Commodities: An Abundance of Policy Missteps

Commodities: An Abundance of Policy Missteps

17 Mar, 2022 | Market Insight

This week we would like to look at the commodities market. This is a fascinating topic in a world coming out of a global pandemic, in the midst of a “Green Transition” and tackling exacerbated income inequalities. Toss into this mix the context of Russian sanctions. These sanctions matter and will have outsized impacts given that the country has a GDP about half that of the UK.
At the cost of dragging out the introduction and getting to Russia, we would like to give a little context about the world as it is today. Before proceeding further, credit where it’s due, this examination was inspired by a keynote address at BMO’s 31st Metals & Mining Conference by Canadian Financier Robert Friedland (of Ivanhoe fame). To sum up his key points succinctly, they are:

  1. On Copper – The total amount of Copper mined since the advent of human civilization is around 700 megatonnes (Mt). In order to maintain 3% global growth (target rates), we would need to mine another 700 Mt in the next 22 years… This is without taking into account the Green Transition.
  2. Green Transition – An EV takes around 84kg of copper, or approximately 3.5x that required for a combustion engine. This is what you see on the surface but look further and think around the tremendous pressure on the electricity grid should this transition accelerate. And don’t think just Australia. Think about the 1.4 billion people in China as well as the fast growing middle class of the 1.38 billion in India. This is not taking into account the replacement of the 100 year old transmission capacity in a developed nation such as the US.
  3. The problem with the above scenario? As most will be aware, the commodities market is notoriously cyclical. This makes it excessively difficult to finance and bring additional projects online. Since the last bust in mid 2015, there has been scarce investment made in financing any new exploration or bringing new supply to market. As an example, Rio Tinto (RIO.ASX) has a payout ratio of around 72% with $17bn in dividends paid to investors in 2021 alone. New projects?
  4. We touched on copper and its centrality to EV so far, but what of the hydrogen “alternative”? This requires immense demand for platinum (key). Another key material that has been heavily underexplored and developed.
  5. Policy Missteps – This is one issue that we have been on about for a few years now. To imagine that the largest component of the energy mix across the globe (i.e. hydrocarbons, which includes crude oil, natural gas and coal) can be turned off and simply be transitioned over to wind and solar overnight is/was, in our view, the greatest debacle of the 21st century.


​With the above context we turn to the issue of Russia and why it actually matters. Before proceeding further, we understand, energy is one issue that tends to be divisive (despite our view that it is a purely scientific and economic question). Whatever your view may be on the issue of climate change, it is worth noting that this might be the first time in human history that we have intentionally transitioned from a more efficient to a less efficient means of production. Again not we are deliberately not taking a stance, as the technology currently stands it is a reality. Critical components, namely the very building blocks, have been overlooked.

The other point that investors have to consider is that there is very little appetite left for investors to finance new hydrocarbon or oil projects, despite their necessity during the transition period. This does make sense when you consider that many economies are targeting net zero (or at least vast reductions) by the time these projects would finish their life cycles. The most rational decision for existing players given the uncertainty is that they cannibalize existing assets and strip cash flows to distribute to shareholders. In fact, most US shale producers are mandated contractually to distribute cash flows back.

So, why does Russia matter? 

It is within the above context that Russia matters. With apologies to any Russians reading, but the easiest way to describe the nation is the petrol station of the world. The nation’s exports since the demise of the Soviet Union (and even preceding that) sit predominantly within the energy sector. The top four export categories by percentage are:

  1. Fuel & Energy – 53.6%
  2. Metals & Metal Products – 11.2%
  3. Chemical Products – 7.6%
  4. Food Products & Raw Materials for their production – 7.2%

The common theme of the above? All four fall squarely in the CPI basket and how it’s measured. Take the EU as an example, close to 30% of her petroleum oil imports come from Russia, also accounting for a staggering 39% of natural gas. The EU was first amongst the world in implementing targets towards net zero while basically crippling drilling and production. This came at the same time as there was pushback against alternative sources such as nuclear production in Germany following Fukushima in 2011. A policy failure that came to the fore in the wake of the Russia-Ukraine conflict. This remains the reason why the Biden administration is finding it difficult to have sanctions include energy. Putting it simply, there is no alternative.

To give a sense of the magnitude of Russian production specifically in relation to energy, the nation accounts for around 10.1m BPD of crude oil and natural gas condensate. The world consumes around 97m BPD of crude. Push this mode of sanction too far and the globe risks taking away approximately 10% of her energy supply. The US, while producing 11.1m BPD, still remains a net importer of the black gold. The end result, given the centrality of the crude to the global economy, is that it adds substantial inflationary pressures to the global economy while providing big risks in terms of what is already turning out to be a fragile recovery.

