Are we entering a commodities supercycle? And what does it mean for small cap investors?
“…What does seem clear is that the stars are aligned for commodities as they have not been for some years. There are opportunities in copper, lithium, vanadium, nickel and other materials, and also for the oil and gas producers…”
How can you play a bull run in commodities? Here, we look what a commodities supercycle will mean overall and more importantly how it will affect the small cap sector. We offer some ideas and Companies to consider if you believe we are indeed entering a new era in the commodity markets.
Companies and ideas covered that should benefit from any move up in their respective Commodities include: #BLOE #BMN #BRD #CHF #CGO #CMET #CUSN #ECR #ECHO #EEE #GUN #HE1 #IRR #IRS #JAN #JAY #KAT #KAV #KRS #LND #NTOG #PALM #PXEN #SAV #SHG #SRES #UJO #ZPHR
As the global economy’s tentative recovery aligns with government spending programmes focused on green infrastructure, speculation about the possibility of new commodities supercycle has been swirling over the past few weeks.
“Talk of a supercycle may or may not be premature, but we can act on what is happening right now, an alignment of circumstances in favour of commodities that has not seen for quite some time.”
What is a supercycle, and what does it mean for small caps investors?
The term is shorthand for a bull market lasting several years during which a shortage of metals, oil and gas, crops and other commodities forces a significant and sustained price rise.
A cycle is triggered by a war or some other crisis that hits production, or simply a long period of stability in which modest demand for commodities limits the prices producers can charge for them, and therefore their incentive to invest in costly new exploration. Suppliers rundown their stockpiles until the glut turns into a shortfall, supply falls behind demand, and prices start to rise. Because commodities are expensive to produce their supply cannot be quickly ramped up – it takes well over five years to get a new mine up and running – so prices stay high for quite some time.
Fluctuations in the commodities market are common, but supercycles are rare. There have only been four over the past 120 years, driven by the recoveries from two world wars, the OPEC price shock that drove up oil prices in the 1970s, and China’s rapid industrialisation during the early 2000s, the sheer pace of which took the market by surprise, pushing up metal and oil prices.
A new supercycle? – the case for
Though the last supercycle ended quite recently, the exceptional circumstances of the past year have generated increasing speculation that we might already be entering another one.
Commodity indices have surged by up to 40pc since last July as the world economy gradually recovers from the pandemic. Asian economies have fought back strongly after disciplined lockdowns, and return to some kind of normality is keenly anticipated in the US and Europe as vaccination programmes are rolled out.
An influential Goldman Sachs report published last month was among the first to argue that the particular circumstances of the recovery mark it out as the beginning of a new supercycle.
In contrast to the aftermath of the 2008 banking crisis, the argument goes, governments seem prepared to underwrite the present recovery with programmes of sustained support for businesses and consumers. The severity of the downturn caused by the pandemic and the unpopularity – and questionable effectiveness – of the turn to austerity following the financial crash has rehabilitated the Keynesian belief that stimulus programmes pay for themselves through the growth and inflation they generate (higher inflation erodes debts).
Furthermore, like the investment programmes that rebuilt the global economy through the 1950s and 60s, the post-pandemic recovery programmes depend on a sharp increase in the supply of commodities. China, Europe, the UK, and – since Joe Biden’s election – the US, have all committed to programmes focused on the rapid development of the infrastructure necessary for transition to the emergent green economy.
Goldman’s report suggests that the transition has the potential to generate some $2tn a year in infrastructure investment over the next decade, a prediction in line with estimates by energy consultants Wood Mackenzie that at least $40tn will be spent over the next 20 years.
The mass rollout of solar panels, wind turbines, fuel cell and flow batteries, green hydrogen, electric vehicles, and the other green infrastructure necessary to meet net-zero commitments, will place huge demand on the supply of the materials needed to make them. Wood Mackenzie forecast copper and aluminium demand will increase by about a third by 2040, nickel by two-thirds, and cobalt and lithium by 200pc and 600pc respectively.
