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Goldman Sachs Asset Management Statement on the Russia-Ukraine War. Read it here .

   

May 18, 2022 | GSAM Connect

Position For Secular Importance of Key Minerals

CIO Macro and Market Observations from Multi-Asset Solutions

Russia and China have been important drivers of macro risk this year in strangely complementary fashion. First, the disruption of Russian oil and gas supplies has underscored how critically important it is for countries to wean themselves off of fossil fuels. At the same time, the green energy transition could force countries to turn to China, an important source of the key minerals necessary for green energy.  As we discussed in our previous Outlook (link), the interplay of geopolitics, technology, and social and environmental causes is likely to have a lasting impact on energy trade patterns and the world economic order. It is important for countries and companies to be strategically positioned for energy independence or reliable supply provisions independent of the form of energy they focus on. In all cases, these secular developments in the energy space provide unique investment opportunities in the commodities complex that should be captured in investors’ portfolio mix.

From Oil Dependence to Metal Dependence?

As countries and businesses focus on renewables, demand for metals is expected to surge, as mineral requirements are much higher for renewable energy sources and the focus is shifting to building related infrastructure and solutions. For example, copper is considered one of the most important metals for the green transition due to its key role in electrification and the ability to be recycled repeatedly without loss in performance. In photovoltaic systems, the usage of copper is 11~40 times higher than conventional fossil fuel generation. What’s more, wind power generation requires six times the amount of mineral commodities (copper, zinc, and nickel) as a coal-fired power plant and 13 times more than a gas plant, while solar requires three times as many minerals as a coal plant. The growing electric vehicle market will also increase demand for commodities such as lithium, cobalt, and nickel. Under the International Energy Agency’s “Sustainable Development Scenario,” the demand for lithium is expected to increase more than 40-fold over the next two decades.

With substantial demand shifts underway, the supply side is expected to adjust accordingly, leading to fundamental shifts in the commodity industry landscape. The pace of the transition will require rapidly increasing the availability of certain raw materials, yet production has lagged even before this year’s macro shocks. More recently, activity lockdowns in China are stretching the country’s supplies even further. Data from the Shanghai Futures Exchanges shows that the deliverable stocks of copper started being depleted earlier this year after a short build-up and now have plunged to the lowest level in a decade for the same period of the year1. Global mineral supplies are not just tight in aggregate quantity. They also exhibit meaningful degrees of concentration. Currently, Russia and China account for 86% of global vanadium2 production and 61% of global reserves, while China alone accounts for 61% of global production of rare earths and 37% of global reserves; it also accounts for 79% of global production in graphite and nearly 40% of refinery production in copper. The Democratic Republic of Congo accounts for 74% of global cobalt production and 46% of global reserves, while 61% of global chromium production and 75% of global reserves are controlled by South Africa and Kazakhstan combined3.

The geographic concentration of key minerals presents both challenges and opportunities. On one hand, it leads to higher concerns of supply disruptions if the top producer is faced with geopolitical conflicts, political dislocations, external sanctions, or internal activity lockdowns. But in those cases, asset prices are typically lifted for the rest of the commodity exporter complex, especially for other producers and processing operations that are perceived as a close alternative to make up for the supply shortfall. Over the long-term, there is strategic incentive for countries to build a diversified source of suppliers to secure the availability of key minerals and to keep the green transition timeline on track. Therefore, this diversification process can create opportunities for resource-rich economies that have the potential to substitute-in and increase their market share. For example, while global graphite production is currently dominated by China, Brazil is another leading producer with a comparable share in graphite reserves and also high up in rare earths reserves; Chile and Argentina both have a strong presence in the lithium processing market where China currently has the highest share; Chile is also the leading producer of copper; aside from being the largest producer of lithium, Australia is also the third largest producer of cobalt, after the Democratic Republic of Congo and Russia.

Indeed, the supply landscape of key minerals has never been static. Rather, in recognition of the secular shift into renewable energy sources, some countries have already positioned themselves as “first movers” to gain the upper hand. For example, Indonesia has devised a commodity-led development strategy with the goal to create an integrated electric vehicle supply chain. While the Nickel market was historically dominated by Russia and Canada, nowadays it is led by Indonesia and the Philippines, with Indonesia’s mine production nearly triple that of Russia.

Inflation Implications

It is important to keep in mind that upward price pressures from commodity-led supply side shortfalls will continue to fuel inflation. The recent developments largely affect the entire commodity complex — not just fossil fuels and their derivatives. For instance, the Biden Administration recently allowed for higher ethanol content in gasoline. While this move initially appears to help ease energy-led price rises to some degree, it also creates inflationary pressures on certain agricultural commodities at a time when supply is tight due to the war in Ukraine. The exact net effect on inflation is unclear but unlikely to be significantly disinflationary. At the end of the day, whether the transition to green energy happens quickly or not, energy-related supply concerns and commodity shortages are likely here to stay for the foreseeable future. This also means that the role of central banks in stabilizing inflation will be much more daunting than previously thought and the path of economic growth much more uneven.

Similar to the Oil & Gas sector, Metals & Mining have suffered from years of under-financing and under-investment, as investors favored capital-light “new economy” opportunities over capital-heavy “old economy” projects that have inherently long life cycle. The supply bottlenecks have been worsened by labor shortage during the pandemic and even with a surge in demand are not expected to recover soon, as it will take years for production to come back online. In the case of metals, the inflation impact may be even more persistent because the end-products show up in the “core” components of inflation (for example, motor vehicles) rather than the just the food and energy component of the headline reading. From time to time, export-bans from some producers may make prices even more volatile. While there could be substitutions among minerals to address raw material costs aided by technological advances, none are in abundance so as to eliminate the potential inflationary pressures. At best, inflation concerns could be mitigated to some degree but not erased.

Investment Implications

Where there are risks and uncertainty, there are also investment opportunities, and this case is no different. We are likely in a commodity super cycle that will support prices in the entire commodity complex for years to come.

In this context, we can identify investment opportunities in “first-movers” and “second-in-line”. First-movers consist of countries that recognize and prioritize the strategic importance of key mineral security and in public firms or private enterprises that are aligned with those policy initiatives, especially within the metals and mining sector. The extent of public policy backing is important for reducing the regulatory uncertainty of such investments that has historically pushed prospective participants to the sidelines.

The candidate list for “second-in-line” opportunities is longer. We think it may include commodity exporting economies that are rich in natural resources and capable of filling the gaps for key minerals if production capacity from Russia or China becomes unavailable. Besides, it can also include technology and raw materials that have the potential to create lower-cost alternatives for renewable energy devices not yet widely adopted. For long-term investors, establishing an early footprint diversified investment approach could make it easier to harvest diverse benefits in their portfolios over time.

From an asset allocation perspective, the name of the game going forward is in diversification, sector and asset class selection and active investing. The commodity space offers all of this through a variety of investment assets both in the private and public markets. Being strategic, forward-looking and nimble will be key to investment success. 

Stay posted on the latest market developments and key investment implications.

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