The future for commodities may look bright
Is the Rebound in Commodities Sustainable?
No serious conversation around the outlook for Australia can take place without an in-depth review of the commodities sector. Australia’s role as a top global exporter for a range of high-quality commodities means that the agriculture and natural resources sectors are always going to have a significant bearing on the outlook for the macro economy. So a key question for Australian equity investors is whether the recent strength in commodities is sustainable. Is it firmly based? The short answer is yes, we think the rise in commodity prices, industrial metals, is sustainable provided the global economic recovery from last year’s short but deep pandemic-driven recession can continue in 2021, which seems likely in view of the coronavirus vaccination campaign currently gathering pace.
It may seem like a paradox that one year after the deepest world recession since the 1930s, Australian mining companies have enjoyed their most lucrative pricing conditions since 2011. Sustainably higher commodity prices depend on three things: 1) global recovery, 2) the absence of major new supply, and 3) the secular growth opportunities arising from global decarbonisation, an important new factor in the commodity pricing equation.
….after the deepest world recession since the 1930s, Australian mining companies are enjoying their most lucrative pricing conditions since 2011.
China’s Early Rebound Supported Global Commodities in 2020
China has been an important factor in the rapid recovery in commodity prices after the pandemic. Having been the first to suffer a sharp fall in activity in the national lockdown last spring, China was the first to recover, the only major economy to post positive GDP growth in 2020. In contrast, the rest of the world was less successful in containing the coronavirus and suffered a deeper lull in activity. This was followed by a slower pace of recovery due to the appearance of a second coronavirus wave and renewed lockdowns.
One of the clearest examples of the divergence in economic performance between China and the rest of the world (RoW) was in steel production. For 2020, China grew steel output by 6.6%, while the RoW saw a decline of 9.7%. In China the fiscal policy response to the pandemic relied on a traditional boost to infrastructure investment, which is commodity-intensive. In the U.S. and Europe the emphasis was mainly on supporting jobs via income transfers and furlough schemes. The difference in fiscal policy response meant that 2020 was a banner year for Chinese steel, which surpassed 1.0 billion tons for the first time ever (for comparison, the U.S. produced 73 million tons of steel last year).
As a result, the price of iron ore – Australia’s largest mineral export – soared and continues to increase today (See Figure 1), since the demand-supply balance remains tight. The sharp rise in the price of iron ore provides a major boost to Australia, which supplied around 700 million tons or 60% of China’s imported iron ore. China is geologically deficient in high-quality ore and needs to import Australia’s high quality ores if blast furnaces are to operate efficiently. So despite the deep freeze in political relations, China has little choice but to continue to import its iron ore from Australia. In the long term, we think that China will diversify away from Australia and Brazil, but that is some years off.
Iron ore was therefore left off China’s list of import restrictions against Australia. The monetary benefits to the Australian economy of high iron ore prices far outweigh the losses from reduced exports of restricted goods like wine, lobsters, other agricultural commodities, and coal. While China’s infrastructure spending may slow in 2021, the trend in steel demand should be enough to support a historically high price over the next year or two, as alternative sources of supply are few. For the next few years, we believe iron ore extraction will remain a highly lucrative business for Australia’s large mining companies, generating record levels of cash flow.
The sharp rise in the price of iron ore provides a major boost to Australia, which supplied around 700 million tons or 60% of China’s imported iron ore.
Global Reflation to Drive Commodity Prices in 2021
The huge fiscal and monetary stimulus taken out last year by large developed economies in response to the COVID-19 is expected to have a lagged impact in reflating the global economy in 2021. As coronavirus outbreaks become fewer and vaccination rates increase, economic conditions are expected to normalise. Income transfers have left household savings at levels significantly above pre-COVID levels, a unique aspect of the 2020 recession. We expect this to support a consumption-led recovery in 2021 as confidence returns and social distancing and travel restrictions are eased.
With the emphasis of policy in developed and developing economies on supporting infrastructure and consumption, we foresee a period of accelerating growth in commodity end demand. Following the disruption to global supply chains last year we also expect to see some restocking of inventories. We are hearing anecdotal stories of auto manufacturers having to restrain production due to shortages of steel, semiconductor chips and other key inputs. Historically, there is a close relationship between global cycles in industrial output and the demand for commodities. Empirically, for every 1% growth in GDP, mined volumes should increase by 2%. Globally, we are mining more raw materials than ever before to meet the demands of a growing global consumption base. On average, each person, consumes around a ton and a half of mined materials every year.
In our view, global reflation in 2021 should be positive for physical commodity consumption. A phase of synchronised global economic growth is usually a bullish backdrop for commodity prices, even if in the present case prices have responded in advance to all the stimulus announcements.
A phase of synchronised global economic growth is usually a bullish backdrop for commodity prices….
Could We Be at the Start of Another Commodities Super Cycle?
The surprisingly strong rebound in commodity prices in 2020 has triggered a debate over the possible return of a new commodities super cycle. We believe the medium to longer term outlook for commodities is bright (see Figure 2). Though we do not think the world will see a repeat of the commodities super cycle that began roughly two decades ago with the economic rise of Mainland China. Driven by urbanisation and infrastructure, that cycle was centered on commodities like cement and steel. In the post-COVID era, we expect increased global emphasis on green stimulus, climate change and decarbonisation as governments everywhere seek to “Build Back Better.” We think this will lead to a different set of secular commodity trends. To achieve increasingly urgent decarbonisation goals will require a lengthy investment transition to non-fossil fuel power generation and electric vehicles. The transition stage will inevitably be metals intensive. We believe it will provide a major positive for a commodity exporter like Australia, boosting the terms of trade over a multi-year period.
Green development goals will require record levels of investment in decarbonisation infrastructure including a new era of electrification, with renewable power expected to be the largest area of spending by the energy industry in 2021. ‘Green demand’ for metals on our analysis could boost metals demand by 4% to 9% annually over the next five years (see Figure 3). For New Energy Vehicles (electric, hybrid and fuel cell), the transition path suggests an increase from 3 million units today to 36 million by 2030, a penetration rate of 40%. Battery investment alone represents an USD350 billion investment opportunity, or a compound annual growth rate of 33% over the ten years to 2030. As a result of these strong, dominant trends, metals that the world will need more of in the future are likely to move into supply deficit following what amounts to a decade of underinvestment by the industry. Metal prices are expected to rise sharply as a result and then stay high, since new supply sources can be expected to take years to develop.
….metals that the world will need more of in the future are likely to move into supply deficit.
We think there is a highly compelling investment case for those natural resources companies that are positioning themselves on the right side of decarbonisation investment trends and broader ESG themes. Global decarbonisation is good news for the metals sector, with mining being part of the solution rather than a problem due to its emission chain. Examples of metals that we like and are seeking exposure to in our investment strategy are copper, a universal beneficiary of electrification, and select battery raw materials such as nickel and potentially lithium (where supply is more readily increased).
What we’re watching next
After a year of China-led growth, we look for signs that a broader stimulus-led phase of global growth has begun, favorable for commodities. Greater emphasis by governments on ‘green’ policies linked to renewable energy and decarbonisation is expected to be metals-intensive, setting up a secular bull story for select commodities.
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