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Harder times for miners? Why you need to get smart with commodity exposure
Commodities have enjoyed a surge in the first half of 2021 as the global economic recovery gathers pace and the outlook for demand gets stronger and stronger.
Copper and iron ore have been two of the standout stars, their prices rising sharply over the past year as the rollout of coronavirus vaccines sparks a surge in economic activity and optimism over the worldwide recovery.
A range of metals, copper included, are also expected to do well long into the decade thanks to strong structural demand growth due to the world’s ongoing decarboisation and the rapid rise of electric vehicles.
But in a market full of intelligent investment professionals whose job it is to make money for themselves and others, all of this exciting potential is already very well-known and to a large extent already priced in.
And the US Federal Reserve’s recent decision to bring forward rate hikes is boosting the dollar and hitting commodity prices.
ROBUST LONG-TERM RETURNS
For those who want to invest regardless with a view to potentially making solid returns over the long-term, FTSE 100 mining stalwarts Antofagasta (ANTO), Anglo American (AAL) and BHP (BHP) are all potential options and have delivered robust returns for shareholders in the past couple of years.
But for those who want to take a more strategic approach to entering the commodities sector and, having seen the strong run commodities have been on the past six months, want to wait for a better buying opportunity, we tell you everything you need to know about the current cycle and provide two options that could well be the smarter way to play the mining sector.
One thing that is clear is that in the next three to five years or so, commodities demand will be much greater than it is now as new technologies, particularly around clean energy and electric vehicles, and infrastructure continue to develop.
Thanks to the properties that make it practically impossible for engineers to design out when it comes to various applications, copper is arguably the commodity that will be most in demand. It’s certainly the one that’s talked about the most in the commodities and finance world at the moment.
COPPER GETTING HARDER TO FIND
Outgoing Glencore (GLEN) chief executive Ivan Glasenberg said the copper price must rally 50% for supply to meet demand. He told the Financial Times recently: ‘You’ll need $15,000 copper to encourage a lot of this more difficult investment. People are not going to go to those more difficult parts of the world unless they’re certain.’
He added new projects would need to be in more riskier areas of the globe including Russia and parts of Africa. There’s a sense that all the ‘easy’ projects in the world have already been done.
In May 2021, the International Energy Agency warned that high minerals prices could delay a transition to clean energy given the amount of metals needs for batteries, solar panels and wind turbines.
Goldman Sachs expects copper to reach $15,000 by the middle of this decade, as does commodity trader Trafigura.
Meanwhile Steele Li, chief investment officer of China Molybdenum, the country’s largest cobalt producer says the electric vehicle sector needs 2.4 million tonnes of copper by 2030 if electric cars make up 30% of the market by then.
He told the Financial Times: ‘We need another two Glencores. That’s the scale we’re talking about… I don’t know how we’ll find that much copper to fill that gap.’
This is a view echoed by Stuart MacDonald, president of North American copper miner Taseko Mines (TKO), who says there is a ‘very limited pipeline’ of new deposits and new mines coming to market.
Part of the problem is the long lead time, he explains. Production can’t be turned on and off like it’s oil and gas. He says: ‘With copper, these projects are usually high in the mountains, they require a lot of drilling, you need a lot of permits, you need to get all the supplies up there, it needs a major investment of capital. Then you’re looking at a two to three year construction period.’
MacDonald adds there’s also political risk in many countries, particularly in the world’s two biggest producing countries – Chile and Peru – which is also putting off miners and investors.
Chilean politicians have backed constitutional reform that would impose a flat 3% royalty on production of copper and lithium to finance environmental and social programs near mining operations.
In Peru, left wing presidential candidate Pedro Castillo, the frontrunner according to opinion polls at the time of writing, has pledged that 70% of mining profits would stay in the country.
MacDonald says: ‘Chile are rewriting their constitution, and in Peru if the election goes the wrong way it could be really bad for mining. Who wants to go to these countries and make a billion-dollar investment when there’s so much risk involved?’
