Investing compass: Do we want Santa to give us coal for Christmas?
In this Sector Spotlight, we explore the commodities industry, and what investors should think about when investing in the industry.
Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.
Mark Lamonica: So, we have a new feature.
Jayamanne: We do. This is highly requested. A lot of people have asked for this.
Lamonica: Yeah, yeah. So, basically, what we're going to do is, we are going to have a transcript of the podcast which we will put on the website Morningstar.com.au, so people would like to read it instead of listening to it or in conjunction to listening to it. We don't want to lose listeners, but…
Jayamanne: I mean, what a lot of people are saying is that they listen to it in the car and then they can't take notes, or they have to go back and find things.
Lamonica: Yeah. So, basically Morningstar has this subscription – or it has this transcription service. And so, we got introduced to a couple colleagues of ours over in India and they go through, and they listen to audio files and…
Jayamanne: We're forcing them to listen to the podcast, basically.
Lamonica: Exactly. And then, they create a transcript. So, we sent the first one over and they sent it back. And we obviously don't know the people doing this very well or at all. We've just exchanged some emails, and it was one where we talked about your dog's incessant habit of peeing on me. And so…
Jayamanne: That was their first introduction to Investing Compass and us.
Lamonica: And us, yeah. So, some poor colleague literally spent like the first six paragraphs and wrote like peed eight times. So, anyway – they probably are not going to be our best friends at Morningstar, but…
Jayamanne: But we'll still have a transcription – a transcript to the people. So, that's good.
Lamonica: Yes, yes. We'll keep doing that. But anyway. All right. So, what are we talking about today, Shani?
Jayamanne: All right. So, today, it's going to be the first in a series of episodes that we are doing that are going to be spread out over the next few months. And this series is a spotlight on different sectors.
Lamonica: Yeah, we want to do these episodes for investors to understand a little more about what they are investing in, which of course, we are huge advocates for. So, these sector spotlights will give an overview of the sector, talk about what influences their success, where the risks and opportunities are, and then major players and prospects for the future.
Jayamanne: And for the first spotlight episode, what better place to start than commodities? It's been a huge contributor of wealth for Australia, with a 25% contribution to Australia's GDP, and with basic materials overall making up about 25% of the ASX 200. It's a fair call to say that Aussie investors have a pretty outsized exposure to commodities.
Lamonica: Yeah. And I think a good place to start here is by talking about what we mean when we reference commodities and commodity prices, because it's a pretty broad and general term. So, when we're speaking about commodities from an investing lens, the main ones we are talking about are iron ore, coal, copper and oil. And while gold and silver are also commodities, their status as precious metals make them a little bit different. So, we're going to exclude them from the discussion that we're having today and focus on those main commodities.
Jayamanne: And another lens to this is that a commodity is a resource that is treated the same regardless of who produces them. Generally speaking, a commodity company is a price taker. So, Mark, do you want to explain what a price taker is?
Lamonica: Sure, Shani. So, a price taker is an entity that just takes whatever price is out there in the market. And this, of course, is the case with commodities, because there is a set price that they trade for, and in the case of commodities, these prices are transparent and widely known. So, we have a decent amount of exposure to the price of iron ore because of course Australia is pretty dependent on it, and we hear a lot about it, oil because of course we fill our cars up with petrol and people are very interested in that price.
Jayamanne: And in general, a price taker is not a company that has a sustainable competitive advantage or a moat. And we want to buy companies that have an economic moat because then they are able to fend off competition, which is good for us as shareholders. It means that they can earn higher returns on invested capital, and it also means that they're able to maintain strong margins.
Lamonica: And a company with a moat is a price maker. So, that means they have pricing control because of the attributes that led to them having a moat in the first place. So, for example, Apple. So, Apple has a wide moat rating. Oh, and for those who have not heard of Apple, they make phones and computers.
