Matthew Tillett
Premier Miton UK Value Opportunities Fund manager
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
In this insight note we cover
- Capital cycle theory points to an attractive long-term supply-side outlook for investors in the resource extraction industries. Sustained underinvestment over many years means these industries may be unable to respond quickly to growth in demand.
- The growth of ESG awareness by the investment community accentuate these pressures. Key energy transition technologies will require substantial investment into natural resources, especially certain base metals, yet ESG factors in the sector make such investments harder and costlier to achieve.
- Against this backdrop, incumbent, low cost and long-life assets may be set for a sustained period of imbalance in their market forces as supply struggles to keep up with resilient demand.
Heavy metal fans?
The extractive industries – mining, basic materials and energy – are an area of the stock market that has always divided opinion. There are many investors who shun the space entirely: “Its just a bet on the commodity price” is the standard reproach. Others adopt a short-term mindset, attempting to forecast swings in demand and the resulting impact on commodity prices.
There is another method, sometimes called the capital cycle theory. It looks at the issue from the perspective of supply and is, in my opinion, the most reliable approach. It is grounded in historical experience; it places greater emphasis on factors that can be understood and is focused on long-term investment outcomes rather than trying to predict the shorter-term ups and downs.
The cure for high commodity prices is…?
The cure for high commodity prices is high commodity prices is the well-known and remarkably accurate anecdote. Repeatedly throughout history there have been long periods (often a decade or longer) of relatively high commodity prices followed by long periods of what seems like very low commodity prices. Why does this happen?
The simple answer is that any capital-intensive industry where the lead time for new supply is measured in years rather than months is likely to be prone to this sort of cycle. When selling prices and profitability are high relative to the cost of new supply, capital will be attracted to the industry. The new capital increases supply which eventually drives down prices and profitability across the industry.
Conversely, when selling prices are low relative to the cost of new supply, capital will exit the industry, increasing the profitability for the capital that remains. Extractive industries are especially prone to these cycles because the lead times on new supply are exceptionally long, which means the supply side situation today is really a function of investment decisions that were taken five or ten years prior when the commodity price environment may have been very different.
Extracting investment answers
From an investment perspective, there are two important reasons why I believe the capital cycle approach is particularly applicable for the extractive industries.
Firstly, the time horizon over which the capital cycle plays out can be longer than the time horizon of most investors. For example, during the 2000s – the last great commodity super cycle – the prevailing narrative at the time was that the recent strength in commodity prices would last forever. The belief was that there was simply no way the industries could keep up with the growth in Chinese demand in the face of rising costs and declining grades (all precious metals are graded by the amount of metal within the ore. A higher grade means that the ore has a higher density).
But new supply did eventually arrive and unfortunately coincided with a slowing in the rate of growth of the Chinese economy in the early 2010s. The result was a collapse in commodity prices, followed by a period of oversupply, and poor company share price performance for the companies exposed to this. The timing is difficult, but I believe that ultimately these outcomes can be forecasted.
Secondly, from a fundamental perspective, it is much easier to assess long term supply trends than it is to predict the short-term ups and downs in demand. For example, in the copper industry, most of the large resources have been found and are already in production. Grades have been in long term decline which means the industry has to run faster every year just to stand still. Moreover, since the collapse of the super cycle in the early 2010s, there has been a decline in investment across the industry as companies have prioritized profitability and balance sheet strength over growth.
These factors mean that it may be difficult for the copper industry to materially increase supply without prices being much higher. From a capital cycle perspective, this is a very encouraging backdrop as it may point to the prospect of higher profitability in the future.
The ESG Paradox
All of this is before we consider an additional set of ESG factors that are accentuating the imbalances between supply and demand. I term this “the ESG paradox” due to the inherent contradictions that exist between, on the one hand, the understandable and necessary drive to achieve net zero, and on the other hand, the unfortunate reality that much of the investment required to make this happen involves huge quantities of natural resources (including fossil fuels). And because such investments are inherently dirty and polluting in nature, often in emerging markets with associated issues around corruption and poor labour practices they face high and rising investment obstacles due to poor perceived ESG metrics. Here are two examples to illustrate the point.
It is widely accepted that electric vehicle (EV) demand is set to grow rapidly over the coming years, eventually displacing the fleet of internal combustion engine (ICE) passenger vehicles. Once this has happened there could be a significant reduction in fossil fuel usage.
What is surprising is the length of time this may take to happen. Although EVs emit a lot less carbon than ICE vehicles over their full life cycle, their manufacture is considerably more resource intensive – due primarily to the battery – and manufacture of EVs is expected to grow very rapidly. Because of this, it may be quite some time before the net impact of the shift from ICE to EV results in lower demand for fossil fuels such as oil.
Thunder Said Energy estimates that it will not be until the late 2030s that this happens. To be clear, this is not an argument against EVs, which are an important component of the energy transition. But anyone expecting the EV transition to result in an imminent and rapid decline in fossil fuel demand may be disappointed.
Turning copper into gold?
For copper, the picture is even starker. Most of the key technologies that are expected to drive the energy transition have higher copper intensity than their fossil fuel equivalents, in some cases significantly so.
The primary reason for this is copper’s efficacy as a conductor of electricity. As more parts of the economy move to electrified systems of power, there may be greater pull on the world’s copper resources. Assumptions and estimates vary, but it is clear that demand for copper may rise because of the energy transition. And unlike energy, where there should eventually be a peak in usage followed by a long-term decline, for copper the medium- and long-term demand outlook may be robust. Nor is copper alone in this – the picture is similar for many other critical metals such as cobalt, nickel and lithium.
Source: Thunder Said Energy data from 2012 – 2020 (thundersaidenergy.com/)
Source: Thunder Said Energy data from 2012 – 2020 (thundersaidenergy.com/)
Achieving net zero may mean using more, not less
The implication is that the world is going to need a lot more natural resources to achieve net zero. This means investing more capital into the resource extraction industries. But as we have seen, these industries have already been starved of capital for the best part of a decade. Such investments are also themselves problematic from an ESG perspective. Aside from the carbon emissions emitted in the construction of mines, mining activities and processing facilities, there are a host of other local ESG issues that must be overcome.
For example, in Chile, one of the largest copper producing regions, the copper mines have become increasingly unpopular with local populations as their activities have drained precious resources such as fresh water supplies. This has had the effect of making expansion projects more costly and challenging to achieve. It is a similar picture in other parts of the world. Additionally, any investor that is constructing a net zero or sustainable portfolio is unable to invest in the sector due to restrictions on holding investments with “adverse impacts” such as high carbon metrics, poor human rights scores, and other related controversies.
The final word
From an investment perspective, the clear conclusion from this is, in my view, that incumbent, profitable and well invested assets with long asset lives may be set to benefit from a period with demand remaining resilient whilst supply is constrained.
Capital cycle theory leads to this conclusion, with the ESG paradox accentuating the demand and supply side pressures. Existing assets also have the advantage of being easier to assess and value and are already funded, whereas large scale development projects are more likely to struggle to receive funding due to ESG obstacles and cost overruns.
Finally, it is clear from the valuation of the mining and energy sectors that the view expressed here is not the prevailing consensus view. In most cases, valuations imply a decline in profitability and/or commodity prices significantly lower than current levels. Such an outcome may be unlikely on any medium to long-term time frame against the backdrop of the supply and demand picture outlined in this note.
