Commodities: remaining selective

04 June 2021

By Jai Lakhani, CFA, London UK, Investment Strategist

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  • Summary
    • Commodities may be on the cusp of a new supercycle. Base metals lie at the heart of the current rally – especially ones such as copper that are key to addressing climate change
    • All three categories that make up commodities – agriculture, energy and metals – have performed strongly in recent months as we emerge from COVID-19
    • Oil has also benefited following a surge in demand and temporary supply-side issues, but further upside for oil appears more limited
    • It’s not a given that a new commodities supercycle is under way, but the outlook for the asset class is positive – especially for copper and other base metals.
  • Full article

    Commodities are a hot topic for investors. The demand, supply and inventory dynamics potentially point to the early stages of a supercycle, with base metals such as copper touching all-time highs. Is now the time to invest in commodities?

    Commodities are grabbing the headlines. Their performance has been quite extraordinary, with the Bloomberg spot commodity index up 18% this year. Whether or not we are entering a commodities supercycle, is it still worth upping exposure to the asset class?

    As we discussed in April’s Market Perspectives, a supercycle is an extended period during which prices are well above their long-term trend as a result of unexpected demand.

    This is often further reinforced by a delayed response on the supply side as producers weigh up the momentum of demand and then ramp up capital expenditure (Capex).

    In order to address the question of whether a supercycle is in fact underway, the whole commodities complex should be evaluated.

    Dissecting performance

    Commodities can be broken down into base metals, energy and soft commodities. Across all three sub-sectors, explaining the strong performance thus far has been exceptional demand as a result of the global recovery, vaccine distribution allowing economies to reopen and, at the same time, weak supply.

    Soft commodities have been boosted by many countries building up food reserves. China drove strong demand for pork, beef, corn and soybeans (see figure 1) while the relatively dry weather in South America lowered crop yields for soybeans and corn.

    Remain prudent on oil

    On the energy front, oil too has benefitted from the aforementioned demand factors plus OPEC+, the Organization of the Petroleum Exporting Countries and allied oil exporters, committing to cuts in production. Supply restraint has also been seen in the US, with most oil producers guiding to keep output flat this year preferring to reward shareholders rather than expanding capacity.

    Additional factors contributed including the recent cyber-attack on Colonial Pipeline facilities in May and Texas facing the coldest temperatures in 30 years in February.

    We highlighted in April that while we were constructive on oil due to strong demand, supplier restraint and increased regulation on the sector, significant upside appeared limited.

    Our conservatism was based on expectations that much higher oil prices would eventually impede the recovery. At the same time, as inventories were becoming stretched, there is increasing incentive for countries such as Russia to deviate from their agreement with OPEC and for US shale producers to bring production back online. Finally, the COVID-19 situation in India was also likely to weigh on demand in the short term.

    Brent crude approached $70 a barrel earlier in the second quarter (Q2) but has since moderated to trade at around $65 a barrel. With Brent and West Texas Intermediate likely to average $66 and $62 a barrel respectively for the year, and Brent surpassing the $70 a barrel mark in Q4, we remain prudent.

    Base metals lead the charge

    At the heart of the recent commodities rally lies base metals. Demand has surged for this group of commodities as countries around the world announce significant infrastructure investments to support the post-COVID-19 economic recovery (see figure 2).

    The importance of copper

    In addition to this cyclical boost, demand for metals such as copper, platinum, lithium and cobalt has profited from a renewed and increased focus on transitioning to renewable energy.

    Copper has experienced one of its strongest bull markets in recent months. The metal is used extensively across domestic and industrial products (see figure 3) and is at the forefront of infrastructure investment, especially around renewable energy. Indeed, copper’s ductility, electrical and thermal conductivity and low reactivity make it essential in most green technologies such as geothermal, solar and wind.

    Demand-supply imbalances likely

    While substantial infrastructure investments from China (which accounts for 58% of global copper demand), the US president’s $2.2tn infrastructure spending plan and the upcoming European green deal have boosted demand. Copper supply has also been under pressure.

    Supply growth had been broadly flat over the last five years and the pandemic exacerbated the growing imbalances.

    Chile, the world’s largest exporter of copper, suffered from significant coronavirus outbreaks last year and its Escondia mine (the world’s largest) saw production drop 8% in the nine months to end of March 2021.

    At the same time, with the uncertainty surrounding the shape of the recovery, Capex plummeted last year. Despite the recent surge in demand, energy consultancy Wood Mckenzie notes that producers still lack conviction with regards to capital spending plans. As a result, depleted inventories can now only cover about three weeks’ worth of current demand.

    While a slowing credit impulse would suggest that demand from China may slow, the metal is still likely to remain in deficit for the foreseeable future. Scrap supply, often seen as a source of supply able to alleviate price pressures, makes up only 25% of total supply and seems unlikely to move the needle.

    Renewables boost

    Furthermore, in the long run, the outlook for copper demand appears favourable. In particular, renewable energies, which account for just 3.5% of total production, are likely to see strong growth. In its road map to net zero emission by 2050 published in May 2021, the International Energy Agency (IEA) suggested that to meet the goal of keeping the rises in global warming below 1.5 centigrade, the value of critical metals would have to be multiplied by more than 10 and that copper alone would see its value increase fivefold1.

    It is estimated that each megawatt of solar electricity capacity requires five tonnes of copper while onshore and offshore wind farms require 4.3 and 9.6 tonnes per megawatt, respectively.

    What’s more is that there are no real substitutes to copper. Its closest substitute, aluminium, is much less efficient in terms of thermal and electrical conductivity.

    Thankfully, from a macroeconomic perspective, copper constitutes only a small share of the global economy and thus, higher prices are unlikely to impede the global recovery or add to inflationary pressures.

    Upbeat outlook for commodities, especially copper

    Whether we are entering a supercycle or not remains hard to tell. While demand is strong and exceeding supply, it is likely to be met with increased production over time and so prices should level off eventually.

    In the medium term, and regardless of whether we are in a supercycle, there are reasons to be constructive on commodities and particularly around base metals such as copper.


Market Perspectives June 2021

Investor sentiment has subsided as inflationary pressures build. Our investment experts highlight our main investment themes, examining if consumers can drive the recovery.


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