Jayamanne: And watches and software and…
Lamonica: Yeah, that was a little bit tongue-in-cheek since everyone has heard of Apple. But anyway. So, Apple has a wide moat rating. And we believe it has a moat because it's a company that has high switching costs for consumers. And what that basically means is that once you're an iPhone customer, it's very difficult to switch away from it, and that's because they get their tentacles into you with a bunch of different ways, right? So, that can be apps that you've purchased, iCloud or other devices that are connected within this ecosystem. And it's basically just a nightmare to leave because you'll have to set everything up again. And Apple hardware just isn't as frictionless when you're connecting to it with a different brand or operating system.
Jayamanne: And this is an example of consumers not wanting to switch. It gives Apple the ability to maintain market share and at the same time, maintain pricing levels and potentially raise their prices as well. And we see this in consumer research. 90% of iPhone users say that their next phone will be an iPhone. And when we look at commodities, it is the opposite. We have no idea, and frankly, we don't care which company produces the commodities we use. The very nature of it being a commodity means we don't care who you buy it from.
Lamonica: Exactly, Shani. In the example of oil, do I really care if it was ExxonMobil or Woodside or Chevron that produced that oil? Of course, I don't, because it's the same product.
Jayamanne: But there are a couple of factors you can look at that differentiate a more successful commodities business from the others. And it mainly has to do with margins or cost advantage. To explain this a little further, let's use an example. So, from a production perspective, we can look at Saudi Arabia. Saudi Arabia is blessed with large pools of oil that are relatively close to the surface. That makes it easy to find and easy to drill. In fact, an energy consultant estimated that it costs around $9 for Saudi Arabia to produce a barrel of oil. In contrast, we can think about what it takes to find oil under the sea and then to put a platform in the middle of the ocean and drill miles and miles into the water. That is how the U.K. produces oil, and the same energy consultant estimated that it costs close to $45 to produce a barrel of oil. So, there can be a different cost associated with extracting commodities.
Lamonica: And there is another cost associated with a lot of commodities, and of course, that's transportation. So, the location of that commodity matters. So, if there was a giant iron ore find in China, and China, of course, is the largest consumer of iron ore, that would be really beneficial because transportation costs would be a lot lower than digging it out of the ground in WA, getting it to the coast, putting it on a ship and then sending it all the way to China.
Jayamanne: And what we're really trying to say here is that being able to increase margins through scale, efficiency and operations can lead to cost advantage.
Lamonica: All right, Shani, let's speak a little bit about cycles.
Jayamanne: Okay. So, over time, Mark, commodities go through boom and bust cycles. During different periods, we have huge swings up and down. And the reason for this is that with most commodities, it takes a lot of investment to develop a new mine or oil field. And generally, what happens is that higher prices in commodities will lead to new investments. That new investment will take a while to mature to bring a new mine online or to bring a new oilfield online. But when it's set up, that's a flood of new production, which lowers prices again. And we can see those huge swings and cycles in commodity returns. So, if we look at 1991 to 1996, the total return of the Bloomberg Commodity Index was 68.6%; 1997 to 1998, -29.5%; 1999 to 2000, 63.9%; 2001, -19.5%; 2002 to 2007, 145%; 2008 to 2020, -54%; and then, finally, 2021 to 2022, 46.9%. And those are a lot of numbers. But what we can get from that is down, up, down, up, down. And that's a perfect example of the cyclical nature of commodities.
Lamonica: That was a lot of numbers.
Jayamanne: It was, yes.
Lamonica: You did a very good job with that, Shani.
Jayamanne: Thank you.
Lamonica: Okay. So, we've explored what commodities are and then some of the cycles in commodity prices. Let's talk a little bit about the current environment and what has led up to it. So, once COVID hit and many countries' economies went into slowdown or even recession, the reduction in demand also pushed the price of many commodities down.
Jayamanne: Since then, though, government and central bank stimulus has helped increase economic growth and, in turn, demand for commodities. So, prices have risen. We saw the Russian invasion of Ukraine has increased prices as Russia is a major exporter of a lot of commodities such as nickel, oil, aluminum, thermal coal, et cetera. And then, on the supply side, a lot of commodities have seen limited investment in new supplies since the bottom of the last bust that we spoke about that happened in 2015-2016. And this was already a problem pre-COVID. The increase in demand since COVID has exacerbated this problem.
