“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness…”
Charles Dickens was clearly not writing about the commodities markets at the start of the 21st Century when he wrote these immortal words, but he could have been. Commodity prices have been on a rollercoaster over the last decade as the “Supercycle” in demand from an industrialising China led to a fantastic boom, followed by a dramatic bust, as Chinese growth slowed sharply.
The wild volatility in commodities has made predictions by industry experts look foolish and has cost mining companies billions of pounds after poor capital investment decisions. Mining company share prices are closely linked to the prices of the commodities they produce, so how should investors look at commodity producing companies? Should they take the view that commodity prices are inherently unpredictable and therefore give the sector a wide berth, or are there times when an investment decision is more than just speculation?
My “tale of two commodities” looks at iron ore and copper1. Although these commodities share many similarities there are some important differences too.
By definition companies producing commodities cannot differentiate their product from another producer’s product and they have no pricing power. But this does not necessarily mean that all mining companies are low quality. If a company has a sustainable cost advantage over most of its peers, it may be able to earn a good economic return over the cycle and provide strong shareholder returns. However timing the commodity cycle remains key to making money from buying miners.
The chart below shows iron ore and copper prices over the last 20 years. There is clearly a strong correlation between both metals and indeed they have both been driven by similar factors.
China’s investment led growth in the early 2000’s created huge and unanticipated demand for both commodities. China accounts for approximately almost 70% of the world’s estimated demand2 for iron ore in 2015 and half of the demand for copper3. As it takes years to bring new mines on stream, there was insufficient supply in the early 2000’s, and so commodity prices spiked higher, to a level considerably above the marginal cost of new supply. The global financial crisis only had a temporary impact on this trend as China continued to stimulate its investment programme to keep the economy growing. However, eventually supply started to recover and when Chinese growth did falter in 2014, higher supply and lower demand led to the price falls seen in the chart.
Although the prices of iron ore and copper look similar over recent history, I expect a sharp divergence in the years ahead. This stems from very different demand and supply dynamics.
Firstly looking at supply. There is no shortage of iron ore in the world. The biggest three miners, Rio Tinto, BHP Billiton and Vale, which supply 52% of the market4, have vast reserves in Australia and Brazil and are able to expand production from existing mines considerably. It is estimated that these companies’ 777,000 tonnes of production in 2014 will expand by about a quarter by 2017 to around 950,000 tonnes5. The cost of this output is well below current spot prices and this is likely to keep downwards pressure on the iron ore price.
In contrast the copper industry has struggled to bring significant new supply on stream. There is limited scope to expand existing mines. New mines are typically deep underground and more complex and expensive than existing mines, many of which are at or near the surface. Many new mines have faced long delays, suffering from issues such as water or power shortages in remote regions. Our own research shows that of 18 large future projects expected in 2009, only 4 are likely to have come in on time or early, with most up to 5 year’s late and 3 cancelled or deferred indefinitely.
In terms of demand, China is clearly a major market for both commodities. However, the copper market is less tied to the fortunes of China’s investment spending. Firstly, China is a bigger consumer of the world’s iron ore than its copper, and secondly, the use of copper is more widely spread. Whilst steel is predominantly used in infrastructure and property development, copper’s usage is far broader and includes electricity generation and transmission, industrial equipment and consumer goods, many of which are re-exported out of China around the world. China has been through an unsustainable boom in infrastructure investment and is now re-orientating its economy towards consumer goods and services away from pure infrastructure. It seems likely that demand growth for iron ore in China will be subdued, at best, for some time, whilst copper demand should prove more resilient.
Putting these dynamics together, the outlook for iron ore suggests persistent oversupply, for some time, as slowing Chinese demand meets rising production. In that environment, the price of iron ore is likely to remain low and possibly even decline until it forces a slowdown in production. Conversely the outlook for the copper price is far more positive. Limited supply growth and rising demand should lead to a significant shortage of the metal in the medium term. The copper price is likely to rise until demand is choked off or supply of scrap metal increases to balance out the market again.
My “Tale of two commodites” is not as dramatic as a Dickens novel, but the medium term outlook for iron ore may indeed be a bleak house whereas for copper I have great expectations.
1. This is no recommendation to buy or sell any particular security.
2. Seaborne iron ore market, source: Credit Suisse.
3. ICSG, 2013
4. Credit Suisse, op. cit.
5. ICSG, op. cit.