Where next for the Commodities market?

In this edition of the Emerging Markets Equities Podcast, Nick Robinson & Ben Shrewsbury sit down and discuss all things in the Commodities space within EM. Will commodity stocks continue to perform well in the current inflationary environment? Will gold benefit from Russia sanctions? Where next for industrial metals like nickel and palladium? And what could it all mean for soft commodities? We seek to answer these questions and more.

Transcript

Nick Robinson: Hello everybody and welcome to the abrdn Emerging Markets Equity podcast. I'm Nick Robinson from the Emerging Market Equity team. In this podcast series we explore the factors that underpin our thinking on emerging markets. From key individuals to evolving trends, we seek to answer the five W's - Who, What, Where, When, and Why, that are shaping investment opportunities in the region. 

In August 1971, the Bretton Woods monetary system ended when Richard Nixon terminated convertibility of the US dollar into gold. Whilst the system had been hugely successful in creating the stability and rules to help rebuild global economies post the world wars, overspending at the time on social programs in the Vietnam War, increasingly made the link to gold untenable,

Richard Nixon: We must protect the position of the American dollar as a pillar of monetary stability around the world. Accordingly, I have directed the Secretary of the Treasury to take the action necessary to defend the dollar against the speculators. I have directed Secretary Connolly to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability, and in the best interest of the United States. (source, The Richard Nixon Archives)

Nick: The end of convertibility led to devaluation and rampant inflation, which the US government struggled to control. Then a couple of years later, following the invasion of Israel in the Yom Kippur War, OPEC announced an oil embargo to those countries that had supported Israel.

Announcer: NBC Nightly News Wednesday, October 17. Good evening, the Middle East war produced developments all over the world today, the oil producing countries of the Arab world decided to use their oil as a political weapon. They will reduce oil production by 5% a month until the Israelis withdraw from occupied territories.

Nick: This supply side shock caused another leg up in inflation which led to a global recession and a halving of stock markets during the period.

Fifty years later, the similarities to today are striking. We've had an inflation scare driven by pandemic spending and monetary debasement, which has now been exacerbated by supply side shock in oil and other commodities due to the war in Ukraine. So today, I wanted to discuss an area of the market that's a traditional safe harbour in this type of environment, the commodity sector. 

Joining me today to tackle this subject is my colleague, Ben Shrewsbury. Ben is an Investment Analyst in the Emerging Market Equity team based in London, amongst his responsibilities is covering companies in the material sector. So he's very well placed to inform us on what's happening. Ben, welcome to the podcast. It's great to have you on - how are you? 

Ben: Hi, Nick. Very good thanks. Thank you for having me on.

Nick: Brilliant. Well, let's get started with what you make of his current inflationary environment. And do you think commodity stocks are likely to continue to perform well?

Ben: Sure, I guess, looking back through previous cycles, what we generally see is that commodities across the board tend to reprice upwards for a period of higher inflation. And the commodity stocks, of course, follow this trend with a higher level of earnings sensitivity to the operating and financial leverage that producers have to their top line. And it's sort of precious metals and most notably gold, they commonly seen as the ultimate inflation hedge, as these are seen as sort of having an intrinsic store of value against a weakness in purchasing power of cash. And that's a theme that's recurring through many cycles. And then also, as we sort of have this emerging concern over global growth and recessionary risks creeping up, you also get golden sort of safe haven assets too and I think this is already the case sort of given the war in Ukraine, and which I'm sure we'll come on to discuss a bit more.

Nick: Yeah, thanks Ben. That's interesting. I also wonder with gold, if it's likely to benefit from the sanctioning of the Russian Central Bank and the realisation that dollar reserves may not always be reliable if a country's relationship with the US breaks down. So that's another interesting point. And what about the industrial metals beyond gold? What's your view there?

Ben: Yeah, in terms of industrial metals inflation, it can be a bit of a chicken and egg situation as high commodity prices themselves are a large component of that inflationary pressure. Given how labour and energy intensive commodities are to first mine out of the ground and then process, we're seeing quite severe cost pressure across almost all mining companies, so those that can keep cost pressures down are the ones that actually get to benefit from higher profitability. So, the stocks that do well in this environment are the ones that can actually grow their earnings and not just their revenues, as that's what ultimately drives the share prices. 

I briefly mentioned when talking about gold, the risk of higher inflation, especially when it's driven by energy prices, it presents an increased risk of slowing growth, as higher energy prices lead to demand destruction, reduced economic activity and the demand from many industrial commodities like iron or steel, copper, nickel, they're all reliant on economic activity. So slow growth means less demand for these commodities, which in turn can lead to low commodity prices. 

