SA’s economy and commodity prices

By Old Mutual Wealth Investment Strategists Izak Odendaal and Dave Mohr

How excited should we be about the year-long rally in commodity prices? Since South Africa’s economy and financial markets are heavily impacted by commodity price moves, the answer is particularly important for local investors.

Commodity prices rebounded quickly and across a broad range after the March slump, in part due to China’s early and rapid recovery from lockdowns, and in part due to Covid-related supply disruptions. The shift in consumer spending from services to goods (which could be consumed at home) also helped, though this is likely to be temporary. Strong expected economic growth this year and next, as the world finally puts the pandemic behind it, should provide further cyclical support for commodity demand.

However, the question many investors are grappling with is whether there will be a longer-term upswing beyond the next few quarters. Some even talk of another ‘supercycle’, a steep and prolonged rise in the prices of a broad range of raw materials, spurred by the fear of a sustained supply-demand imbalance.

Not trapped

In one of the most famously incorrect predictions of all time, Thomas Malthus argued in 1798 that increased food production encouraged population growth beyond what could be sustained by available farmland, leading inevitably to famine and population decline, a dynamic known as the Malthusian Trap. He failed to foresee the massive improvements in farming productivity. The same logic applies to other raw materials. Over the very long term – decades not years – real commodity prices trend lower. With a long enough time horizon, scarcity fears disappear in the face of human ingenuity. This inventiveness applies both to finding clever ways of boosting supply, cutting costs, and of doing more with less (think of how fuel efficiency in cars has improved).

But over shorter periods, commodity prices are very cyclical. The main reason is that supply is usually slow to respond to price increases. It usually takes years to build a new mine. Even expanding an existing mine can be a lengthy process of regulatory approvals. By the time the new production comes on stream, demand might have faded or several other mines may have opened in response to higher prices. Prices fall until demand improves again or unprofitable capacity is taken out. This can be a long process. For agricultural ‘soft’ commodities, the cycles are shorter, usually over a season or two as farmers respond to price changes. But it is still very cyclical. In contrast, other lines of business can expand production quite quickly. The world now produces a few million coronavirus vaccines each day, up from zero not long ago.

Supercycle me

There have been two commodity supercycles in the last half-century. The 1970s cycle was spurred by concerns of scarcity. The 1972 Club of Rome report ‘Limits to Growth’ was Malthusian in spirit but very influential in arguing that the world was destined to run out of raw materials. This was amplified the following year by the first of two OPEC oil embargos. 

The second supercycle kicked off around 2002 after a decade of low commodity prices discouraged investment in mining and China’s rapid industrialisation caught investors and producers off guard. Prices exploded higher. The supercycle was briefly interrupted by the 2008 financial crisis, but China’s post-crisis stimulus was enormous and resulted in a huge real estate boom. However, by 2013 Beijing worried about excessive debt and the breakneck pace of economic growth slowed. Since producers had fully bought into the supercycle narrative, they borrowed massively and spent wildly on expanding output based on projections of Chinese growth that would never materialise. Prices crashed.

As a result of this experience, many major mining companies have spent recent years fixing their balance sheets instead of expanding production. This is one reason why many commentators argue that the current upswing in prices will have legs: a long period of underinvestment will result in shortages. A telling recent comment from Anglo American CEO Mark Cutifani was that the company would not be “seduced by high prices”. The company’s debt-fuelled spending spree caused a near-death experience in 2015 when commodity prices collapsed. If Cutifani’s attitude is held across the industry, it points to greater supply discipline, which should support prices if it holds.

One China

There is nothing quite like China’s industrialisation boom on the horizon. It is true that India and other emerging markets are growing rapidly, but they are nowhere near having the impact on total commodity demand that China still has. India is very unlikely to industrialise at the same pace as resource-intensive China did.  China’s own industrialisation is largely in the past. While the 2021 growth rate is projected at 8%, it will slow as Beijing reverts to its pre-pandemic plan of rebalancing the economy towards services and consumption.

What is on the horizon, however, is the urgent need to transition to a green economy worldwide. This has been spoken about for many years, but it seems as if the Covid-19 pandemic has given fresh impetus to this imperative. For one thing, the embrace of ESG by global investors is no longer an emerging trend but rather a driving force.

Somewhat related is the expectation that governments in developed countries will dramatically increase infrastructure spending after years of neglect. While the Biden administration is working on an infrastructure proposal for later this year, nothing is cast in concrete yet and infrastructure projects usually take years to go from the planning stage to the building stage.

Going green

A transition to green energy and green transport has to happen for all our sakes, and will have a major impact on commodity demand, boosting it in some cases and reducing it in the case of fossil fuels. But this is a long-term process, and not one that markets can necessarily accurately price here and now in early 2021.

