Resources stocks are flying high on improved commodity prices, a more disciplined approach to supply and the rotation of money out of the scandal-plagued banks and financial services companies.
But the demand dynamics for commodities have changed dramatically since the mining boom era, as China’s increased focus on environmental sustainability has disrupted the business model for producers of lower quality commodities.
The battery boom is also dragging a number of “off-Broadway” commodities into the spotlight.
Three of Australia’s top commodities analysts – Vivek Dhar, associate director of mining and energy commodities at CBA; Lachlan Shaw, global commodity analyst at UBS; and Clarke Wilkins, director of equity research at Citi – gave us their views on the big questions facing investors in commodities.
Q: Can oil prices continue their recent strength over the next three years? Given Saudi Arabia’s influence on the market, what influence could an IPO of Saudi Aramco have on oil markets?
Dhar: Oil prices can potentially sustain their recent strength over the next 12 months, but over the next three years we think supply and infrastructure can respond sufficiently to weigh on oil prices. Oil prices are already encouraging US oil supply to come online strongly this year and projections for 2019 are turning increasingly positive. We think growth projections for 2018 are likely too ambitious given pipeline constraints. Over the next three years, though, additional pipeline capacity will reduce infrastructure limitations, helping boost US oil supply. Saudi Arabia’s IPO of Aramco and the OPEC-led accord are the key positive risks for oil prices. Saudi Arabia is reportedly targeting crude oil prices near $US80 per barrel in preparation for the IPO of Aramco. That also helps explain why Saudi Arabia is still pushing for supply-side discipline.
Shaw: Oil prices have risen above our forecast, in part due to the US withdrawing from the multilateral nuclear disarmament deal with Iran. This has come at a time when global crude inventories continue to fall, demand is strong and new supply is limited to ramping US onshore shale output. Conventional supply growth is likely to be muted following some years of reduced new project capex. OPEC and Saudi Arabia’s role here will be crucial, with many OPEC member countries as well as Russia needing higher prices to balance budgets. It will be an opportune time to sell a stake in Aramco should oil prices remain high or shift higher, but ultimately, we wonder of the motivation for Saudi Arabia to sell a stake in what is one of, if not the world’s, most valuable oil business.
Wilkins: There is significant uncertainty on the supply-side of oil markets with Iran/Venezuela/Saudi disruption risk, Permian constraint risk and OPEC/Russia timing risk. On the bullish side, the probability skew is much higher as there could be significant disruptions to Iran (US president Donald Trump not signing sanctions waiver and/or breakdown of the Joint Comprehensive Plan of Action), Venezuela (US sanctions) and Saudi (Houthi facility attack) that could easily disrupt more than 500,000 barrels of oil per day by the second half of 2018. If this is in conjunction with binding constraints on US infrastructure and production as well as Saudi/Russia allowing the market to overheat, prices could well edge towards the $US80 per barrel mark at times and a level that recent Bloomberg reports have detailed Saudi Arabia as having “targeted”. However, going into 2019 and beyond we expect oil prices to fall as higher prices now are locking in even higher supply growth for next year.
Q: Lithium prices have boomed in recent years, can they hold at these levels or will supply from new mines drag the price lower in the next three years?
Wilkins: Lithium prices have already fallen 10 per cent this year despite the strong start to the year of [electric vehicle] sales in China, so the new supply, or threat of new supply, is already having an impact in the market. We see supply of lithium outstripping our strong demand growth forecasts over the next few years to drive prices lower, although the market comes back into balance in [about] 2025 as demand for [electric vehicles] from Europe, US and the [rest of the world] accelerates to match the government policy driven demand we are seeing over the near term from China.
Shaw: Lithium demand growth is strongest for the highest-quality battery-grade products as the electric vehicle and stationary grid battery storage thematic really gets going. The outlook suggests very strong demand growth from these drivers well into the future. The challenge for industry is to supply enough high-quality battery-grade product to meet this demand. . While there is a very large amount of new supply potentially commissioning in coming years, we remain focused on construction delays, ramp up delays and recovery rate challenges throughout the chain. If the industry performs as it has done in the past, we believe that battery-grade lithium prices could well remain supported around current levels for another year or two at least.