And specifically in a stagflation environment where commodity prices are on downward pressure from weak demand, and producers are still suffering from upward pressure on their cost base - that's a squeeze for margins for miners. And then in this scenario, preference therefore lies with producers that are both low cost - so their profitability has a high margin of safety, and then also able to keep control of their cost base. So, material producers that are integrated into low carbon energy generation to support their assets are therefore particularly well placed in this environment. And that's a trend I see continuing as carbon prices become more relevant to the cost base over time. 

I'd also probably just quickly add that if commodities and commodity stocks do well, this often reverberates through to the economies where the material is actually produced and exported from. And often this is an emerging market economy like Chile or South Africa. So also second order benefits that can come through to support sectors in these economies beyond just the mining stocks.

Nick: Yeah, that's interesting. I think also, with places like Chile and Peru, in particular, you get these, when you when you have the commodity price rallies, typically the government's try and increase their royalty share, which ends up being a bit of a wealth transfer from the companies to the governments and then hopefully that ends up in the population to boost those economies - so I think that's a really interesting point. What's been the impact of the Russian invasion of Ukraine in terms of particular commodities and the supply chain disruptions that we were seeing?

Ben: Sure, so of course, we've seen significant upward pressure on oil and gas prices already, as these sanctions have been applied to some various Russian entities. And in some cases, oil shipments have effectively been embargoed, even where explicit sanctions haven't been applied. 

I think energy kind of makes the headlines as these seem to be the most politicised resources. And that's probably given it's their sort of importance to the Russian economy. And then, of course, we've got oil price reaction, we've seen response to that it's had some quite severe knock-on effects in terms of energy costs and inflation. 

Russia isn't just an oil and gas exporter, though, they produce 40% of the world's palladium, around 20% of high-grade, class one nickel, and then also sort of five or 6% in materials like aluminium, copper and steel. And that's quite actually a material amount when these commodities are already in quite tight supply deficits. And certainly interruption to that five or 6% can still be quite significant in terms of supply and prices. 

Looking into just bit more detail into platinum group metals like palladium, a significant portion of demand comes from the auto sector. And what we've seen in the last few years is demand for palladium has increased from tightening emission standards, but supply hasn't actually been increasing. So, you've seen a growing deficit in the palladium market for some years now and the prices accordingly moved upwards. So, the week following Russia's invasion of Ukraine, there was heightened risk of palladium supply being severely limited, especially given that 40% number is obviously a very big chunk of global supply. And we saw a very high price hike, sort of following that based on sentiment around palladium supply concerns. 

Nick: Yeah, I feel like there's been an awful lot of volatility lately in that market. Have we seen those prices come off again recently?

Ben: Yeah, yeah, we have. And you're right. I mean, I think when you get a tight supply deficit in a small market, like palladium, you get a lot of volatility anyway. And that's really just been exasperated and sort of recent, recent times. And yeah, you're right. We have seen that price often, sort of shortly after the initial jump. 

Firstly, I think actually, the supply disruption for palladium is expected to be relatively minimal. I think this is because the physical quantum of material is very small, only handful of tons are actually produced and shipped per month. So, you don't need a complete overhaul of distribution channels to get the metal out of Russia and to the end consumer. And then given the price per weight is so high, the relative cost of longer and slow distribution channels is pretty much negligible. 

And then another reason around the sort of reduction in price more recently, I think there's been this emerging concern, as we mentioned before, on demand starting to slow and I guess the question is, given a lot of this demand is based in the auto sector, do people really have the appetite to buy a depreciating asset like a car when the oil price is over $100 a barrel and inflation is high. And I guess also just bare in mind that a car is basically a two ton block of metal on wheels. So, when you also have steel, aluminium and copper prices go up, that cost for the vehicle manufacturer at the end of the day has to be passed on to the end buyer. And this dynamic’s even more extreme for electric vehicles, as the price moves for nickel and lithium have been much greater. So this sort of improving price competitiveness of EVs may start to weaken, if not even reverse.

And just finally on palladium demand and how that's driven by the automobile production. We saw through 2021, a lot of supply chain issues relating to semiconductor chips, and although that's slowly starting to improve now, and there are potentially other challenges that come through instead, and with this situation in Ukraine. So, for example, a lot of neon for chip manufacturing, and wiring harnesses for electric circuits and cards are produced in Ukraine. So any sort of production stoppages or supply issues there would have an impact on production in autos, as well. And we have already seen that so BMW and Volkswagen have - because of shortages of wiring components - have had some disruptions to their production numbers. So quite a few specific parts there that can also have a knock-on effect. And quite a lot of that does actually seem to be around but the auto sector.

