Pedal To The Metal

It’s all about the supercycle, stupid. Michael Wilson dons his helmet and gloves to do battle with the elements

If you can’t stand the heat, stay out of the kitchen. There’s still a good deal of truth in the old wisecrack about not getting into volatile commodities unless you’re prepared to take the (sometimes very) rough with the smooth. Metals aren’t like other investments, honestly – they work according to their own rules and their own rhythms, and heaven help the investor who ever confuses a bull phase for equities with an automatic win for commodities.

The last few months have also provided a particularly nasty shock for anyone who fools themselves that buying into a copper mine or an aluminium producer is tantamount to a proxy on the global economy (but with added dividends). Never mind that global growth is barrelling on regardless, with the International Monetary Fund forecasting a 3.9% upturn this year rising to 4.9% in emerging markets) – Donald Trump’s punitive sanctions against America’s most faithful allies have proved that there’s really no such thing as absolute certainty. Commodities are an intensely political subject.

Changing perspectives

Okay, that’s the wealth warning out of the way. But should we be concerned that a few hundred billion dollars of new tariffs will infect the whole global shebang? Or are those tariffs no more than a mosquito bite, as Manulife Asset Management recently argued in the Financial Times?

I really don’t know. But let’s start this exploration of the metals business with a little historical perspective. Back in the 1970s, if you wanted to set up your grieving widow for life after you’d departed this earth, you’d make sure she had a portfolio full of Lloyds Bank and Rio Tinto and ICI. With rock-steady dividends of inflation plus three per cent, or maybe more, you’d know that she’d need no market knowledge at all to enjoy a lifetime of guaranteed security.

But alas, that dream of stability came undone. The late 1970s saw the United Nations pushing aluminium smelters and uranium mines (and soyabeans and bananas and coffee) at dozens of poor countries who could barely afford them, and all that ever resulted was a global glut of raw materials that pushed down commodity prices and nearly bankrupted them. In chemicals, the traditional lead of companies like ICI was swallowed up by an industrialising third world, and by the time the 2008 financial crisis had crippled the banks there were almost none of the widow’s three safe bets left standing.

Suddenly, only the leanest and fittest producers could hope to survive. Long before China ever entered the international metals scene, the bells were already tolling for indolent Western producers who hadn’t bothered to update their manufacturing facilities, and who spent their time lobbying Congress for protection from the need to innovate. The same was true of US oil refiners, who fought the introduction of low-sulphur diesel for a decade before capitulating. Little by little, the rustbelt industries became outdated and were outpointed by nimbler, better-equipped factories elsewhere. These days US steel capacity is capable of supplying only 20% of the country’s needs.

In fact the current crisis in rustbelt America wouldn’t have been lost on Bruce Springsteen, who lamented as far back as 1983 about small-town Main Street’s “whitewashed windows and vacant stores”, or about the “foreman [who] says these jobs are going, boys, and they ain’t coming back.” In England and South Wales, too, the coal and steel industries were inexorably priced out of contention by countries that granny had never even heard of. Mr Trump, you can’t blame all of that on Barack Obama. And if you do blame China for metals dumping, as you purport to do, why have you exempted Beijing from this year’s import tariffs?

Can’t get no correlation

But there I go, getting all political again. Maybe we should go back to the basics, to see which bits of the Trump rhetoric stand up and which ones are due to misunderstandings?

I should start by declaring my own long-term holdings in metals producers such as BHP Billiton – not because they might swing my argument, but because they really have turned out to be the long-term portfolio stabilisers that I always hoped they would be. Even if they do sometimes deliver nasty downward shocks on equity market up-days.

The reason for all this is that minerals such as metals don’t conform to the ups and downs of the traditional bond and equity markets. Metals are, to use the term, poorly correlated, and that makes them worth considering as a storm anchor for a portfolio. Indeed, they don’t even correlate very well with national economic growth itself – consider the price surges in the 1970s that coincided with shocking global industrial performance – and that makes them interesting.

One of the popular theories behind this lack of correlation is that there’s such a thing as a mining supercycle, and that it’s been a decade in the doldrums so that it’s currently ready to get back into gear. There are plenty more who say that supercycles don’t exist, or perhaps that they have been thrown off course by the emergence of China as a massive consumer – or perhaps by new technologies which have simply shifted the balance of what people want.

Let’s look at the ‘pure’ logic of the supercycle idea, as far as it goes. It’s always going to take you five or ten years to sink a new silver mine if the international price of the metal happens to go up far enough to make it viable – and that time-delay gives the world five or ten years’ notice in which to enjoy the high prices before the new mine opens and the global productive capacity expands and suddenly there’s a glut again.

At the other end of the food-chain, a steel producer might be prompted by attractively cheap iron ore to plan an expansion of his factory – only to find on opening day that the metal price has soared and that he won’t turn a profit. In both cases, the time lag is always likely to create distortions of the balance between demand and supply. And all the while, the varying interest rate cycles and business cycles exert their own impact on how much companies are going to invest in new and potentially expensive technologies.

Which, some investors would say, makes metals a perfect place for a natural contrarian to be. But there’s a trap for the unwary, which is that metals will sometimes drop out of demand for reasons that nobody had thought of.

