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Commodity Investing Is More Than Just China’s Story

Will the renewable energy transition lead to a new commodity supercycle?

At present the world is facing a challenging transition to renewable energy, which will take shape over years and potentially decades to come. We have yet to see any significant supply-side response to recent price gains, leading to still abnormal levels of backwardation across the asset class, something we’ve written about before. We believe the confluence of structural demand growth from the low-carbon transition and suppressed supply-side forces may result in long-term support for commodity prices.

Maybe somewhat ironically, the move toward a more sustainable future will likely depend heavily on commodities. The resource requirements of a renewable-energy ecosystem differ profoundly from a fossil-fuel system. Take the transition from internal combustion engines to battery electric vehicles (EVs) as an example. Compared with a conventional vehicle, EVs require six times as many minerals—namely copper, nickel, and graphite—which are critical commodities for battery production.

Minerals used in the production of a single vehicle

Minerals used in the production of a single vehicle chart

Source: International Energy Agency, 5/5/2021. The values are for the entire vehicle including batteries, motors, and glider. Actual consumption can vary depending on battery technology choice.

In addition to commodity intensity, the speed of the transformation is crucial for estimating future commodity demand. Returning to the EV example, the adoption of EVs is booming, with the IEA expecting sales to leap 35% this year after a record-breaking 2022. S&P Global Mobility forecasts that EV sales in the US could reach 40% of total passenger-car sales by 2030. More optimistic projections call for EVs to surpass 50% worldwide by 2035.

Moreover, building the infrastructure associated with decarbonization could require additional use of fossil fuels and other traditional resources, at least in the short to medium term. In many ways, the path to clean energy will be dirty until a critical mass emerges. Altogether, capital spending on physical assets to reach net-zero emissions by 2050 could require over $9 trillion annually, according to McKinsey Global Institute. That’s significantly greater than the $2 trillion spent in 2021, and it dwarfs the infrastructure spending by China and other emerging market countries that helped propel the last commodity bull market.

The good news is that global reserves of critical resources appear likely to be large enough to cover the needs of the global low-carbon transition. The crucial question is whether natural resource producers can cope with this massive increase in demand over the next decade. Troublingly, some public companies have already started reducing their capital investments in favor of cash distributions to shareholders, in part due to investor preferences. Simply put, equity owners have demanded excess cash in the form of dividends and share buybacks, when companies could instead redeploy that cash into sectors of the economy that fit less well into the net-zero movement. This behavior reduces future supply in the marketplace, potentially too soon. Although the immediate situation isn’t yet so dire, even under the most conservative scenarios for demand growth in the coming years, many commodity markets are expected to be in short supply by the end of the decade. If policymakers implement more ambitious net-zero strategies, that timeline could easily compress.

The bottom line

Commodity investors have long thought their fate was tightly linked to Chinese economic growth. While periods of concert over the last two decades have added support to this theory, the truth is far more nuanced. Commodities have been traded for many years in the US and have delivered long-term value, though with a fair amount of volatility, irrespective of the triumphs and troubles of the world’s second-largest economy. In the end, global supply-and-demand dynamics dictate commodity prices, and both seem poised to support the asset class amid the secular shift to a more electrified world economy. Looking ahead, we see little reason to think the asset class won’t continue to offer value to strategic long-term investors.

This article originally published on Parametric Portfolio’s website on July 14, 2023.

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