The party in commodities isn't over

The past month has been pretty brutal for commodities connoisseurs.

After all, the S&P/ASX 200 Resources Index is down nearly 9% over the past four weeks alone, while copper and iron ore prices have cascaded significantly into the red over the same time period. Steel, platinum, silver and gold haven't exactly survived this beating either, with all four metals falling in June.

It probably doesn't surprise investors to learn that at the stock level, it's been far, far worse. 

For example, lithium favourites Mineral Resources and Pilbara Minerals have seen their share prices fall more than 20% over the past month, while dividend favourites BHP and Fortescue Metals Group have dropped more than 6% and 9% respectively.

That said, they say you should buy when there is blood in the street.

So in this thematic episode, Livewire's James Marlay was joined by AUSBIL's Luke Smith and Paradice Investment Management's Tom Richardson for their take on the opportunities and risks of investing in Australia's materials, miners and explorers.

Plus, they also share why they believe the party in commodities isn't over (and not by a long shot), as well as the sectors (and stocks) within this burgeoning space that are catching their attention for the right reasons over both the short and long term.

Note: This episode was recorded on the 22nd of June 2022. You can watch the video, listen to the podcast, or read the transcript below. 

Edited transcript

James Marlay: Hello, and welcome to this thematic discussion brought to you by Livewire Markets, and today, we're talking boom or bust in the commodities cycle. It's a very topical part of the market. Two sectors, energy, materials, top of the pops, but how long can they stay there? And one thing we know is that Australians love their material stocks. It's a big part of the market. To help me get the story on the rocks, I've got a couple of experts, a couple of "rock stars", Luke Smith from Ausbil and Tom Richardson from Paradice. Welcome to the show. Thanks for your time.

Alrighty, we're going to start with a little bit of a game. We asked Livewire readers to tell us what time it was on the famous Lion Selection resources clock. Tom, I'll start with you. If you had to give it a time, what time do you reckon it would be, and why?

Tom Richardson: Well, I might split it up into energy and materials if that's all right, James. I think for materials, we're probably more like 9:00, although this month it's felt a bit like Cinderella crashing into midnight. But I'd say 9:00 for materials and probably more like 4:30 for energy. I think it's a bit earlier in the cycle. We haven't really had any investment in that sector for some time, so we probably got a bit more runway on the energy side.

James Marlay: All right, let's stay with you. Just dig into that a little bit more. Bullish energy, that's just before the boom at 6:00. Why are you so positive about the outlook for energy?

Tom Richardson: You've basically had a decade of underinvestment. If you look at that clock, 2:00 was declining exploration. We've absolutely seen that. 4:00 was mergers. We ticked that box with BHP and Woodside, and so next up is cash takeovers. Now, we haven't seen any of those yet, but maybe that's coming. But I think the cash generation of those companies going to be significant. 

We've got a good runway. There's a bit of a slowing global growth backdrop, which might just put the coolers on there for a little bit, but generally speaking, we think we've got good runway there.

James Marlay: Okay. Materials, you reckon it's a little bit later in the cycle. Talk me through it.

Tom Richardson: Yeah, well the boom started earlier, didn't it? I mean, 2016 was the low. We've been five years into this on and off. We've got an energy transition, which is supporting demand, but the supply growth has been a little bit stronger across the board on the commodities side. So, we're probably just a little bit later on that one.

James Marlay: Luke, same question for you. What time? Are you going to hedge your bets like Tom, or have you got a bit more conviction and give us a single number?

Luke Smith: I really should have compared notes with Tom before coming in here. 

But based on last month, it looks like we're at midnight - based on the crash that we've seen over the last month. It's been pretty horrible, but from our perspective, we're very early in the cycle for both materials and energy. 

If you look at the clock, at 8:00 we're talking about rising exploration. We haven't seen a lot of that this cycle. We haven't seen a lot of investment in new supply. Where this cycle is different, and never trust anyone that says to you, "Where this cycle is different," but where this cycle is different is just that lack of investment in new supply. That’s from our perspective, why we think that we're still very early in the cycle from a natural resources and energy perspective. 

James Marlay: So, we've established both things. A little bit more to run across both the energy and materials sectors. Let's look more specifically at some of the underlying commodities because you got your bulks, you got your pressure, you got your battery minerals, all that stuff. Luke where are you most constructive, and where are you more cautious

Luke Smith: Again, it's been quite a volatile month, especially for this space. But we are quite constructive on battery materials. Unlike the spreadsheet jockeys at the investment banks suggesting that it's over, from our perspective, we're extremely early in this cycle. The supply response is taking time and will not be easy in terms of bringing on the amount of supply that we need within the batch materials complex, and demand continues to accelerate. We can see that in terms of the China EV sales at the moment, European EV sales accelerating, and on top of that, US starting to be part of the story as well. So, where we're very constructive is within that batch of materials complex.

