Commodity markets in transition
The world is moving from a fossil-fuel based energy system to a metals-based system. In building the infrastructure necessary to harness the energy that exists in the natural world, such as wind and solar, we will use vast quantities of metal.
But fossil fuels are not going away in the near term. The transition to a low-carbon economy will take decades. In the meantime, energy security is crucial to drive economic activity, growth and development – which is why it remains a priority for governments, as clearly evidenced in current geopolitical tensions. Consequently, we will need companies that produce oil, natural gas and coal – and for them to be well-capitalised – beyond this decade.
Energy commodities and beyond
This is the first commodity cycle in which greenhouse gas emissions are a prominent factor. That is clear from current price trends in energy commodities, which are partly a function of the fact that concerns about emissions have led to a lack of investment in supply. The pressure on hydrocarbon companies over the last five years to reduce carbon emissions has created strong disincentives to expand production – to some extent regardless of the price signals the market sends to do so.
The sharp price rises in recent months in natural gas, coal and other commodities illustrate how sensitive the energy market is to accelerating demand, in this case driven by economic re-opening after COVID, as well as to supply disruption. The interconnected relationship between oil, gas and coal, given they can partly be substituted for one another, has also been in sharp relief over the last 12 months.
Interruptions to coal supply in China have put upward pressure on natural gas prices in Europe, which in turn has led to increased demand for oil. Thermal coal prices rose late last year to more than double their historical records. The equivalent move for crude oil would see prices above US$300 a barrel.
Eventually, market mechanisms will kick in and fossil-fuel prices will correct, but there is unlikely to be a strong supply response any time soon. In the meantime, investors and other stakeholders will be looking for hydrocarbon producers to progress their energy transition strategies and reduce carbon emissions.
To ensure they attract the capital they need over the long term, such companies should be stress-testing future scenarios and industrial pathways and assessing whether demand for their core products will start declining. They face some critical questions. How can they future-proof their businesses? Are there other business areas they can expand into? Or should they focus on returning cash to shareholders?
These questions might seem obvious, but it is not clear that all fossil-fuel producers are confronting them. As active investors, we are spending a lot of time engaging on this issue. We favour management teams with ambitious but credible plans to move their businesses to areas where future cashflows will grow and where structural demand trends are favourable.
Of course, heavy emitters are not only found in oil and gas. Industrial processes such as making steel, aluminium, cement, pulp and paper, chemicals and fertiliser are also difficult to invest in for specialist sustainable funds. The carbon externalities are simply too large. For companies in these industries, the incentive to clean up their operations is arguably greater than for those in fossil-fuel sectors, given that their products will remain relevant and, in some cases, increase in importance as decarbonisation advances. In the future, we can expect high-carbon products to trade at a discount to the low-carbon alternative, whether because of consumer preference or regulation. If manufacturers are also paying a high carbon price or tax, it will be very difficult for them to compete against cleaner operations. Simply put, these companies’ decarbonisation strategies may have a major bearing on their future profitability and competitiveness.
If the transition to a low-carbon economy requires a move to a metals-based energy system, what does this mean for mined commodities (and those who invest in them)? Different products will see different outcomes, but most metals and minerals have a role as enablers of the energy transition. At present, we think the market underappreciates the importance of steel, and by extension, its inputs such as iron ore, manganese and ferrochrome. Further processing of steel, for instance galvanising with zinc and converting to stainless steel using nickel, requires many other mined resources.
Developing wind and solar power is far from the only reason these commodities are needed in the energy transition. The electrification of transport will require vast amounts of material. The copper content in electric cars is a multiple of the amount used in combustion-engine vehicles, not to mention that required for charging infrastructure. The make-up of batteries for these new automobiles will vary, but we expect nickel, lithium, cobalt, phosphates and other mined products to be essential inputs.
To finance the energy transition, the investment community will be needed to support metal and mineral producers with sustainable operations. We look for businesses that carefully consider their impact on the natural environment, neighbouring communities and all other stakeholders. This will be another area of differentiation and competitive advantage, together with lower carbon intensity.
Agriculture and food
We also anticipate that energy transition impacts on the agriculture sector and on the manufacturers of certain agrochemical inputs. Low-carbon versions of chemicals such as ammonia, which is widely used in the fertiliser industry, are being developed, partly as hydrogen replaces coal as an energy source. Current producers of ‘grey’ ammonia look well placed to produce ‘blue’ ammonia, and some have launched ‘green’ ammonia projects as well. Changes to protein markets are also likely. Meat consumption may decline in favour of plant-based products, whether because vegetable dishes move to the centre of the plate or due to the adoption of meat imitations made from soy or pea protein. Ocean farming is seeing faster growth already, and we may see a sustained trend for marine products to take market share from land-based animals. Underpinning all of these sectors is the fact that population growth and rising living standards are likely to continue driving overall food consumption higher, even if the food mix changes.
Barriers to ownership
Over recent years, ‘barriers to ownership’ have developed in public markets regarding commodity businesses, which have often been seen as part of the problem from an environmental perspective. Intuitively, blanket investment exclusions would seem likely to result in companies and assets in the resources sector being mispriced – suggesting opportunities for active investors.
Our expectation is that the market will start rewarding heavy emitters with ambitious but credible transition plans, while inflated commodity prices should lead to superior returns and cashflows relative to the broader market. We do not expect low to mid teen-free cashflow yields to last very long as the equities will re-rate.
Tom Nelson, co-head of thematic equity, portfolio manager, Ninety One