The natural resources sector has seen considerable highs and lows in recent years. When China was experiencing significant economic growth, it created a sustained period of high demand for raw materials, which started to fall away as the pace of that growth slowed. Investors may have been left with a lingering sense that the sector is just too unpredictable.
But there have been significant and enduring changes in the sector in recent years, which we believe have changed its long-term prospects.
Long seen as a sector only likely to thrive at times of economic expansion, today the natural resources is hooked into a number of long-term structural trends in the economy. At the same time, resource companies are improving their capital discipline and paying higher dividends to shareholders. This comes at a point when the supply of certain commodities is falling, but also when stock valuations look lower relative to history.
Energy Transition
Climate change is becoming an increasingly insistent problem. As it moves from the focus of a few activists to a preoccupation for policymakers across the globe, the way energy is created and used is a puzzle that the resources sector has an important role in solving. With the portfolio split between energy providers and mining, it’s an important consideration for us too. The move to a lower carbon economy creates challenges for some companies within the sector, but other areas are proving part of the solution.
The rapid adoption of electric vehicles (EVs), for example, has been well-documented. However, relatively little examination has been made of the supply chain. Possibly the most important component of the EV is the battery system, which determines the vehicle’s performance and the driver’s experience. Perhaps more importantly, it also determines the cost differential between an EV and a standard internal combustion engine vehicle (ICE). The speed with which battery costs can be reduced is likely to influence the adoption of electric vehicles.
EV batteries rely on key raw materials for their production. The namesake element of the lithium-ion battery, lithium, is produced through two district routes: hard-rock mining and brine processing. Most hard-rock lithium mines mine a mineral called spodumene to produce a spodumene concentrate, which contains around 6% lithium. Increased demand for lithium has been met in recent years primarily by growth in spodumene mining with several new mines coming into production in Australia and Brazil.
Other vital raw materials include cobalt, nickel, magnesium, copper and aluminium. For these elements, ores are mined, concentrated and converted into various compounds that go into the battery. In this way, certain natural resource companies look set to be one of the key beneficiaries of the drive to a low carbon economy.
Good Governance
Elements of the resources sector have earned a reputation as "Wild West" in their approach – spending excessively at the wrong time in the cycle, entering into reckless mergers and demonstrating poor corporate discipline. In some cases, this reputation was justified but there has been a profound change in recent years.
Capital expenditure has more than halved since its peak in 2013, as investors have put pressure on mining companies to rein in spending and better match supply to demand. Management teams are not embarking on new capital spending programmes and debt has reduced.
Mining companies have always been cash generative, but they have not been a particularly fruitful area for dividend investors. Previously cash fwas directed towards capital spending programmes but today, that isn’t happening, so it is being returned to shareholders. This means the sector is currently seeing its highest level of dividend pay-outs in two years. We received 38% more in dividend income last year than in 2016 from the companies we invest in.
Supply Side Changes
In 2018, most commodities saw higher average prices compared with the previous year – notably nickel, coal, uranium and aluminium. This year, that trend has been compounded by supply difficulties in several sectors. The iron ore market, for example, has been hit by the tragedy at Vale’s Feijao Mine in Brazil in January. The copper market has also seen supply reduce. Copper mining companies continue to search for new projects across the globe, but it takes time to bring supply on stream. In the meantime, rating agency Fitch is forecasting that the copper market will remain under-supplied through to 2021. Across the board, visible commodity inventories are below their long run averages in most cases. This should be supportive for the margins of commodity companies.
The resources sector today looks more stable. The companies themselves have improved their governance, while long-term structural trends such as the drive for clean energy, is working in some companies’ favour. We believe the sector merits another look from investors.
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