Nick: Yes. And I suppose one thing that we learned last year was just how these complex supply chains - if one part of it is disrupted even slightly then that completely halts production of autos, and it has quite a significant impact on those economies. You mentioned nickel briefly there. What's been the key impact on the nickel market, that's obviously been in the news an awful lot the last few weeks?

Ben: Yeah, well, like I said, sort of 20% of this high grade, class one nickel comes from Russia. And that's the type of nickel you need in these NMC batteries for electric vehicles. And so you saw a huge jump in prices in nickel recently. 

There is a slight difference between nickel and what I said on palladium when it comes to supply chains. While palladium can be quite flexibly flown everywhere, nickel tends to travel by container ships, which has seen a lot of disruption, as some container companies won't process goods from Russia, and some ports in Europe are even just refusing Russian ships. So there's certainly more supply chain disruption here. And this will likely also be the case in copper and aluminium deliveries to the West. If delivery disruptions continue, I think in time, the market probably starts to look for solutions. And expect this probably comes from changing geographic exposures to basically Russia probably selling less to the West and more into China, while others probably do the opposite. From a logistics perspective, though, this is potentially quite inefficient. And given the challenges already on container shortages, it might not actually be that easy to do. And then the other issue is on exports from Russia and Ukraine. There are fairly few cargo ships willing to go in and out of the Black Sea. And those that do sort of have to battle exceptionally high insurance costs as well.

Nick: Yeah, that sounds challenging at least. So presumably, we would expect Russian production volumes to decline from here.

Ben: Well, I think it kind of depends on how long standing the sanctions are. Yeah, I think you might see production dropping in time, as are restrictions on what Russia is able to import. So, where sort of sanctions reduce the access to consumables machinery and spare parts, that can affect output in time, but it does sound like Russian producers have quite a decent inventory build of the things that should keep them going for sort of at least a few months that would have thought.

Nick: Okay, thanks. And I guess we've covered quite a few of the metals, what about the more Soft Commodities which are particularly important part of the region's exports?

Ben: Yeah, good question. So, Russia, Ukraine and Belarus together make up around 30% of the global wheat trade, and 20% of the global corn trade. So, a lot of potential disruption on availability of these crops. And especially with Spring right around the corner, and we're heading into the planting season. And we've also seen Russia putting some export restrictions on certain grains into the EU, which will tighten supply beyond just logistical challenges. And then to add to this, you're also seeing cost inflation for other farmers globally as fertiliser prices, which already exceptionally high, have climbed even further. Those three countries are relied upon for somewhere between 10 and 40% of the main three fertilisers used by farmers, with potash the highest at that 40% point. So there's going to be a lot harder for farmers to increase their yields and quality of crops without taking a big hit on the cost side. So that effectively then has to roll through to crop supply and high food price inflation. In general, there is actually excess capacity in fertiliser production, and so we may see some more material coming to the market from outside of Eastern Europe, but these producers have a pretty good hold of the market. And for quite a while now they've been taking a ‘value over volume’ strategy. So, you might not actually get those extra tons coming through. Again, though, what you might see in response to the challenges is a rejigging of supply chains, again, Russia, and sending more volumes to China. But this is actually harder to do with fertilisers and crops compared to some metals, because that sort of value on a per tonne basis is quite low. So additional costs from longer transport routes can have quite a meaningful impact.

Nick: Thanks. And I suppose another point on that is that we saw a bit of a backlash a week or two ago, when Shell bought some oil from Russia, even though not formally prohibited by sanctions. There was some reputational damage that they suffered from that, do you think that's likely to spread through into other commodities? And have you heard anything from management teams on that in your discussions?

Ben: Yeah, it's an interesting one. So, you've obviously had this huge reaction to oil and gas, and loads of international companies have discontinued their operations in Russia. But beyond this supply chain disruption, it doesn't actually seem to have been much in the way of commodity buys, turning away from Russia. And to be honest, I'm not really sure why this is, it's kind of taken me by surprise. It might just be that these other commodities can fly under the radar, and they don't get politicised in the same way that energy does. It'll be interesting to see how this evolves as the crisis lingers on - so its potential upside for commodity prices, if you do start to see this theme recurring. But speaking to producers, both in and out of Russia, it doesn't seem like any behaviour from bias has changed yet. 

