Recession-shy investors can turn to the capital cycle

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By Breakingviews

As the world braces for a seemingly inevitable recession, commodities have taken a hit. Oil, copper and iron ore prices have all dropped sharply from their highs earlier this year. That is not surprising, since the demand for raw materials tends to move up and down with economic activity. But another factor is the cycle of capital: the amount of investment going into or out of an industry. Given the severe lack of money that has affected conventional energy and commodities in recent years, it is possible for commodities to generate positive returns even as the economy contracts.

Despite the energy crisis caused by the Russian invasion of Ukraine, many investors fear that the demand for hydrocarbons will evaporate in the coming years. The oil giant BP He says that if governments want to fulfill their promises to reduce carbon emissions to net zero by 2050, the share of fossil fuels in final energy consumption must fall to 20%, from the current level of around 65%. The prospect of such a dramatic decline makes energy companies reluctant to invest in expensive projects with decades-long profits.

Canadian scientist Vaclav Smil, author of “how the world really works“, dismisses the notion that the world is about to give up fossil fuels. Hydrocarbons are not only used for transportation and heating, but are an essential input in the production of what he calls the “four pillars of civilization”: steel, concrete, plastics and ammonia (for fertilizer). It is unlikely, says Smil, that these industries will eliminate their dependence on fossil fuels in the coming decades, especially in low-income countries with huge infrastructure needs. “We don’t yet know most of the details of this next transition,” he writes, “but one thing is certain: it will not (cannot be) a sudden abandonment of fossil carbon, or even its rapid demise, but rather its demise.” gradual”.

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Adam Rozencwajg, managing partner of the natural resources investment firm Goehring and Rozencwajg, points out that renewable energy has huge upfront costs, since it consumes large amounts of conventional energy and raw materials. Building and installing a 1.5-megawatt GE wind turbine, he says, uses 190 tons of steel, 600 tons of concrete and 9 tons of copper. Renewable sources of energy, such as wind and solar, take several years to recover the energy used in their construction. Therefore, the transition to green energy will boost, in the medium term, the demand for hydrocarbons.

However, investors need not spend too much time obsessing over future demand. The capital cycle approach recommends that they turn their attention to current supply instead. Here the picture is much clearer. Capital spending by energy and mining companies has fallen since the investment boom peaked in the middle of the last decade.

Conventional oil production has not increased since Lehman Brothers collapsed in 2008. Instead, the incremental growth in demand for black material has been met primarily by higher US shale oil production. But shale resources are being depleted much faster than conventional oil fields and their production is not being replaced. The number of active oil rigs in the United States is just 40% of its 2014 peak. Over the past year, growing demand for oil has been met by American wells drilled before the pandemic and by tapping into the United States’ Strategic Petroleum Reserve. US government. Both sources of additional supply are nearly depleted.

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Refinitiv data stream, Baker Hughes

Spending by the oil majors on finding and drilling new wells has increased over the past year. But it is well below historical levels. Capital spending by the big European oil companies has fallen from more than twice the depreciation in the mid-2010s to less than once, according to Bernstein. In 2013, US giant Chevron’s capital expenditure was $38 billion. Last year it was $8 billion.

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Even if oil companies overcome their aversion to new investment, severe equipment and labor shortages mean the supply situation will not improve any time soon. Halliburton, the giant oil services company, has cut its spending on property, plant and equipment by two-thirds since 2013. Exploration for new deepwater oil fields isn’t going to pick up any time soon, either. After suffering massive losses, the US offshore rig industry has consolidated, leading to a reduction in the number of available “floaters,” rigs that don’t rest on the ocean floor.

A similar picture emerges in the mining industry, whose capex boom also ended about eight years ago. My former colleague Lucas White, who heads resource strategy at investment firm GMO, estimates that capital spending by commodity producers is down 65% in real terms since 2014. Given the 10-year time frame for new mines, lack of investment will limit supply for at least the next decade.

Copper is one of the key materials needed to wean the world off hydrocarbons. It is used in electric vehicles, renewable energy production and power grids. According to global S&P, the energy transition could double the demand for copper by 2035. That implies that the annual supply will have to grow by 5% per year, approximately double the rate between 2000 and 2020. However, the current supply is barely enough to satisfy the current demand. And once again, mining companies are not investing enough. Freeport-McMoRan, one of the world’s largest copper producers, cut capital spending from $7.2 billion in 2014 to $2.1 billion last year.

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Commodity prices collapsed at the start of the 2008 recession. But Rozencwajg argues that the energy and mining sectors are better off today. His situation is more comparable to that of the late 1920s, an era when investment in commodities dwindled as capital flowed into new technologies like electricity, automobiles and radios. Having been starved for cash, oil and mining stocks generated positive returns between 1929 and 1937, while the US stock market halved. Even if the world economy were to collapse once again, the cycle of capital could allow commodity producers to post positive returns.

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Publisher’s note: The bullet points in this article were chosen by the editors of Seeking Alpha.

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