We believe that a fundamental shift in the core commodities that defined the ‘super cycle’ of yesterday is now underway. The significance of that change should not be underestimated.
The name ‘super cycle’ signifies something extraordinary. In the case of natural resources, the term describes the dramatic upturn in commodity prices over the 2004-08 period that was driven by a seemingly insatiable appetite for raw materials from key emerging markets, the most conspicuous being China.
Our core competency in the Baring Global Resources team is our expertise in equity investment. We take a bottom-up investment approach, conducting in-depth company research to gain insight into how companies operate and move to profit during times of great change, such as the present. In the course of our analysis we have drawn several insights into the condition of the current mining market and the macro commodity trends that affect the individual companies we assess.
Over the past year, prices have fallen for iron ore (-40%), thermal coal (-25%) and West Texas International oil (-42%). The fall in prices for these key industrial commodities has prompted many observers to conclude that the cause lies with China’s faltering economic activity, a factor that spells the end to the super cycle. We believe such simple analysis misses the point. We think, instead, that the changing market conditions signal an evolution and not an end to the cycle.
This chart illustrates our view of this process, with a shift away from industrial toward more consumer-based commodities (see Figure 1). Commodities that were at the heart of the 2004-08 super cycle are now giving way to a new suite of mineral resources such as zinc, aluminium, palladium, diamonds, uranium and lithium. Importantly, these commodities have not experienced falls as severe as those outlined above during the past 12 months.
Figure 1: Super cycle evolved
Forces of change
What is driving this change? We believe two key forces are at play. First, the supply and demand fundamentals are more robust for this complex of commodities. Second, changing Chinese consumption patterns require access to new high-tech focused raw material inputs and commodities as economic priorities shift toward the environment, pollution control, consumer goods, clean energy, smart cities and the demands from an ageing population.
We have too often seen what we think is a misleading comparison between copper and iron ore. Our analysis shows that iron ore will be demonstrably over-supplied during the next five years, even under a positive demand growth scenario. In contrast, we think copper will see tighter supply as producers struggle to replace a reduction in inventories resulting from grade decline and the closure of older operations. On that basis, we think that even under a scenario of moderate demand growth, the copper market will enter a multi-year supply deficit over the next five years.
There is also a growing awareness and understanding that we are entering a new, more sustainable, phase of the cycle as declining capital expenditure (see Figure 2) is starting to underpin price stability for some commodities. And as demand growth returns, this may act as a constraint on supply, helping to pull prices higher. We believe that the combination of a more robust commodity outlook coupled with the realisation of the improved supply and demand fundamentals should lead to a healthier earnings environment. In fact, we believe the outlook for the sector is already moving towards earnings upgrades.
Figure 2: Mining capital expenditure
Ultimately, however, we invest in companies, not commodities. We remain optimistic as we continue to find promising investment opportunities where businesses are positioned to benefit from the industry shift. Here, we would highlight a company such as Boliden AB, the Nordic base metals producer. The company’s strong balance sheet is supported by a healthy organic growth profile in core long-term commodities, copper and zinc. In addition, the company benefits from what we regard as a best-in-class management with a clearly defined strategy.
Consensus forecasts for many core mining commodities are now at or below year-to-date averages. To us, this implies that many analysts in the market may be a little behind the curve and that sector earnings may start to be upgraded after a prolonged period of downgrades. Although there are risks to the short-term outlook for the sector, this positive development is one that we expect many investors will welcome as proof that the painful balance sheet restructuring of the past five years and focus on project optimisation may be starting to bear fruit.
Finally, many companies are starting to evaluate selective, growth-enhancing M&A opportunities or are looking to accelerate growth through their existing organic pipelines. To us, this signals that confidence for the commodity outlook is rising as these businesses begin to factor in the longer term positive demand picture combined with a tighter supply outlook.
The super cycle of the past has evolved. Today, the global mining cycle is based on a new complex of minerals, but also a corporate model that aims to balance corporate growth with shareholder returns. We believe the time is approaching for the producers of these new, in-demand commodities to benefit from a better price environment, and we have invested into high-quality companies that we believe stand to benefit the most during this time of industry change.
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