Platinum, as we’ll see shortly, has seen its price dropping in the last few years as governments have clamped down on diesel cars – the vehicles that are most likely to use platinum-based catalytic converters. (Instead, all the action these days is in palladium, which is better suited to petrol-engined cars.)

The rise of rare earth

Without much doubt, the fastest growth these days is in so-called ‘rare earth’ minerals such as yttrium, europium, terbium and neodymium, all of which are essential to the running of high-tech electronic equipment. And there’s a good chance that you won’t even have heard of them.

Neodymium, for instance, is the magic ingredient in the super-magnets that run the hard drives in your computer, or in that wind turbine up there on the hill. Ruthenium, europium and rhenium are what make your OLED television work. And the hell of it is (for President Trump at least) that the overwhelmingly largest producer of all these metals is the People’s Republic of China.

The United States has a few deposits of these ores in California, but it imports well over 90% of its rare earths – 12,600 tonnes in 2016 – from Chinese suppliers. Not because they’re globally rare (they’re not), but because the task of refining the ores into metals is extraordinarily labour-intensive – and that no other country can produce them affordably. Now that’s what I’d call a national security issue if I were in the White House…

While we’re on the subject, what will happen when we finally exhaust the world’s reserves of lithium, the rare metal which runs the batteries in your laptop, your phone and your brand new Tesla? And will there ever be enough cobalt – a rare metal that’s essential for the batteries in an electric car, but which sources two thirds of its global supply from the chaotic (and violent) Democratic Republic of Congo? (Most of it through the troubled Glencore.) And whose price has trebled in three years?

And could that be why China has recently signed up a deal with Glencore to buy half of the world’s annual raw cobalt? And should it bother us that China is already the world’s biggest cobalt refiner, with 80% of global production of the finished metal? Yes, you can bet that Washington is getting antsy about all that. The problem being that it can do absolutely nothing about it.

Of course, there’s always the chance that something technologically new will come along to knock some of these metals off their perches, or at least to avoid the price and supply crises that seem to loom. This time next year, we may find Trumpium or Melanium powering the superfast chips in our iPhones, and then it’ll all be over for the existing components, just as it’s been game over for the ingredients in early solar panels. More probably, though, we’ll find better ways of recycling lithium and rare earths in a way that will assuage the fears being felt in Washington.

Hmmm, maybe you’d be better off backing the Australian miners who supply China with the ultra-high-quality coal that it needs for specialised steel production? And which China signally lacks?

Some market trends

So who says there’s a politically-inspired price crisis brewing? At the time of writing, copper was back up to the price levels of 2013, at nearly $3.50 per pound – up by almost 75% since the sub-$2.00 low of early 2016. (Source: Kitco.) And warehouse stocks plummeted in the second quarter of 2018 (although that isn’t a particularly unusual development.) No doubt about it, those darned Chinese have left their footprints all over this one – although a series of mine problems in Latin America have also disrupted the supply chain and raised prices.

Aluminium, at around $1.10 per pound, is 70% above the $0.65 level last seen in April 2016. And nickel, at $7.00 per pound, is already 70% above the levels of last August, although still below the $9.30 levels last seen in April 2014. Could that be the same aluminium that President Trump says is being sold by America’s rivals at unfairly low cost?

But if you’re expecting to see anything similarly impressive happening in traditional precious metals, think again. Platinum, which we’ve discussed, has been stuck in the $950 range (per ounce) since autumn 2016, at a time when equity markets were roaring. And gold hasn’t made it past $1,400 in the last five years – a bitter shock after the $1,900 heights of 2011. Why is that, you ask? More because of rival attractions in the investment markets than because of any special weaknesses, we’d suggest. These have been bullish years, remember.

For an example of a metal that’s really taken off, palladium has seen its price more than double since the lows of late 2015 when it dipped to $467. June’s price level of $1,010 is getting on for 10% below the January price of $1.122, but it’s still an impressive performer overall.

Companies or indices?

Forgive me for spelling out the difference between buying a commodity price index and getting into shares in the mining companies themselves. The former won’t get you any dividends, but it’ll free you from the specifics of dealing with producers whose company fortunes are likely to depend on an untidy mix of politics, labour relations, weather, international trade relations, and sometimes military tensions.

In addition to plain ordinary luck, of course. Every mining company builds its valuation on its estimated reserves, and on the ease of getting them out of the ground – and, as too many have discovered to their cost, the test drills can always be wrong….

The rapid spread of exchange traded funds (or, in this case, exchange traded commodities) has brought ease and respectability to metals trading for the small man. There was a time when a direct purchase of a futures contract was the only way to lock into a raw material commodity price; nowadays, however, you can do it from your desktop.

You’ll need to accept that (gold and precious metals apart) you’re dealing exclusively in synthetic ETCs – you really wouldn’t want 100 tonnes of iron ore delivered to your vault – and that does mean that you need to have studied the counterparty liabilities of the fund and its underlying indices very carefully before investing. I once had a scare with an MSCI index fund that was ultimately backed by the AIG insurance group, the second biggest reinsurer in the world, and I was not best pleased when AIG became briefly (and technically) insolvent in the 2008 crisis and my ETC was declared untradeable until the Federal Reserve had bailed it out.

But hey, that couldn’t happen nowadays, could it?