Lamonica: So, we spoke a little about what impacts commodity prices. There's demand, which is mainly driven by changes in economic growth, which of course is cyclical. But there's also structural factors. So, one is the massive increase in steel production in China over the past two decades as it's invested in real estate and infrastructure. And that has dramatically increased the demand for iron ore because of course iron ore makes steel.
Jayamanne: And Mark, I know you love history, so tell me a little bit about what's happened with China and why it matters for the future of the commodity sector.
Lamonica: All right. Well, mate, a couple of things have happened. So, if you go back and look at China over the past couple of decades, there's been this unprecedented urbanization. So, go back to 1980 – 22% of the Chinese population lived in the city, In 2022, it's just under 65% of the population. So, you've had this huge migration. And also, of course, China has a huge population, and they've moved from the countryside into the city. And of course, those cities had to be built and those cities being built required steel, and as we said, iron ore is required for steel. So, we've had all this urbanization in China, which is slowing and almost stopping at this point given that huge swing, basically that 45% of the population shifting from rural to urban.
Jayamanne: The other part of this is infrastructure to support a growing population and a population shifting into cities. And just to keep the economy going, there has to be heavy infrastructure spending. But at this point, on a per capita basis, China has reached Western levels. So, while there still will be development of infrastructure, there isn't going to be this huge cyclical catch-up that we've seen in China continue. So, this is another factor that we need to consider.
Lamonica: So, Shani, as we start to see that demand pull back, what's it going to do to iron ore prices?
Jayamanne: Well, logically, prices are going to pull back because there's less demand. But the other thing we need to look at is what's going on with inflation. During COVID, we saw, particularly with oil, a huge fall in demand and then, of course, price. We've seen that bounce back as economies have come out of COVID and of course, we've also seen inflation increase.
Lamonica: And commodities are used as a hedge for inflation.
Jayamanne: They are, Mark. So, commodities become hugely popular in inflationary environments and higher commodities prices drive inflation as well. So, we've actually seen this pretty recently when we saw inflation numbers reported here in Australia, but a lot of this has been driven by petrol prices going up, increases in the cost to build almost anything amongst other things.
Lamonica: And we can see that a lot of people use commodities as an inflation hedge when you look at a Vanguard study. The research has shown that over the last decade, commodities rose 7% to 9% for every 1% of unexpected inflation. And when we say unexpected inflation, we mean the difference between projected and then realized inflation.
Jayamanne: And we've seen commodity prices come down since February, and that's because of expected inflation. The market's fear is that central banks move global economies into recession and commodities do perform poorly during recessions.
Lamonica: And this is because they are cyclical as we said before. And if you look at different companies and industries, cyclical industries follow the economic cycle. They'll do well when the economy is doing well, but they do poorly when the economy is doing poorly.
Jayamanne: If we look at what this means, a lot of the basic materials commodities are inputs into construction and construction is pretty cyclical in itself. You have investments into new buildings, new houses, et cetera, when the economy is doing well and people are comfortable spending and borrowing money, and then these projects get taken offline when the economy is doing poorly, or they get delayed until better conditions. And this, of course, impacts commodities.
Lamonica: Okay. So, Shani, what does this mean for us as investors?
Jayamanne: So, as investors, there are a few questions we should look at when we're looking at commodity prices, and we can take those questions from the scenario we just outlined. So, the first is, has inflation peaked. Then, will increases in interest rates drive the economy into a recession. And lastly, will there be further supply shocks, such as the war in Ukraine or some new event in the perpetually unstable Middle East.
Lamonica: We go back to the 1970s. The oil embargo was a supply shock that drove up prices and inflation. And one of the things, of course, that's contributing to the commodity prices at the moment is the war in Ukraine as we look at supply out of Europe and sanctions on Russia. How that impacts commodities is, of course, a larger question. So, if the war is brought to a conclusion, in theory, that would open up new supply. And we'll briefly mention the Middle East here as well just because it's such a large concentration of commodities, particularly oil, obviously, and it will impact the supply of oil to the rest of the world if there's any instability.