Demand for copper, the most important of the world’s industrial metals due to its use as wiring for electrical appliances, is forecast to double by 2050, with its application in renewables and electric vehicles expected to grow more than seven times over the next 30 years. Copper’s price has surged by 80pc from its lows last March to a nine-year high above $8,400 a tonne.
The prices of nickel, lithium aluminium and lead, all essential for electric vehicles, renewables, and batteries, have also risen sharply. Tin, used to solder circuit boards and wiring together, has enjoyed perhaps the most remarkable ride of all, prices rising by more than 70pc from their 2020 lows to almost $23,400 a tonne, reaching a seven-year high after demand from manufacturers drained stocks. The Bloomberg Commodity Index – a basket of 27 commodity futures from coffee to nickel – rose by 10pc in Q4 2020.
As TMS discussed in depth earlier this year demand for oil and gas is also picking up after a traumatic 2020. With the price of Brent now above $65, Goldman, together with JPMorgan Chase, argues that soaring demand for oil will contribute to the new supercycle.
Given the industry’s recent travails that forecast might seem rather rash. But Goldman’s forecast was written by the same analyst – Arjun Murti – who called oil’s last supercycle correctly, predicting in 2005 that oil could go well above $100 a barrel. The most bullish forecasts suggest the price of crude could be heading back to those regions as Asian economies continue to grow, and developed economies rely on fossil fuels for the power necessary to support the development of green infrastructures.
Supercycle advocates argue that commodity prices will soar as producers struggle to respond to demand. The low commodity prices that preceded the pandemic, and the emergency measures provoked by the crisis, have forced producers to curb spending on expensive new projects. Many industrial metals were already in short supply before the pandemic. And oil and gas producers sharply reduced already curtailed capital budgets as they struggled for survival last year.
So producers will be understandably hesitant to increase production until they can be sure rising prices are here to stay. And even if they do commit to new investment they face new challenges to secure capital in a market more sensitive to environmental, social and governance considerations than the past, and in which carbon taxes loom on the horizon.
Wood Mackenzie suggest that producers of the five essential energy transition metals will need to commit at least $1tn of investment over the next 15 years to meet demand generated by green infrastructure programmes aligned with the 2C Paris Agreement target.
A supercycle or an upturn? – the case against
For supercycle advocates the argument is compelling. We have a global economy underwritten by governments, prepared to sustain a recovery that will depend on commodities in short supply: a perfect storm of circumstances sweeping us into a new, enduring commodities boom. But rather more commentators are urging caution.
The pace of the recovery is still uncertain. Western economies, having failed to control the virus through on-off lockdowns, are highly dependent on the success of their vaccination programmes. A critical mass of populations, some 70pc to 80pc, will need to be covered before transmission rates can safely be controlled and economies freed from all restrictions.
As the tensions that have already surfaced make clear, that will test the capacity of countries to coordinate the distribution of vaccines equitably. And although a robust upturn in demand seems inevitable it is likely to be very unevenly distributed. Many of those who have been able to keep working through the pandemic have had opportunities to build their savings, and as the rush to book holidays abroad indicates, are keen to indulge in some spending.
But millions of others have lost their jobs, or face a long struggle to rebuild devastated businesses. The evidence from past recessions is that business closures and unemployment leave scars that are hard to recover from. European economies are not expected to surpass 2019 GDP levels for at least another two years. And poorer nations without access to vaccines will continue to suffer for some time.
As is always the way with today’s global economy much will depend on strong Asian growth. But even here it is unclear how long the massive demand for commodities that has driven their extraordinary rise can last. China, which accounts for half the world’s commodity demand, has bounced back on the strength of a stimulus programme exceptional even by the country’s own standards. But the latest injection, equivalent to 6pc of the country’s GDP, goes against the grain of China’s long term aim to transition to an economy driven by domestic consumption rather than commodity-intensive exporting industries. Beijing has already begun to wind back some of the stimulus used to restart its post-pandemic economy, with its central bank increasingly concerned about the stability of its default-prone $4tn corporate bond market.
