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Good morning. The European Central Bank decided to raise interest rates by a quarter point yesterday, to an all-time high of 4 per cent. The currency markets responded to the bank’s firmness by sending the Euro down against the dollar. The Fed’s job has been hard. The ECB’s job has been and will remain much harder. Email me: [email protected].
Some years ago I met a frontier market investor who had invested in companies all over the world. He said that with detailed knowledge of local markets, it was possible to make money in any country. He saw only one exception: Pakistan. He thought the politics and the business environment were simply too hard for an international investor to navigate.
I thought of this conversation when I read a Financial Times story about the Reko Diq copper project, in which Barrick Gold wants to invest $7bn dollars. It is not just in Pakistan. It is in the spur of Pakistan wedged between Iran and Afghanistan, a region where a separatist conflict is simmering. The three countries are 108th, 127th and 173rd out of 190 in the World Bank’s ease-of-doing-business rankings. This is not a place anyone puts serious money to work unless the potential returns are very high. Barrick, it would seem, expects the copper price to be very strong indeed in the years to come.
The decarbonisation of the world’s power grids and auto fleets will drive up demand for copper. Electric cars are copper intensive, and electricity from solar farms and windmills needs to be carried over copper wires to where electricity users are. At the same time, copper supply is coming under strain as global copper mines age and become less productive. New mine sites are increasingly remote or politically vexed. As Barrick’s hopes for Reko Diq demonstrate, where it’s easy to get copper, it’s already been got.
The result is a lot of industry charts that look like this one, from AllianceBernstein’s Bob Brackett. The charts shows a market where, in 10 years, supply is short of demand by 20 per cent or so:
Saad Rahim, chief economist at the commodities trader Trafigura, says that a copper market that is more than 20 per cent short is a bit like the oil market if Saudi Arabia and Russia were to stop producing. Of course, supply and demand always find a way to meet; supply must equal demand. The question is how higher prices, demand destruction and new supply combine to bring about that equality.
With this basic framework in mind, it might seem very appealing to have some copper exposure in one’s portfolio. The metal might play a gold-like role as an inflation hedge, with the possibility of participation in a step change in the copper price.
In general, commodities can be a fine short- or medium- term trade, but are a mediocre long-term investment. What generates really good stock performance is companies with high barriers to entry, which can compound profits at a rate well above their cost of capital. Commodity producers’ barriers to entry are low. Investing in the commodity directly or through futures markets has downsides of its own. Then there is the volatility that commodity market investors must endure. It is particularly acute for copper, a small enough market to be dislocated by financial speculators. The notorious sensitivity of copper to economic growth invites speculation. As Rahim puts it, when the copper price falls, traders conclude global growth is slowing — which is a reason to sell more copper. Of course this can happen in reverse as well.
The list of great long-term commodity investments is very short (the big oil producers Exxon and Chevron are the notable exceptions, having produced outstanding shareholder performance for decades). Here is a chart of Freeport-McMoRan — a very big, very copper-focused miner — versus the price of copper itself and the S&P 500 over the past quarter century or so:
With all that said, if you believe the energy transition is going to happen, you have to believe copper will be uncomfortably scarce in the medium-term future.
Production from the highest-producing nation, Chile, has been falling for several years. The quality of copper ore coming out of the ground has been falling globally. Not many new mines are being dug: “There are not many copper projects coming online in the medium term, and the ones that are will not significantly shift the supply vs demand balance,” Brackett writes. Global inventories are near long-term lows, part because higher prices and higher rates making inventories more expensive to carry, but sheer scarcity may be playing a role, too.
Wood Mackenzie estimates that, if the world is to reach carbon neutrality by mid-century, the amount of additional copper required for low-carbon projects over the next 20 years will amount to 60 per cent of current production. Under that scenario, they estimate, the copper price, now $8,350 a ton, will move to $11,000 within five years. This is not out of line with other analysts’ estimates.
It all makes a strong buy case, but there are two big questions. The first is the true elasticity of supply. If there is a big step up in the copper price, new mines will be dug and scrap supply will come out of the woodwork. More importantly, perhaps, there will be pressure to find substitutes and technologies that reduce copper demand.
The history of disappointed commodities investors is in large part the history of greater than expected supply elasticity. Copper bulls retort that mines take many years to bring to production, recycling can only go so far, and the special characteristic of copper (its conductivity) makes substitution especially difficult. There is no technological revolution on the horizon that will increase the copper supply in the way shale drilling increased the oil supply.
I’m frankly not sure how to assess these arguments.
The hardest question of all, and the dreariest to contemplate, is whether the green transition will happen at all. The proliferation of electric cars and renewable energy may stall for lack of human will, and the associated copper demand may never show up. It is an ugly possibility to contemplate, but it has to take up significant space in any copper investor’s probability distribution.