Is copper the next opportunity for investors?
How tightening supply and rising demand could reshape returns.
Who knew copper could be sexy? It is for Australia’s mining giants which are falling over themselves to get more exposure to the metal.
Recently, Rio Tinto proposed a $300 million merger with Glencore to create the world’s largest miner. It’s essentially a takeover and through it, Rio wants to increase earnings from copper and the AI data centre theme while reducing its reliance on iron ore and aluminium.
Strangely, it comes a month after new Rio chief executive Simon Trott told shareholders of his “stronger, sharper and simpler” strategy for the company. Simpler, meaning a mega merger?
The Rio news follows BHP ending its more than year-long quest to buy Anglo American and its prized copper assets.
There are lots of questions from these proposed mega deals, with a central one being: why are the mining behemoths falling over themselves to get more copper, especially after the metal’s price has already trebled this decade?
LME copper price
We’ve seen this movie before
Long time investors have been here before. In the 2000s, the rise of China was the big theme. Its infrastructure and property build-out catapulted demand for commodities. And supply couldn’t keep up.
As commodity prices skyrocketed, mining giants went on a spending spree. In 2011, BHP paid US$20 billion for US shale assets. In the same year, Rio Tinto bought Riversdale Mining in a $3.7 billion deal to get access to its Mozambique coal assets. There were many other deals like it at the time.
The problem? Commodity prices soon went south as supply exceeded demand.
Annual global mine production increased 20% annually between 2000 and 2011 in US dollar terms, with more than half of that growth coming from coal and iron ore. Iron ore production doubled over the period in volume terms. And, mining capital expenditure rose more than 5x during that time.
Meanwhile, demand cooled as the Chinese economy slowed. You may remember talk of China’s ‘ghost cities’ then, as whole cities popped up with millions of apartments and no one to occupy them.
Almost all the mega deals from 2010 to 2012 turned out to be duds. They resulted in billions of dollars in impairments for the companies and pain for their shareholders. For instance, Rio wrote down the value of Riversdale by 80% within a year of its purchase.
Interestingly, the one deal of the time that turned out ok was Glencore’s US$62 billion merger with Xstrata, thanks to the canny operators at Glencore.
Post boom, investors shunned miners for the best part of a decade, scared off by what the companies did with shareholder money.
Lately, that sentiment has sharply turned.
The way mining cycles work
Why do mining companies go on acquisition sprees when research shows that most merger and acquisition deals (M&A) fail? And why do they do many of these deals at, or near, the peak of commodity cycles?
One of the best frameworks for understanding boom-bust cycles is the capital cycle concept developed by highly successful UK investment firm, Marathon Asset Management, as outlined in two books, Capital Account and Capital Returns, by Edward Chancellor.
Put simply, the capital cycle theory suggests that high profitability and returns on capital in an industry will attract a wave of fresh investment from new and existing participants. Eventually, this results in excess capacity, weaker pricing and profits, and falling returns on capital.
Conversely, an industry that has low returns on capital will see declining investment, and eventually capacity will shrink through businesses cutting back and leaving the industry.
That sets the stage for a period of higher profits and returns on capital for the companies that remain, and so the cycle can start anew.
Marathon has used the capital cycle framework to identify industries that look toppy – and as it successfully did with the telecoms boom of the 1990s – and industries which may be closer to a bottom (harder to do).
Look closely enough and you can see how the capital cycle played out in the last commodities boom and how it’s unfolding in the current one.
Where are we in this boom?
The capital cycle is a guide, without being precise. What can be said is that supply is still trailing demand for many commodities today. Despite gold prices hitting record highs, there’s been little growth in mining production. Copper supply is rising but lags booming demand from AI data centres. Aluminium prices may be reaching new highs, but a supply response hasn’t happened yet.
The only outlier is oil. The oil industry is gushing with supply despite depressed prices. Slowing demand as the world goes greener hasn’t helped its cause.
The recently proposed deals from Rio and BP are likely indicative of commodities being in the mid-cycle of a boom rather than at the end of one. Until the supply of commodities ramps up, and there is a wave of large mining deals, then we’re probably a while away from the boom turning to bust.
What should investors do?
How can investors ride the commodities boom without being burnt by companies doing bad deals? There are four main options:
- Be choosy about which mining stocks you buy – and hope they don’t make silly deals.
- Invest in an ETF of mining producers - though an eventual bust is likely to impact the whole sector.
- Royalty companies are an interesting and compelling way to play commodities as they benefit more from higher volumes rather than prices and aren’t as capital intensive as the miners.
- Invest in physical commodities rather than producers. This way, you’ll be purely exposed to commodity prices rather than commodity companies.
This article first appeared in Firstlinks, a Morningstar Australia publication. If you’d like to join the conversation and contribute your thoughts, you can leave a comment on the original article here.