On the opposite side of this, though, I do wonder if Russia actually starts to put on more blocks on exports, like I said before, palladium is a key material for the auto sector, and in the US and Europe is a huge sector in terms of jobs - so starving those markets from Russian palladium would be a major pain point for the West, or is the value for that market for Russia itself in terms of tax revenue generation, so on is much lower. 

Putin has already put through some import bans, but these have really been on quite specific products rather than broad commodity-based ones, with the exception of crops I talked about earlier. But that I think seems to be more on securing domestic food supply than necessarily hurting the West.

Nick: We've talked on previous podcasts about the energy transition, and particularly Europe's reliance on Russian energy. As governments look to increase their energy security, do you think the green commodities will benefit? Or is there a likelihood that this triggers a bit of a reversal back into fossil fuels and fossil fuel production from other countries outside of Russia?

Nick: It's kind of hard to say which way it goes to be honest, because there are a few competing forces at play. And it's always very political. So, I think it really depends on who's in power and where. Biden, for example, has been very vocal on not having shale production pick up in the US. And the EU already has this green recovery fund in place. So that would indicate an acceleration of the green trend. The issue, I guess, is getting this done quickly. So perhaps we see more reliance on ex-Russia energy resources in the near term and fossil fuels, which may actually worsen the energy mix. If, say, more oil and coal instead of gas from Russia, although in Europe, they do seem to be plans underway to get more LNG. Either way, in the long term, I think this gives reason to invest more into renewables, and probably also into things like biomethane, and potentially even hydrogen. 

So yeah, I think its support for green metals, especially ones like copper, where there's already this structural trend for higher demand and decarbonisation, and electrification, which, in the long term against a backdrop of little supply additions, and very few feasible substitutes, should support the copper price in the long term. So acceleration of those trends, brings all of that forwards. Copper demand, though, is linked to GDP. So we may actually see that weakened in the shorter term given those concerns around growth that we discussed earlier. Similarly, we may see some demand destruction on green metals like nickel that have seen these extreme price hikes. So the rate of EV  penetration growth might pull back a bit. Although there are alternative technologies like an LFP battery that doesn't use nickel.

Nick: Thanks. It's I find it interesting that you mentioned hydrogen there. Hydrogen always feels like something that's a little bit beyond the horizon in terms of mass adoption. What's the view there? Do you think that this is likely to accelerate the adoption of hydrogen as a fuel?

Ben: Yeah, I mean, I think it's a really interesting one, the hydrogen story. It can be created just using water and electricity. So, if you have access to low or even zero carbon electricity, the hydrogen itself is low or zero carbon. I think realistically we're probably quite a long way from using hydrogen on a huge scale. But the idea of using hydrogen as a fuel for vehicles is really interesting to look at and as the two main issues with electric vehicles are the charging time and then also the range of vehicle can go between charges. And these issues are potentially improved quite a lot by using a hydrogen fuel cell instead of a battery. So filling up hydrogen car would be as quick as going to a petrol station and the energy density of hydrogen is really high, so you don't need to fill up as often as you would need to recharge a battery. And that advantage is more clear, at least to begin with to decarbonize heavy vehicles with fuel cells, as the weight of a massive battery in a truck makes the economics of an electric HGV, very hard to justify, whereas a fuel cell truck doesn't have this problem. And again, benefits in a commercial sense on lower charging times and long mileage.

The hydrogen economy would be really good for platinum, by the way, a fuel cell vehicle uses five to 10 times more platinum than a standard internal combustion engine vehicle. So, this would be a major change in demand for platinum in the long term. And I think you do eventually see this materialising, but what you need is a major build out of hydrogen infrastructure before the demand can start coming through. And the economics actually makes sense. I think that takes a lot of time and a lot of investment. But we were saying, you know, not too long ago, that was some of the issues with battery vehicles, and the charging infrastructure rollout. There has been a huge success and its grown really well. So who knows? Maybe we do see similar and hydrogen coming a lot quicker than we expect.

Nick: Thanks, Ben. Yeah, that's, that's really interesting, really, it will be interesting to see how that market develops now. 

Well, thank you, Ben. It's been, it's been a really fascinating insight into the various commodity markets. And I think that's probably a good place to draw the podcast to a close. So with that, I'd just like to thank you, Ben, for joining us. 

Ben: Great. Thank you Nick. 

Nick: And I'd like to thank everyone who took the time today to listen in. If you enjoyed today, then please download our other podcasts from our website, or wherever you normally get your podcasts. Watch out for the next episode and tune in.