Investment Matters

Shock and Ore

BHP’s quarterly activity report this week offered some insight into the dynamics we have seen in commodity markets.

Reporting on Tuesday, the company noted that the prices of iron ore and copper have been buoyant. This reflects a strong rebound in Chinese demand as well as a gradual lifting of COVID related restrictions globally.

More recently, prices have reflected supply concerns, principally the impact of COVID-19 on South American producers.

Three commodities covered in BHP’s report in particular are relevant to your portfolio: iron ore, copper, and uranium, all of which have been impacted by a curtailment of supply.

We look at how the prices of these commodities have been impacted and how this has been reflected in your portfolio.

COVID-19 and commodity prices

The initial shock of an abrupt halt to economic activity led to a broad decline in commodity prices in March, which fell by 6% at their trough.

However, this was more than offset by weakening of the Australian Dollar, as can be seen below:

240720WM01Prices broadly bottomed in April, as we saw a gradual return of economic activity, particularly in China, as well as a curtailment of existing supply.

However, the prospect of supply disruptions for several commodities has continued, and had an impact on their prices, particularly iron ore, copper and uranium.

This has principally related to the profound impact COVID-19 has had in South America, which has experienced a late surge in cases (see the graph below).

240720WM02

Brazil: Iron Ore

With respect to Iron Ore, eyes have been on Brazil, which is the world’s second largest iron ore producer (behind Australia).

Soaring case numbers have led to a reduction in supply, with its largest iron ore producer Vale ordered to suspend production at several of its mines in early June.

This, coupled with a strengthening of Chinese demand (with stronger than expected steel production) has led to a surge in the price of iron ore since late May:

240720WM03

Your portfolio has benefited from this through its exposure to domestic iron ore producers BHP and Mineral Resources. During this time, production for these companis has been unaffected, with BHP’s production of iron ore reaching record highs in the June quarter.

Mineral Resources in particular has benefited, with its share price now 28% higher than pre-COVID levels. Further supply disruptions should see these companies continue to benefit and generating significant cash flow.

Chile: Copper

We have also seen a rebound in the price of copper, which has again been spurred by activity in China, as well an improvement in investor sentiment.  Much like iron ore, the price of copper is particularly vulnerable to South American production, with Chile responsible approximately 28% of global supply (Source: Macquarie Insights).

240720WM04While supply from Chile is yet to be meaningfully impacted, the price of copper has already begun to reflect the threat of a curtailment of supply:

240720WM05

The outbreak in Chile is particularly challenging. The country has one of the highest per capita rates of infection, at 17 new cases per thousand population (for reference the US currently has 12 new cases per thousand population) (Source: CoronaTracker). Thousands of copper workers have been infected to date and several deaths have resulted. With public outcry and the prospect of union action, production restrictions are a rational possibility.

While BHP has not been immune to supply disruptions in Chile (with copper production expected to be lower in 2021) it provides a broad diversified exposure to commodities and, as mentioned earlier, has benefited from the boom in iron ore.

Importantly, your portfolio also continues to benefit from higher copper prices through Sandfire Resources.  One of the biggest improvements to the composition of the portfolio through the COVID-19 sell-off was the opportunity to correct the “missing” copper exposure through Sandfire Resources. Sandfire Resource's primary mine, DeGrussa, is in Australia. Given Degrussa is approaching the end of its life, near term copper prices have had a material impact on the company’s value. We added the company in the low $4 per share price range, and stock is now trading around $5.50.

We see that the very real prospect of curtailment of supply from Chile will continue to drive the price of copper and provide upside for these companies in the near term.

Kazakhstan and Canada: Uranium

Similarly, COVID-19 has shifted the uranium market, with the commodities two largest producers, Kazatomprom and Cameco significantly curtailing supply. This includes suspension of world’s largest operating mine, resulting in an approximate 17% cut in world annual supply. More recently, there is speculation that some of these cuts will be extended.

Supply destruction has been reflected in a sharp upwards move (+32%) in the commodity’s spot price since late February:

240720WM06The reduction in supply from mines being filled by mobile inventory from the market (supplies of uranium that are not held for strategic purposes or already turned into nuclear fuel). Critically, this removal of excess inventory shortens the timeframe for what many see as an impending shortage in available supply of uranium (at prevailing prices).

Your portfolio has benefited from this through its exposure to Paladin and Deep Yellow, whose share prices are now 50% and 22% higher than their pre-COVID levels respectively (for reference, the All Ordinaries Accumulation Index remains 14.5% below its pre-COVID peak). 

Outlook and positioning

Short term fluctuations in commodity prices can have a pronounced impact on the share price of producers. Your portfolio has benefited over this period as a result.

However, we also remain focused on the cash flows these companies can produce over a longer time frame. The bulk of their value is determined by longer term assumptions around market dynamics (pricing) and optionality in their resources base.

We still see room for upside in your resources exposure that has not been captured by current prices. However, we are also willing to take advantage of any exuberance we see and sell if prices overshoot.

Overlaying long term assumptions with short term price dynamics we will size these investments appropriately over the coming period.