And as explained above, supply is probably the bigger driver of commodity prices. The example of cobalt is instructive here. Batteries are the single most important and most expensive component of an electric vehicle (EV). Cobalt is a key ingredient in making the lithium-ion batteries that are predominantly used in EVs. Excitement about the future of EV adoption saw the price of cobalt, most of which is mined in the DRC, go vertical in 2016. However, this encouraged a vast informal ‘artisanal’ cobalt mining sector that eventually flooded the market. The price spike also encouraged battery makers to find ways of reducing cobalt usage. Even after the recent rally, cobalt is still well below its 2018 peak.

The final argument that commodity bulls trot out is the spectre of inflation. Many fear that inflation will surge because of the trillions of dollars policymakers have thrown at Covid-hit economies. Inflation fears are probably overblown, but commodities are seen as the best way to hedge against inflation risk. If nothing else, the decade-long underperformance of commodities relative to stocks and bonds means it is still cheap for investors to buy this hedge.

Backlogs and bottlenecks

With that background in mind, we can turn to the commodities that matter most to South Africa, and the general outlook for our mining industry. The direct contribution of mining to our economy is only around 8% and agriculture is another 2%. But if both sectors do well, there are positive spill-overs into other sectors. The manufacturing and construction sectors get a boost if mines are expanded, while employment growth stimulates retail spending and of course financial institutions provide funding. Increased profitability means more tax revenues for the state. However, to really benefit the economy, we need more than just higher prices. We need mining companies to invest and expand.

A few days ago, the Department of Minerals and Energy gave a very depressing presentation to Parliament, admitting that there is a years-long backlog in dealing with mining rights applications. This is an example of how “structural reform” does not have to be flashy or contentious. You just need government departments to be able to perform routine tasks with reasonable efficiency. However, a plan to address this and other impediments is being developed by government and industry.

The other problem is that the unreliability and cost of Eskom power is a major headwind for growing the industry. Here too, there are green shoots. Goldfields announced that it finally won regulatory approval to build its own 40MW solar plant at South Deep. Expect many more such announcements.

While mining production and investment increased during the previous global commodity boom, it lagged the growth seen in places like Australia, partly due to regulatory uncertainty. It was a huge missed opportunity given our bountiful resource endowment. We cannot afford a repeat.

Digging it

In terms of our major commodities, coal is South Africa’s most important mining product by volume according to Stats SA. It is also one of our biggest export items. This is problematic from a climate change point of view. Just last week, the UN Secretary General called for the cancellation of all new global coal projects to end the “deadly addiction” to coal. He also called for an end to the financing of coal plants. There is a risk that our coal mines become ‘stranded assets’, producing a product no one wants. However, South Africa’s Integrated Resource Plan implies that coal still has a long if less illustrious future ahead. After all, we are still in the process of finishing two of the world’s ten largest coal-fired power plants Kusile and Medupi.

South Africa is the world’s biggest producer of platinum group metals (PGMs) by some margin, and it constitutes 22% of our overall mining production. PGM output in South Africa has been extremely volatile over the past 15 years, including the prolonged 2014 strike, but has essentially moved sideways. While EVs generated all the excitement, the more mundane task of reducing harmful emissions from internal combustion engines continues and this requires platinum and palladium.  Demand should be solid, but again it’s concerns over supply that have driven the price action of the past year.

In terms of the key inputs of lithium-ion batteries, South Africa is a big producer of manganese and a small producer of nickel, copper and cobalt.

The shine has come off

South Africa is no longer a major gold producer and output has been on a long-term decline.  Most of the known ore bodies have been mined out over the course of the past 130 years. However, gold still constitutes 16% of local mining production, according to Stats SA. Gold was the early winner from the pandemic, responding positively to plunging real interest rates. However, bond yields have increased in the past month and this has put pressure on gold.

Finally, there’s iron ore, the key steel-making ingredient. Steel demand has increased sharply over the past 10 months, and with it demand for iron ore. At the same time, iron ore production has faced a number of interruptions and the price of this red rusty rock has doubled over this period to levels last seen in 2011.

The mining shares have already benefited, whether the broader economy does or does not. After all, the big JSE-listed miners mostly operate outside South Africa. The JSE’s Resources index (excluding dividends) has more than doubled form the March 2020 low, and has finally regained its 2008 peak. Reported earnings are still well below the 2008 peak, but are recovering strongly.

Bottom line

The bottom line is that, generally speaking, commodity prices have received a big boost from strong post-lockdown global growth and restricted supply. Longer-term demand also looks good for several metals but is likely to be met by a longer-term supply response. Investors should therefore not get carried away by talk of a supercycle. The local economy and the JSE are benefiting from the upswing in commodity prices but the day will come when prices turn again. Since almost no-one predicted the 2020 commodity price upturn, don’t expect anyone to be able to call the top.  Diversified exposure across companies, sectors and countries remains the name of the game.