What about the energy transition, which surely promises to drive robust long-term demand for commodities?
On paper, it certainly does. But although the shadowy outline of the future green economy can be discerned now, the businesses and governments have much work to do to realise the ambitious net zero targets they have committed to.
Governments of developed nations must answer to electorates often unsettled by rapid economic transformation, as demonstrated in the past couple of years by the 2019 Australian election, in which parties with progressive climate agendas were defeated, and the ‘gilets jaune’ diesel tax protests in France.
Even if political difficulties can be navigated the energy transition is a long term programme that will gather momentum over decades, unlikely to unfold as quickly as the rapid Chinese urbanisation, over seen by a one party state, that drove the last supercycle.
And the suggestion that an oil and gas sector tentatively emerging from the wreckage of 2020 might encounter a supply crisis any time soon seems highly questionable.
It’s true that the industry mothballed its supply capacity during the darkest days of the pandemic, and wrote off some reserves altogether. The US lost around two millions of barrels of production last year. But the industry’s present concern is to restrict supply to keep prices up, perilously reliant on OPEC to maintain its fragile consensus against ramping up production to take advantage of rising benchmarks. Although the US fracking industry was particularly hard hit last year, its tremendous success in preceding years illustrates the capacity of modern drilling technology to discover and exploit new reserves rapidly.
Indeed it is unclear how much demand for oil and gas a commodities boom driven by the construction of a greener economy can support. The quicker the move to renewable power the more rapidly demand for oil and gas will tail off. Again, much depends on Asia, which currently accounts for nearly 40pc of world fossil fuel consumption. But like much of the rest of the world Asia is pivoting to green energy, and without having to navigate the same political sensitivities as western governments.
Finally, it seems the current spike in commodity indices does not just reflect increased demand, but also investor anxieties about inflation. As concerns about unprecedented monetary and fiscal policies rise investors are shifting assets into gold and copper as a hedge.
What it means for small cap investors
So what does it all mean for investors? Attempts to discern the direction of something as complex as the global economy are fraught with uncertainties, in this case about the strength of the recovery, the speed of energy transition, the capacity of producers to respond.
But it is useful to take the time to appreciate something of the complexity of the debate so as not to get carried away by the most bullish forecasts – the ones that tend to make the financial headlines.
What does seem clear is that the stars are aligned for commodities as they have not been for some years. For producers with the financial firepower to make some response to price signals there are opportunities to help meet what seems set to be a sustained upturn in demand for copper, lithium, vanadium, nickel and other materials, and for oil and gas producers serving specific markets.
The upturn in the mining sector has been reflected in recent results from the largest mining companies. BHP, which with a market capitalisation of $170bn recently overtook Royal Dutch Shell and Unilever to become the UK’s largest company, has announced it will pay an interim dividend of $5.1bn as profits hit a seven-year high, and Glencore is to payout $1.6bn to shareholders after scrapping its annual dividend last August.
TMS readers open to the opportunities the small cap sector can offer might wish to review parts one and two of our roundup of mining stocks to look out for in 2021. We have also looked at interesting oil and gas stocks. Other companies to consider include tin and copper miner Cornish Metals (AIM:CUSN), lithium miners Savannah Resources (AIM:SAV) and IronRidge Resources (LON:IRR), vanadium miners Bushveld Minerals (LON:BMN) and Invinity Energy Systems (LON:IES), and manganese miner Keras Resources (AIM:KRS).
Investors might also want to think about supplementing investments in individual stocks with funds to gain broad sector exposure. There are of course several well known actively managed funds and trusts, but inexpensive ETFs like the Invesco Bloomberg Commodity ETF (LSE:CMOD) should also be considered.
Talk of a supercycle may or may not be premature, but we can act on what is happening right now, an alignment of circumstances in favour of commodities that has not seen for quite some time.
