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The world may be gradually coming to terms with the COVID-19 pandemic, but new tensions have emerged, from geopolitical instability and soaring energy prices to record levels of inflation and rapid monetary tightening.
Specifically, Nick asked our speakers to address three areas of tension for investors:
According to Commodities Portfolio Manager David Chang, three developments are creating near-term risks for commodities.
First, a slowing recovery in China, the world’s number-one end user of commodities, has dented demand. This slowdown is largely linked to the impact of intermittent COVID flare-ups — which led to the closure of facilities for prolonged periods —and a cooling property market. Second, Europe’s decision to wean itself off Russian gas has forced industrial end users to curtail their activities. And lastly, in the US, Federal Reserve rate hikes are dampening demand for commodities as economic activity slows.
In contrast, the sector’s long-term outlook seems robust, especially in metals. Against the backdrop of low prices today, there is no excess of supply, with inventories currently at their lowest for the past half century or so. And while the sector has experienced a slowdown in demand, this has not translated into excess supply. Producers today are more disciplined, and instead of pursuing high growth with the aim of returning capital to shareholders, they are more conscious of overconsumption and their emissions footprints.
Over the longer term, the need to decarbonise the global economy bodes well for commodities producers. Much of the technology used in the energy transition is heavily reliant on metals, whether that is for wind turbines, new grids or electric vehicles (EVs). Demand for copper, for instance, is currently growing at a rate of 2.5% annually.
Another positive is the redrawing of supply chains along more regional lines in response to COVID-19 lockdowns and geopolitical tensions. Manufacturers are being supplied by new producers, who are typically less efficient and have higher production costs. Furthermore, building these supply chains is also commodity-intensive, all of which should drive prices upwards.
With annual yields for commodities currently exceeding 10%, this year could be an opportunistic entry point for investors. As David points out, “Today’s very attractive yield more than compensates for the potential near-term risks associated with exposure to the asset class, particularly if done in a selective manner”.
Underinvestment, decarbonisation and supply-chain regionalisation provide a strong backdrop for commodities.
The decarbonisation efforts of the energy sector have helped accelerate the net-zero agenda. This is especially the case for utilities companies, many of which are aggressively pursuing low-carbon sources. With gas prices at record highs, power suppliers are having to consider affordability as well. This is creating a trade-off between the need to reduce their carbon footprint and the care they owe more vulnerable customers.
Social considerations are significantly more material for utilities companies than in the past, notes ESG Analyst Jennifer Rynne. In addition, governments are intervening to stabilise power markets, with some imposing windfall taxes on utilities companies to pay for energy subsidies. Not only are such measures injecting uncertainty into the power sector, but they also make utilities companies more susceptible to further policy changes.
Governments must tread carefully, says Jennifer. They need utilities companies to further advance the energy transition agenda, while in the short term, “keep the lights on” in homes, businesses and industry. High gas prices are also prompting power producers to return to coal, thus reversing the positive climate action taken by the sector over the past decade or so.
The environmental-social trade-off should ease in the future as the growing availability of renewable energy will lessen the world’s reliance on gas. Meantime, the US’s efforts to increase liquified natural gas (LNG) exports should, to an extent, help relieve pricing pressures. According to Jennifer, a long-term resolution of the current ESG dilemma means meeting the three energy “lows” of low cost, low carbon and low conflict. Until we have found such a solution, governments, companies and investors will have to balance the associated E and S challenges.
The three energy lows, namely low cost, low carbon and low conflict.
For Portfolio Manager Alan Hsu, the provision of renewable energy is not just critical for the transition to a low-carbon economy it also represents an opportunity for nations to become less dependent on energy imports, especially oil and gas.
Many of the new technologies that are driving today’s energy transition can be assembled and deployed domestically. These range from solar panels to biofuels and smart grid infrastructure. In the face of rapidly growing concerns over climate change and energy security, governments around the world are incentivising companies to get on board. In the US, for example, the recent Inflation Reduction Act of 2022, also known as the Climate Act, offers tax credits to domestic businesses across a wide range of sectors, including EVs and hydrogen production.
While moving beyond fossil fuels will lessen reliance on oil- and gas-producing countries, adoption of cleaner energy sources also creates new challenges. Notably, a significant amount of the metals needed to build these new technologies are extracted from either Russia or Ukraine. Currently, inventories of copper, aluminum, platinum and palladium are well below five-year levels. Investors, therefore, must keep a careful eye on how these inventories evolve in the near to medium term.
Over the longer term, investments in the materials and technologies that will drive tomorrow’s decarbonisation agenda should contribute to a winning investment strategy. “Increasingly, there’s greater demand for this type of infrastructure, and we’re still far behind achieving an end-state,” asserts Alan. “Underappreciated companies that make the best technology or product lineup, have competitive moats and healthy balance sheets and are in a position to capitalise on supply-demand imbalances should, in my view, do well in the future”.
Energy transition is energy security
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