Revelling in resources

Resource shares in the investment universe, have yet again, become an essential consideration for investor portfolios

Over the past 18 months to June this year, the resource sector has outperformed with a vengeance, following its turn to the ‘dark side’ between 2011 and 2015. The sector has benefitted from higher spot prices, mainly from iron ore and the platinum group metals (PGM), combined with South African mining companies’ conscientious capital expenditure and stellar shareholder returns.

The confluence of these factors have boosted the sectors’ earnings and led to a perfect windfall for the country’s fiscal position. Of late, PGM and iron ore spot prices have softened, driven by supply-demand dynamics, which in turn have been influenced by global and commodity specific circumstances. Resource fund portfolio managers have reaped these benefits, but, true to character, the sector’s cyclical and volatile nature continues to turn capital allocators grey.

Research-led, data-driven investment, based on philosophy and robust investment process

Fund managers that have dedicated investment professionals managing specialist resource mandates, are fortunate because their broader investment team can leverage commodity views and research, generated by these capabilities. This pulls through into share selection and portfolio construction decisions in the mandates they manage.

Fund managers perform research, based on their investment philosophy and process, to examine investment fundamentals of commodity companies, looking at balance sheet strength, profitability, quality of management and capital allocation decisions. This informs their view on the ability of the company to generate earnings and cashflow, ensuring they gain an understanding of what the market has priced into share prices. Today, environment, social and governance (ESG) factors are included in the risk analysis permeating all of the above.

Fund managers as a driving force for ESG

The environmental component of ESG, carries a heavier weighting in commodity producers’ overall ESG scores. Fund managers usually seek to understand plans around de-carbonisation through constructive engagement and collaboration with company management, holding them accountable for their carbon footprint. These engagements are complex because de-carbonising affects the commodity mix and capital allocation of the commodity producing company, which has material implications for future capital expenditure.

Traditionally, periods of high commodity prices were characterised by excessive capital expenditure to increase production in response to these higher prices. High levels of capital expenditure reduced cashflow generation and shareholder dividends. As a result, SA commodity companies have since adopted a disciplined approach to capital expenditure. This, combined with elevated spot prices, has supported high profit margins and generous dividend payouts, to the benefit of investors.

Extracting alpha from this cyclical sector is challenging, having to consider the resource cycle, the influence of global macroeconomic drivers on supply-demand balances, and how this feeds into spot prices. These are considered in the assessment of overall fundamentals of each commodity and its effect on the operating environment of a specific company.

Commodity spot prices are influenced by global growth, changes in commodity inventory levels, currency, and China’s contribution to global commodity demand. Historically, there has been an inverse relationship between the USD strength/weakness and commodity prices.

Looking at specific commodities

As the world’s largest iron ore and steel consumer changes in China’s growth rate and composition matter to commodity markets. Slowing PMI numbers out of China, combined with their announcement of restrictions on crude steel production (to cap input costs and reduce carbon emissions), does not bode well for commodity demand.

As a result, the easing of supply bottlenecks will put downward pressure on iron ore prices. The effects of supply bottlenecks and the implications of renewable energy transition on supply-demand dynamics, together blur the outlook for commodities in the resource sector.

PGMs are used in the production of auto catalytic converters, to reduce carbon emissions produced by the internal combustion engines in automobiles, whose loadings are legislated by environmental protection agencies. South Africa is the largest producer of platinum globally, and the second highest producer of palladium (after Russia). The current worldwide microchip supply shortage has resulted in falling production levels for automotive manufacturers, which increases risks to the downside for PGM demand.

Original equipment manufacturers (OEM) of vehicles are shifting their research and development focus to battery electric vehicles (BEV). In time, these will replace internal combustion engines. The delta of the BEV increase into the total vehicle market can impact PGM spot prices at the margin, because less palladium and rhodium will be consumed. This could swing these markets into surplus – so a lot depends on the speed of BEV market penetration.

However, the long-term tail wind for PGMs is likely to come from the hydrogen economy, in which hydrogen is used as an alternative to fossil fuels.

The hydrogen economy can become a dominant source of platinum demand because platinum and iridium are used in Proton Exchange Membrane electrolyser technology, which is used to produce hydrogen. These metals are also important components in hydrogen fuel cells, which are used to produce electricity by combining hydrogen and oxygen atoms.

Old and new technologies will need to co-exist for a while still

As we know, capital expenditure by commodity companies affect supply balances. Expansionary projects have been sparse over the past decade, so production is unable to respond to demand shortfalls in both old and new commodities.

Given that the quantity of transition metals required to generate 1 MW of power is more demanding relative to that required by older technologies, shortages already envisaged for transition metals could, in fact, be exacerbated.

As policy pushes to support the transition to renewable energy, under-investment in old commodities could lead to shortages during the energy transition period. A lag in the supply of metals required for clean energy, which could see old and new technologies co-existing for longer time periods.

The environment for commodities remains challenging, as commodity demand finds itself within a globally supply constrained sector; in an industry grappling to balance fossil fuel produces versus clean energy opportunities, against a backdrop of intensifying ESG requirements.

While resources are essential building blocks for any country’s economy, and are key inputs for the livelihood of secondary sector industries, capital allocators will play a greater role as custodians for the future of our resources – and the future of our economy.