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Will A Bet On Commodities Pay Now?


  • Iron ore prices are falling as supply continues to grow, while copper and zinc prices show signs of supply gaps forming.
  • Low exploration and discoveries indicate that metals will be winners again in the future.
  • The possibility of future inflation increases the appeal of commodities.

Introduction

Diversification is the ultimate protection against various economic factors, in recessions you might want to hold gold or treasuries, in inflationary times you want to be long stocks and commodities. Therefore it is very important to always know what is happening in each potential diversification sector.

Three weeks ago we discussed how aluminum is a bet on global transportation and while a supply gap is not the issue, productions costs are. In this article we are going to analyze what is currently going on with iron, copper and zinc. Before we analyze each individual metal, there is one very important trend in the mining sector which will affect all three metals, low prices which minimize exploration investments and new discoveries.

figure 1 discoveries
Figure 1: Expenditures and mineral discoveries. Source: Rio Tinto.

 

The low number of new discoveries means that sometime in the future there will be a new supply gap like the one we experienced in 2011. It is too early to call for such a situation now, but those are the future benefits of a well-diversified portfolio with commodities.

Iron

Let us start with the most mined metal in the world, iron. Iron prices have been declining since 2011 after hitting a 30-year high of nearly $200 per ton. Prices then bottomed out in December 2015 at $40 per ton, only to jump to $60 per ton in April 2016 and then slowly decline to the current price of $50 per ton. From an historical perspective, prices are still high, but it is important to analyze the current supply and demand situation in order to see if iron is a good diversification metal, especially as central banks target inflation.

figure 1 iron ore prices
Figure 2: Historical iron ore prices. Source: index mundi.

 

All the biggest iron ore producers recently came out with their Q2 2016 production reports, giving a clear indication of the trend in commodities. The results are mixed, Rio Tinto (NYSE: RIO) increased iron ore production by 10% year over year while BHP Billiton (NYSE: BHP) decreased production by 2% and Brazilian Vale (NYSE: VALE) decreased production by 1%. As all major producers are developing new mining projects—like Vale’s 90 million tons per year S11D—and are able to increase production if necessary, we cannot expect the formation of a supply gap in iron and a surge in prices similar to what we witnessed in 2011. Further, as major producers keep increasing production it will keep a lid on future prices.

In order to be diversified with iron, the best thing is to look at the lowest cost producers who are profitable at much lower prices.

figure 2 iron ore cost curve
Figure 3: Iron ore cost curve. Source: Metalytics.

 

The lowest cost producers manage to have positive cash flows even with iron ore prices below $40, which is still a possibility if we see more global turmoil or slowing in China. On the other hand, iron should be a relatively good hedge against inflation.

Copper

Copper has reached its seven year low in January 2016 with prices below $2 per pound, but the recovery has been much smaller than with iron. Current prices are at $2.20 and copper has been trading in the $2.05 to $2.25 range since March.

figure 4 copper prices
Figure 4: 10 year copper prices. Source: Nasdaq.

 

But copper is expected to enter a supply gap in the next few years as global copper grades are getting lower, big mines are being closed and demand is constantly growing.

figure 5 copper deficit
Figure 5: Expected copper supply gap. Source: Visual Capitalist.

 

A sign of how important copper is comes from the fact that both Rio Tinto and BHP Billiton base their strategic exploration on copper. In 2015, Rio Tinto spent 66% of its exploration budged on copper with 25 of 37 exploration targets being copper focused.

figure 6 rio tinto exploration
Figure 6: Rio Tinto’s exploration. Source: Rio Tinto.

 

A commodity that is already in a supply gap and is a great example of what can happen to copper, is zinc.

Zinc

Similarly to the above described commodities, zinc has reached its multi-year low in January 2016 with prices below $0.7 per pound. But, unlike copper, prices have quickly rebounded to the current $1.03 and the trend looks very positive.

figure 7 zinc prices
Figure 7: One year zinc prices. Source: Infomine.

 

The reasons for such strong performance are an increase in Chinese infrastructure spending, mine closures and a global increase in demand. With current zinc usage a few percentage points higher than production, we should expect even higher prices.

figure 8 zinc supply
Figure 8: Zinc supply and usage. Source: International Lead and Zinc Study Group.

 

Investing Opportunities

The lowest risk commodity investments are big miners with low debt levels and low costs.

Another option is to invest through ETFs that hold metal futures. Such an ETF equally spread in aluminum, copper and zinc is the DB Base Metals Powershares. Higher returns can be achieved by investing directly into specialized miners with low debt and low costs, giving a greater assurance of a profitable investment, however the risks also increase. 

Conclusion

Knowing how metal markets work, that near term supply gaps exist for several metals, and that prices are still close to multi-year lows minimizes risk and makes metals an attractive investment opportunity. But the main point of this article is that commodity metals are a protection against inflation since the metal supply is not flexible in the short term and fewer and fewer profitable mining operations are being discovered. With global central banks keeping interest rates very low, and increasing money supply, sooner or later inflation will kick in. Until that happens and metal prices rise, you can enjoy the high dividends miners are currently paying and have a well-diversified portfolio.

 

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