But in the here and now, despite the clear structural growth drivers and what evidently looks like a looming supply crunch, some believe prices are too hot and are pricing in too much future demand, with current supply of commodities meeting demand.
COMMODITIES ALREADY PRICING IN RECOVERY
Mike McGlone, senior commodity strategist at Bloomberg Intelligence says the optimism for recovery that’s priced in commodities ‘is the risk for the rest of 2021, as we expect more of the same conditions from before the pandemic, favoring ones with low rather than high supply elasticity.’
He says corn and crude oil have been ‘major duds’ in the past decade and for good reason, as rapidly advancing technology has buoyed supply at a greater pace than demand. He adds: ‘This isn’t new by historical standards, but the pace of electrification, decarbonization and digitalization is accelerating. Supply is harder to bring on in metals, which are the easiest to store and sit at the forefront of demand from innovation.’
Though McGlone adds that if by the end of 2021 the stock market has continued its upward trajectory, ‘broad commodities should be fine’, pointing out that gold and silver appear ‘well situated if equities revert a bit’.
One investor who isn’t convinced about current prices is Mark Smith, manager of TB Amati Strategic Metals (BMD8NV62), who is getting ready for a correction in commodity prices, particularly copper.
Smith believes the market is ahead of the supply and demand fundamentals in metal markets right now, and while there could well be a looming supply deficit, ‘I don’t think it’s the same degree as what the commodity prices on the screen are telling us at the moment.’
Using copper as an example, he thinks the price should really be around $3.25 to $3.40 per pound, ‘certainly not $4.50 that we’re seeing on the screen at the moment.’
He explains: ‘What happened is we’ve had this thematic come through for investors that ‘okay there’s this green wave’ and the globe will be short of strategic metals needed, and at the same time we’ve had a lot of money, a lot of liquidity in the markets looking for an investment – the two have really come together and created this bubble we’re seeing in the copper space at the moment.’
GETTING READY FOR A CORRECTION
Smith does believe there will be a ‘strong super-cycle’ later this decade, but in the short-term forecasts a looming correction, with the current price spike being driven by investment fund managers looking for places to put their cash.
He says: ‘When you’ve got the framework of global inflation coming through, copper is one of the metals which is a good way to play that inflationary trade, but at the same time investors are playing this green theme as well so it’s a good way to do it, but we’d rather step aside for a correction.
‘The reality is we’ve got a balanced market in the copper space at the moment, supply is meeting demand, but the metal price you are seeing on the screen is telling you something else. It’s really been manipulated by inventory investments and moving inventories around the world to create shortages in certain exchanges.’
This general view regarding a correction is echoed by UBS analyst Daniel Major, who thinks we could be at the top of the cycle in commodities and despite a ‘robust’ near-term outlook would not recommend topping up positions in mining stocks at the moment, believing that prices very well ‘normalise’ in the not too distant future.
Major highlights that 10 years ago, ‘commodity super-cycle euphoria was reaching fever pitch’ – Glencore listed on 31 May 2011 – and commodity prices and the combined market cap of the five largest UK miners were at similar levels as today, with many components of the investment case for the mining sector being the same then as they are now.
WHEN COMMODITIES PEAKED BEFORE
As it turned out, the first quarter of 2011 was the top of the commodities cycle. The LME metals index proceeded to fall 50% and the market cap of the five largest UK listed miners fell by around 75% over the next five years.
Major says: ‘Looking at history does not necessarily help to predict the future, but it is a reminder that commodities/miners are cyclical and at some point the cycle will turn. In our opinion, the commodity outlook is better (i.e. less vulnerable) than 10 years ago and the miners are much better companies than in 2011; they will deliver attractive cash returns near-term and we do not see an obvious reason for a near-term collapse in commodity prices.
‘However, we do not see a fundamental shift in the major commodities that supports materially higher commodity prices long-term and we struggle to find fundamental valuation upside for the miners at normalised commodity prices.’
For investors interested in the space, Smith says the biggest mistake is the fear of missing out: ‘Once these investments in these metal markets start to take off they generally over-reach on the upside and over-correct on the downside.
