 11 bankruptcy in early September. The company was among the first major oil producers to file for bankruptcy protection back in April, and now its restructuring plan allowed it to lower its debt by approximately $3 billion, while it also cut a third of its workforce and proceeded with key management changes. Nevertheless, investors should still be cautious, as for other companies, any help might come too late to save them from bankruptcy.


Finally, it is crucial to understand the dynamics on the demand side. A lot has been said and written over the last years about the switch to “green” energy and all the activist efforts to either aggressively reform or topple the oil and gas sector. Although many countries have made pledges and took some early steps towards various sustainability goals, the fact of the matter is that oil and gas demand is expected to remain stable in OECD countries at least for the next decade. In fact, according to OPEC estimates, demand is even expected to rise in the mid- and long-term in markets like India and China, “driven by an expanding middle class, high population growth rates and stronger economic growth potential”. For natural gas, the global demand outlook is even more positive. It has already been rising steadily over the last decades and it is projected to climb even higher, as it is seen a cleaner alternative to replace existing coal plants and used in new power plants to add clean, reliable energy to the overall energy mix.


The investment implications are therefore quite clear. The energy sector at large shows promising potential and there are numerous buying opportunities to be found at price levels that were rendered even more attractive by the covid shock. ETFs can provide exposure to oil and gas prices, as well as to producers, oilfield service providers and other relevant companies. Investing in individual stocks can also prove very profitable, but it does come with higher levels of risk. Given the debt levels and the additional pressures exerted by the pandemic, we see it as essential to have a very detailed and careful screening process in place to identify those companies with healthier balance sheets.


Base Metals


The base metals sector has also been plagued by low prices and years of underinvestment and it now presents some very interesting investment opportunities. Copper and nickel are the most prominent among them, as there are very strong supportive forces at play in both cases.


The “traditional” demand driver for nickel is the stainless steel industry, accounting for over 70% of nickel demand. Nickel is the essential ingredient that makes stainless steel highly corrosion resistant and thus its price fluctuations are closely correlated with the infrastructure and construction industries, the major consumers of stainless steel. In this regard, economic activity in China plays a key role in determining the direction of the nickel price. The country’s stainless steel output accounts for approximately 50% of global production, and it is expected to keep growing, albeit at a slower rate of 3.4% in 2020, compared to the 9.4% year on year increase in 2019.


There is also another important demand driver, namely the rapidly growing electric vehicle (EV) industry. Nickel is heavily used in EV batteries and the global move towards automobile electrification, driven by government incentives, companies and individual consumers, did slow down by the pandemic, but it already shows signs of a strong comeback. Currently, the EV batteries’ share of global nickel demand stands at only 4%, but as EV sales climb, it is projected to reach nearly 10% of the total in 2022 and 20% by 2030, according commodity research firm Roskill.


The case for copper could be even stronger, as a growing number of analysts concur that the red metal has the best long-term prospects in the base metals sector. As an S&P Global Market Intelligence report put it, copper is just emerging from a “dismal decade” of massive underinvestment. As the report highlighted, 224 major copper discoveries were made since 1990, but only 16 of those were in the past decade and there has been only one major discovery since 2015. As a result, while there are enough reserves to meet immediate demand, the production cuts of last decade are likely to cause a supply crunch in the years to come.

Often dubbed “Dr. Copper”, the red metal is widely acknowledged an indicator of economic health. As such, to a very large extent, copper’s demand prospects are tied to the pace and the scale of the recovery from the covid crisis. Copper is omnipresent as a core component in electrical equipment, wiring and piping, telecommunications, construction and industrial machinery, therefore the macro environment, the revival of the manufacturing sector, and infrastructure, play a considerable role in price direction. Indeed, the metal rose to a 2-year high in early September, as investors welcomed improving manufacturing data, especially out of China, a key source of copper demand. In addition to this, in recent years, the metal has also seen increased demand due to advances in “green” technologies and renewables, as it is heavily used in solar, hydro, thermal and wind energy systems.


Finally, copper is also an excellent inflation hedge, because of its extensive uses and its instrumental role in manufacturing, industrial production and end consumer goods. Naturally, as the price of goods and services rises, so does the price of the commodities used to produce them. In fact, copper has a better track record as an inflation hedge than gold, which is the ultimate crisis hedge.


ETFs can provide very good exposure to copper and nickel, as would single miner stocks. In the latter case, much like with oil and gas, caution is necessary in the screening process to ensure the selection of high-quality stocks.


Precious Metals


As we outlined in our previous issues of the InSights, the investment case for gold and silver is very strong. The fiscal and monetary responses to the covid crisis have already paved the way for the return of inflation, and not just for asset price inflation, but also for consumer price inflation. Now, as it becomes clear that the economic damage is here to stay and as governments start to prepare for a “second wave” of relief packages and massive spending, the outlook for precious metals appears even brighter.


However, it’s not just inflation that precious metals can provide protection from. Especially gold is a solid hedge against different risks that are on the forefront of many investors’ minds. The currency crises currently underway in Turkey and Lebanon, the sovereign debt crises in Argentina and Ecuador, are arguably just the tip of the iceberg. Given the scale of lockdown damage and the decades of excessive debt accumulation that preceded it, there are many more countries that could find themselves in a financial dead-end. According to Fitch Ratings, sovereign defaults are set to hit a record this year, as in only the first four months of 2020 there were a record 29 sovereign downgrades.


The overall climate of uncertainty, the heightened volatility and the stretched valuations in equity markets are also driving investors to seek refuge in precious metals. This is increasingly true for retail investors and ordinary savers too, many of whom never owned any financial assets before. A recent survey by LendingTree revealed that one in six Americans bought gold or other precious metals in the last three months. On Robinhood, the popular mobile trading app for amateur investors, the number of users holding two of its largest gold funds has tripled since the start of the year.


Conclusions


As we enter fall, concerns over a new wave of covid infections are on the rise and so are fears of further lockdowns and restrictions on economic activity. On the other hand, fresh stimulus packages are also in the pipeline, as fiscal and monetary support is here to stay. For investors, it is certainly a time of widespread uncertainty and great volatility, but the forces that are likely to drive commodities are already in place and set to intensify over the coming months and years.


For instance, we might not know yet exactly what form the new fiscal relief efforts will take in major economies, whether there will more “covid checks” or an introduction of the Universal Basic Income, a trial launch of which we recently saw in Germany, but we do know further stimulus is on the way and it is likely to break new government spending and borrowing records. More monetary easing is also all but guaranteed and so are “lower for longer” interest rates, thereby solidifying inflation expectations which are set to benefit commodities at large. What is also highly probable is that the shift towards the “green” economy will continue and likely accelerate, since much of the stimulus, the grants and the loans, are tied to the green agenda, as we saw in the case of the Eurozone recovery deal.


Overall, we feel that the previous decade of severe challenges and widespread underinvestment has created many opportunities in commodity sectors that are especially attractive at the current price levels. However, although our commodities outlook is very positive, we must highlight the need for investors to be cautious and to employ a very careful screening process when evaluating individual stocks. There are indeed great bargains to be found in commodities and there are companies that will emerge stronger from this crisis, but there are also those that will not emerge at all. Therefore, it is essential to mitigate these risks by identifying high quality companies, with healthy balance sheets and a solid track record.


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