Dhar: Over the next three years, lithium markets do face surplus risks if all new supply comes online as expected. In fact, on current projections, a physical lithium deficit is only expected later next decade. These oversupply concerns have slowed the ascent of lithium prices since August 2017. It is worth noting, though, that prices are yet to correct lower on surplus forecasts. We think it is likely that lithium prices will slide lower once the newly proposed supply reaches the production stage.
Q: Iron ore markets seem to have bifurcated based on grade and quality, do you expect this trend to be permanent and what can producers of lower grade ore do to compensate?
Shaw: Iron ore markets have witnessed an increased focus on quality over quantity in the last 12 to 18 months. We do believe that China’s “war on pollution” remains and is likely to intensify during China’s winter especially. Meanwhile China’s steel capacity reform programme will continue to restrict steel supply, leading to structurally higher margins though the cycle. Both these factors lead to, we believe, higher incentives for Chinese iron ore buyers to prefer high-grade material more than they have in the past. This is likely to see low-grade discounts remain structurally higher in future, although likely a little lower than current levels.
Wilkins: There is both a cyclical and structural component to the increased premiums for high-grade, low-impurity ores and increased discounts for low-grade, high-impurity ore. We expect utilisation rates of Chinese steel capacity to be structurally higher after the closure of illegal induction furnaces, rationalisation of capacity and environmental pressures. Structurally this drives a preference for higher-grade, higher-quality ores. However, discounts for low-grade ores have swung too far and as the high-grade supply increases and the stockpile of low-grade ore at the port normalises, we expect some of the discount to be removed.
Dhar: We believe the preference for higher-grade ore is permanent because it is driven by structural policy in China to reduce pollution and improve productivity. Policymakers have also heightened emission standards and the penalties for non-compliance, which will also entrench the preference for higher-grade ore in China. Steel mill margins will also influence the premium that higher-grade ore commands. Weaker margins should weaken the premium and vice versa. However, these impacts will be cyclical.
Q: What is your top pick in the commodities sector for investors with a three-year investment horizon, and why?
Dhar: We think nickel has the most potential to outperform the commodity market over the next three years. While our forecasts suggest nickel will track close to $US6 per pound for the foreseeable future, the upside potential is significant given the evolution of battery technology. Battery chemistries are increasingly looking to boost energy density to improve energy storage performance. That has resulted in battery manufacturers looking to add as much high-purity nickel as possible. The rise in battery demand for high-quality nickel may also result in a structural change in the nickel market over the next three years. The nickel market is currently driven by stainless steel demand, which accounts for about 66 per cent of nickel consumption. As a result, nickel purity is less important because lower-quality nickel can be used. Batteries, though, need higher-purity nickel which means that nickel markets could develop a permanent price premium for high-purity nickel.
Shaw: We believe that nickel is the best prospective commodity on a medium-term view. While the nickel market in the last year or so has continued to be dominated by steel supply and demand drivers, the real kicker for nickel markets will be the lift in [electric vehicle] battery demand. The global battery chain is shifting toward nickel-rich batteries, as they have higher capacity and better performance, and within nickel-rich batteries, there is a shift toward higher nickel loadings as well. Meanwhile the preferred form of nickel used by the battery chain – nickel sulphate – can only be supplied by less than half of today’s mines. New mine capacity will be needed in the medium term and much of that will need to come from very expensive nickel laterite deposits. This investment will most likely need nickel prices well above today’s spot prices.
Wilkins: Over the next three years we are more bullish on the base metals than bulk commodities driven by the risks around sustainability of Chinese demand from property and infrastructure. Our key pick is aluminium as the Chinese supply side reform is a game changer that will limit supply growth to below-demand growth. There will be a growing need to incentivise production ex-China, where higher construction costs drive a higher incentive price.