‘Because there is that euphoria and excitement over discovery, generally the exploration stocks will price in more than they’ve actually discovered because the market wants to join in on these investments.’
He continues: ‘That’s the biggest mistake people make. You need discipline, you need to be patient in the markets because it’s cyclical. It’s hard to do nothing. The easiest thing is to chase the trend but that trend can correct very quickly, so that’s the biggest mistake, not doing your homework and not being patient.
‘The markets always give you a second chance and you have to be methodical in the way you invest. Because of the cyclicality of the metal markets, they’ll always come back.’
FOCUSING ON FUNDS
For investors who want to take a more strategic approach in the shorter term, with the view that commodity prices could correct at some point soon, it could be worth looking at funds that invest in the mining and metals sector as they have flexibility to hold cash back to take advantage of opportiunities created by volatility and can have selective exposure to different commodities.
However, it’s important not to just pick any resources or commodities fund that invests in the mining sector. If you’re thinking about choosing a fund in the sector, always check its factsheet first, as many in the resources sector still have a large weighting to oil and gas firms, have underwhelming three and five year returns and can be particularly expensive, with an annual fee of 1.5% or more.
Also worth considering are comments from analysts at Stifel, who point out the commodities sector now trades on an average discount of 3%, having started the year on a 10% average discount.
They say: ‘This is a significant reversal for a sector which traded around a 20% discount before the pandemic started. This suggests that should inflation expectations not be met and/or the strong commodity price rises are not sustained, then there could be a sharp reversal of both underlying prices, as well as the sector rating.’
So for an investor looking for a smarter way to play the commodities and mining sector, below we pick out two options that are worth considering.
TWO MINING FUNDS TO BUY NOW
TB Amati Strategic Metals (BMD8NV62) 103.86p
A relatively new fund having launched in March 2021, TB Amati Strategic Metals (BMD8NV62) aims to achieve long-term growth by investing in a portfolio of 35-40 metals and mining companies listed in London, the US, Canada and Australia whose main revenues are sourced from selling ‘strategic metals.’
These are metals deemed to be of strategic importance to the global economy and future macroeconomic trends, including gold, silver, platinum group metals, copper, lithium, nickel, manganese, and rare earth metals.
The fund currently has room to add another three to four stocks to its portfolio and is sitting on a significant amount of cash as it adopts a disciplined approach to investing in the base metal sector, choosing to wait for a correction in the copper market before deploying capital in the sector.
The managers of the fund look for attractively valued stocks that generate free cash flow, having strong operating margins and are well-diversified in terms of their mines and assets. Combined with their strategic approach to deploying capital and a reasonable 1% annual fee, this fund could well be a smarter way to play the commodities super-cycle.
BlackRock World Mining Trust (BRWM) 565.9p
One of the diversified ways to capture the upside in the rise of the commodities sector as a whole could be through FTSE 250 investment trust BlackRock World Mining Trust (BRWM).
On paper, the £1.2 billion trust’s one-year return of 78.9% return looks incredible, though it’s worth remembering that this came after the market sell-off in March 2020 and the subsequent bounce back after the value and commodities rally in November.
Nonetheless the trust still has a strong track record with a three-year annualized return of 21.5% and a five-year annualized return of 27.4%, making its 0.99% annual fee look decent value. It also pays a quarterly dividend with a 3.3% yield, and the managers see further upside on the income front given soaring iron ore prices, with miners likely to return surplus cash from the iron ore boom back to shareholders in the form of share buybacks and higher dividends.
Analysts at Numis call the trust ‘a good way to gain diversified exposure to the mining sector’, which they say can be ‘highly volatile on a stock-specific basis.’
It does admittedly have a 21% weighting to copper, though its exposure to iron ore – another primed for a pullback – is much lower at 5%, while its 19% allocation to gold should provide protection in the event of a correction in copper.
While copper and gold technically speaking have no fundamental relationship, copper is a bellwether metal for the global economy while gold is a safe-haven asset and an inflation hedge, so when one goes down the other has typically gone up.