We found it almost beyond belief that policy makers failed to understand the nature of the energy transition. It is not an overnight effort to switch energy sources after all. While the EU’s move towards the green transition is commendable, to rely on one source for a third of her energy mix baffles to say the least. Regardless of your stance on climate change, relying on a nation ruled by a man that has consistently taken a rather adversarial approach for that much of your energy is perhaps an equally egregious policy failure. The latest fiasco has at least moved several governments to reconsider nuclear within the energy mix it seems.

Starting with the price of crude, we move to the other categories that are of particular concern. Take the last time we had a substantial rise in the food price index (FPI) for example. Many may still have memories of the 2007-2008 world food price crisis, which also happened to be the last time spot prices for Brent hit the triple digits. The root causes of that particular crisis were a confluence of factors including the use of arable land for the production of biofuels (substitution effect), costs of fertiliser (directly related to oil) and costs of transportation. The massive fall in demand as a result of the GFC was the factor that eventually led to stabilisation, though problems arose later in 2011-2012. The political and economic instability that followed cannot be understated.

Moving to metals and metal products. Russia, as an example, produces for a third of the globe’s supply of nickel (an essential component of lithium-ion batteries). It is also the eighth largest producer of copper and the largest producer of palladium (an essential component of chip manufacture). Again, a policy failure of note. Let us assume that governments wish to speed up the process of the energy transition, copper as it currently stands is vastly underproduced for status quo demand (as mentioned above). We are essentially seeking to take out the eighth largest player, accounting for around 820 metric tonnes, while trying to build out wind and solar alternatives which require precisely those materials at the same time.

Aside from the green transition and the bottlenecks that may have resulted for the more short term oriented, as it pertains to the second category of metals and mining, palladium is the more important to remember. Global supply chains are already stretched (Covid-19 related) when it comes to chip manufacture, now take out the supply of an essential component. Importantly, this effectively freezes up production of automobiles, another component of CPI.

We already touched on the impact that higher oil prices may have on food prices but, as if that weren’t enough, some may be surprised to learn that Ukraine and Russia account for about a third of global wheat production, 19% of corn and a staggering 80% of sunflower oil. Again, think through the impact upon this for importers such as India, China and the rest of emerging Asia. These economies are the drivers of growth for the foreseeable future. The direct results, of course, will once again be upon CPI.

Sunflower Oil

What’s the takeaway?

Firstly, one can very reasonably ask the question why a nation with such abundant resources key to global supply chains remains an economy with half the GDP of the UK? And, by extension, what the massive stores of wealth built up by the oligarchs actually implies about the sheer scale of the outright loot. But let’s move on from that and focus on the implications for us investors.

At the time of writing, the Fed has not released its announcement. We would suggest that monetary policy makers will find the current situation exceedingly difficult especially within the context of a global supply chain already stretched to the limit. We would guess a 25bps hike with more through the year. The irony of this is that raising rates slightly (as mentioned in our previous article) might actually be inflationary. Consider the amount of debt for higher cost shale producers in the Permian. Energy companies, including the likes of Exxon (XOM.NYSE) and Chevron (CVX.NYSE), are back in the limelight (perhaps for the right reasons for once?). There will need to be a drastic rethink of the fragility of global supply chains and overreliance on particular nations/economies for critical components; something that has already begun with incentives for rare earths manufacturing capacity in the US. We would also make the call (and assuming monetary policy makers are reasonable) that as long as growth stays at reasonable levels, this particular conflict may have just manufactured an imperative for speeding up the process of looking for alternatives.

On that final point and in order to make it clear, should oil continue on its upward trajectory (which we do expect), there is a turning point; something in economics termed demand destruction. That is, the market speeds up the process of actively looking for alternatives. The irony perhaps  being that it could very well make the economics of renewables much more attractive, though it has not been talked about. The administration Stateside and in the EU may now seek to incentivise new exploration but we somehow doubt that energy majors are going to bring on new supply or additional production (it must be remembered these projects are high CAPEX and long payoffs). It would be much more rational for management to continue distributing cash flow to shareholders as opposed to new production. While the price may be attractive at the moment, there is too great a degree of uncertainty around how much longer the industry lasts. This is one policy misstep by the West that consumers are likely to pay for, for a long time yet.

On the point of monetary policy, we remain of the view that policy makers are caught between a rock and hard place. The rhetoric will be substantively different from policy outcomes. One cannot see any other outcome but to keep nominal rates below inflation. We find it rather hard to believe that perfectly rational and respectable investors are calling for 5-8 rate hikes. Yes, it is true that if one were just focused on inflation it would be what is required but consider the interest burden for local and state governments Stateside or even at home? We neither have the demographics nor the scaffolding of Volcker. That said, we are not making the call of seeing the 70s again given demographics. Oversimplifying the issue (a proper explanation is an article in its own right) but suffice it say, an ageing demographic acts as a counter to an inflation. That and the sheer amount of household wealth tied to the property sector in Australia, which believe it or not, does matter substantively (despite rhetoric).

Finally, to the question of a secular bull cycle in commodities? We stated that this would be the case before this latest crisis. It may have just put the foot on the gas pedal and sped it up though!