Jayamanne: Adding complexity to this is ESG considerations. Regardless of how you feel about ESG and whether it has a place in your portfolio, it's important that we acknowledge that it is impacting the commodity sector. What has happened is that a lot of banks and lenders are refusing to lend to coal and oil companies for new investments.
Lamonica: And this is important for investors because as a commodity producer, you're depleting your reserves as you continue production. New supply doesn't just continue to magically appear in a mine as you continue to operate them. And so, it's important for these companies to continue to invest in exploration and developing new mines to keep that supply coming. But this hasn't been feasible for a lot of commodity producers, creating tighter conditions for those commodities.
Jayamanne: Exactly, Mark. It's very expensive to develop a new mine, and if you're unable to source capital to open one, this may throw off this boom and bust cycle. Coal has done very well from a price perspective, but there's not a lot of companies developing new coal mines because there's issues with financing. And this, of course, has a knock-on effect, because if there is less coal, then the demand for other substitutes will pick up.
Lamonica: Let's move on and talk about exposure to commodities. So, generally, there is a high correlation between resource companies and commodity prices. And what that has to do with is the fact that these companies are price takers as we mentioned. They don't have much control over the price, and they just get paid what they get paid for everything that they produce.
Jayamanne: So, they have a few choices if prices fall. They can continue to produce the commodity and sell it for a lower price and that will dip revenue while continuing to reduce their reserves. And this is not a great scenario. They can also decide that they don't want to deplete their reserves at lower prices and not keep selling the same volume, hoping that they can drive up prices. And we've seen this a lot with OPEC, the Organization of Petroleum Exporting Countries, as Mark likes to call them, the oil cartel. That's basically their strategy, and they are releasing and constraining supply depending on what happens in those different cycles.
Lamonica: So, one thing to be aware of is that investing in resource companies will give you high correlation to the prices of the commodities that they produce. So, just getting direct shares will give you really good exposure to this sector.
Jayamanne: And what you can do is invest directly in commodities as well as they trade on exchanges. And this is how we set global prices. Then, depending on the quality of the commodity, you'll be priced below or above this global price. And this, of course, is more tricky to do than direct shares. We can go and buy futures to get exposure to commodities. But generally, you're going to get pretty good exposure if you just buy the resource company.
Lamonica: And this should not be a surprise to anyone, but as Australian investors you are likely overexposed to commodities. If you're like the average Aussie, and you put a disproportionate amount of your money into the Aussie market or invest in an index product, you'll have a large allocation to commodities. If you look at the ASX 300, 22.7% is in basic materials compared to the MSCI Global World Index, which is 3.67% as of the 1st of August. That is a huge tilt.
Jayamanne: But if you're investing in direct shares to gain exposure, it's important to keep in mind that the price of commodities will have a large impact on the performance of the company, because, again, they are price takers.
Lamonica: Again, have we mentioned price takers before, Shani?
Jayamanne: I don't know, Mark. I don't think we've mentioned it. But seriously, we are saying this because if you are interested in an individual company in this sector, have a look at what the forecasts are from analysts for the price of the commodity, and it will give you a fair indication regarding what they think the prospects are. And looking a few years out is called the mid cycle price and looking at the expectations of the price will reflect what people expect for the company. So, Mark, what do our analysts think?
Lamonica: Well, our analysts think the likes of iron ore, copper and coal will remain elevated in the near term, and that's due to the increase in economic growth from the COVID-induced lows and because of the supply issues.
Jayamanne: And those were the supply issues that we've spoken about before, the war in Ukraine and the lack of investment in new mines.
Lamonica: But given commodities are ultimately cyclical, our analysts think capitalism would do what it always does, and in this case, that is increasing supply and/or reducing demand to balance markets and prices will return to our mid cycle estimates in around 2025, 2026. So, Shani, what do our analysts see as opportunities in this sector?
Jayamanne: Yeah. So, of all the resource companies that we cover in Australia, we've got one moat in this sector. As we mentioned, you just don't see a lot of moats with commodities. And the company with the moat is Deterra Royalties, which is ASX DRR, and that is a little bit of a unique situation because the moat is awarded for intangible assets because they do have a royalty agreement.
