The use of commodities correlates well to an S-curve which inflect rapidly at key milestones relative to GDP/Capita of around $3-5k. While China’s urbanisation is a well-known story, there are burgeoning sources of demand in other emerging markets at these important inflection points.
We also think there are important and overlooked demand sources in the developed world related to grid investment for stability and advances in mobility technology that are essential to modern lifestyles. In short, the digital era does not displace the need for copper but enables it.
On the supply side, we see trends that serve to dramatically arrest any supply response and extend the cycle. Mining majors were priced for mass default not long ago and the priority has been to de-leverage rather than invest. Upstream capex across several key base commodities has fallen over 70% from peak levels, for instance.
The shift of ownership of equities from active to passive vehicles prohibits investment in early stage enterprise owing to their risk and volatility. Passive investors also prioritize return of cash through share repurchase and dividend irrespective of the merits of investment and thus depress reinvestment rates. These vehicles did not exist in the previous cycle and we don’t think the market has incorporated their pernicious impacts on supply and demand.
There is limited appetite for non-producing enterprises as much speculative capital is now directed to Crypto or Cannabis which has shut traditional ports of call for these embryonic companies. Streaming and royalty capital is expensive and in shortage which makes those avenue meagre substitutes. The exploration companies help renew pipelines and offset mineral depletion, their suffocation today may have an impact on supply tomorrow.
Commodity prices are informed by marginal costs. These are subject to intermittent disruptive forces that may be deflationary or inflationary. Good examples are electrification and high-volume capital equipment which lowered unit costs and depressed prices in the past century. Today, we see limited low-hanging fruit in productivity any more, and resource depletion leading to grade declines forcing production to more expensive underground locales, a limited number of technological leaps in mining engineering, and resource nationalism as inflationary forces that solve for higher prices.
In the case of some commodities, wide-spread bankruptcy has converted distressed debt positions into equity. Sponsors who now own that equity have board representation and also prioritize return of capital to investment.
Outlook for commodities through 2019
We see differing supply and demand balances for differing commodities, so it is difficult to answer this question succinctly.
Presently, we see a very interesting trade-off in Uranium where both sides of the supply and demand equation have conspired to tighten the market. The importance of nuclear energy in the global production mix is large at 10% while listed miner count has plummeted by 90% due to exits forced from the extremely low pricing regime post Fukushima. The accident cratered prices which has discouraged investment due to a short-term surplus of Japanese stockpiles, and these are finally being worked off.
We are also positive on copper owing to the lack of supply response for new production which may cause a shortage in the medium term.
Though coal is perennially out of favour, incredibly high hurdles rates have disincentivized investment to a point that supply itself is shrinking more rapidly than demand is shrinking which conspires to create a positive backdrop for investment.
Following fads or what is fashionable leads to return purgatory and so feel more comfortable running away from herds then following them.
Michael Alsalem is head of London office of Azvalor Asset Management
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