Lamonica: And we do see some oil and coal shares as opportunities because they are undervalued. So, that includes Whitehaven Coal and Santos. We're not going to go through their entire thesis and fair value for this episode, because we just want to keep this as a broader look at the sector. But you can, of course, find the full list of undervalued stocks and analyst reports on Morningstar Investor and we'll pop some links into our resource page.
Jayamanne: It is important to keep in mind that some of the giants in this sector, like Rio Tinto and BHP, are more diversified than the smaller players. They've been diversifying outside of the coal and oil businesses while a lot of the smaller businesses are just pureplay and have hitched their wagons to one commodity. And it's important to keep this in mind because if you believe that one particular commodity has good prospects, you're able to go for a pureplay instead of a more diversified player that would have a diluted interest.
Lamonica: And again, as we mentioned in our shared deep dive episode on Fortescue, the quality of the commodity, of course, can vary. It can trade at a premium or a discount to the global price that's set for that commodity.
Jayamanne: So, how should investors incorporate commodities into their portfolio, if at all? And how much exposure is ideal? And you'll probably know what we're going to say here, but it's completely dependent on your personal goals and circumstances and how much risk that you're taking.
Lamonica: Yeah, and it's likely that most of the people in Australia that listen to this podcast would have an outsized weighting to commodities just because of the concentration to Aussie shares that most of us have in our portfolios and especially, anybody who is an index investor. So, many of us that would be index investors and they go invest in individual shares, in those industries are just doubling down on this exposure.
Jayamanne: And for those looking to invest through ETFs, you can increase or mitigate your exposure depending on the instrument. So, the SPDR S&P ASX 200 ETF, which is ASX STW, a Bronze medalist ETF that covers the top 200 stocks. Its weighting is based on market capitalization, and its composition mimics the heavy weightings towards resources that is synonymous with the Australian market. So, 47% of its assets are in its top 10 holdings. So, it is highly concentrated. Investors that may want to diversify their holdings from sector risk, maybe those in retirement or those that are nearing the end of their time horizon for their goal.
Lamonica: And for those investors who do want to diversify their holdings but still want exposure to Aussie markets, try an equal weighted ETF such as VanEck's Australian Equal Weight ETF with the ticker symbol MVW. So, what that means is that the ETF, in this case, only covers 100 shares, but the allocation is equal. So, in this case, the allocation to basic materials is around 17.5%. So, that is less. Still a lot, but less. And there are few situations where you would choose one over the other. You may choose equal weighted if you're wary of overexposure or concentration risk, or you may choose market capitalization weighted if you have a longer time horizon. So, we can see many of the larger names with bloated holdings having stretched valuation. Longer time horizons allow for those valuations to normalize.
Jayamanne: And as an investor just remember the cyclical nature of commodities. During a boom cycle and with rising prices, you can see the share price perform really well. During these surges in price, that increase will flow right to the bottom line as extra profits, which means that while some of the cash will be invested in expanding production, a lot of it can just get returned to shareholders. And that is when we see those giant special dividends which we got at the end of the last calendar year.
Lamonica: But just remember, the opposite can happen as well when we move into one of the bust cycles. That's when we can see the share price dip, when those special dividends go away, and perhaps regular dividends get cut. Something to keep in mind as an investor because while everything can be fine across the entire cycle, investors can get burned if they buy after the good times because they expect them to continue, but then get spooked when prices fall and sell. That is the worst of all possible worlds because you are playing the cyclicality of the industry in a way that means you miss the upside but get all of the downside.
All right, well…
Jayamanne: That was our first sector spotlight.
Lamonica: That was our first sector spotlight, and wow, we said commodities a lot.
Jayamanne: Yeah, we did.
Lamonica: But anyway, you've made it. You've listened to us say commodities a lot. But thank you very much. We really appreciate you listening. We would love it if you share this with family and friends.
Jayamanne: And also come to the conference.
Lamonica: And also come to the conference. And once again, our Morningstar conference is coming up October 13th in Sydney. We are going to have a special Investing Compass night session. So, look out for that. And yeah, thank you very much for listening.