James Marlay: So, that's lithium?

Luke Smith: Yeah, lithium and graphite in particular. 

And again, there's been a number of investment banks that have questioned where we are at this point in the cycle. But from our perspective, price is telling you the contrary to that discussion, and we're still seeing these commodity prices strengthen at the moment. 

Maybe an area where we'd been somewhat concerned through the course this year, arguably you could throw iron ore out there. Yeah, one of the issues that we've seen play out through the course of this year is China and clearly, China managing COVID or its COVID zero policy. That's really slowed the economic backdrop for China throughout the course of this year. But that doesn't mean that we're not constructive on a look-forward basis, right? China set the tone for how they want to grow the economy through the course of this year, and we think they're likely to stimulate and accelerate in the second half. And ultimately, that's positive for construction-related commodities, such as iron ore.

James Marlay: Okay. Same question for you, Tom. Where are you most constructive or bullish. Where do you see a good outlook at the commodity level?

Tom Richardson: Well, with global growth slowing a touch, we want to be a little bit more selective. And the two areas we're focusing on are somewhere where you have a really strong structural demand story, or where supply outages are going to support the price. 

I absolutely agree with Luke; battery materials look really strong despite the pullback. The structural growth story is there, and it is there for a long time.

James Marlay: And are the commodities specifically in that space? I know nickel gets chucked in there as well. What are your preferred commodities there?

Tom Richardson: Lithium's the most straightforward way to play it in our mind. So, that's the best exposure. Obviously, there are a lot of companies there, so I can get into the company names as well, but I would also throw in rare earths and nickel obviously is a beneficiary as well. And then the other one from a supply story is probably LNG. You might see some slowing growth in terms of demand forecast, but the supply story there is so strong that it's hard to see those prices coming back. 

Then in terms of where we're more cautious, it's the flip side. So, is there some demand softening areas where you're actually seeing a little bit of incremental supply? And the two that I probably have to call out in the short term are probably ex-China steel and copper. 

Long-term copper looks fantastic, but in the next 18 months, a little bit of slowing demand, a little bit of incremental supply. Our view is it's probably not going to get away from us in terms of the commodity.

James Marlay: Okay. On the supply side, we've seen a major disruption with the war in Ukraine. That's obviously had a big impact on energy prices. How are you thinking about that supply-side disruption caused by that particular scenario?

Tom Richardson: I guess it's the short-term and the long-term impact. So short term, immediately everyone was like, "What do they produce? Can we get it out?" And so if you think about nickel, the price just skyrocketed. The same with aluminium, the same with steel. Now, that material is still flowing out. It's finding a way to find buyers. There are always avenues for this material to get out. So, those prices have normalised. What looks more sustainable to us is the energy impact. Now, that's not just from LNG, but the impact that's going to have on cost curves. 

Aluminium is a perfect case. The gas price is causing a lot of smelters in Europe to close and that's going to push up prices as well. So from a Russian perspective, that's how we're playing it. We think the higher cost energy cost will feed through to the cost curve for a lot of commodities and ultimately support low-cost producers.

James Marlay: Okay. Luke, similar view? Obviously, a major tragedy, an ongoing tragedy that is having impacts on the supply side. How have you thought about that particular situation, and how it flows through to the commodity cycle?

Luke Smith: Well, some great points by Tom and I'd completely agree with the points that he's outlined there in terms of the core commodities that Russia has exposure to in terms of fossil fuels, base metals complex. 

Clearly, there's been some major dislocations in supply chains, but the product is still finding its way into the market. The key beneficiary of that, is clearly Chinese, and Indian buyers that are buying some of these fossil fuels, in particular, at 25% discounts to the rest of the world.

But the product is still in the market, which would be the point that I'd highlight. Might almost flow onto the next question you might have around what are the longer-term implications of what's played out within Russia, which is probably worth reinforcing.

I think it plays off what Tom also said there as well, is that what we saw within weeks of the invasion, Europe came out with REPowerEU. And what does REPowerEU mean? It means a reduced reliance by Europe on Russian fossil fuels, in particular, and Russian energy. So in the short term, it's beneficial to seaborne fossil fuels. It's beneficial to seaborne oil, seaborne thermal coal, LNG, as Tom outlined as well. There's this near-term discussion around it being very beneficial for the ex-Russian producers of fossil fuels. Where it's even more beneficial for this market as well, is the changes that they're pushing through around decarbonization. It goes hand in hand. This is energy security about reducing reliance on fossil fuels. And what does that mean? It means that Europe is only going to accelerate this push towards decarbonization. It's renewables, it's solar, it's wind, it's hydrogen, it's a whole raft of areas. Potentially, nuclear comes into the mix there as well. Why is that important as part of this discussion? You don't have decarbonization without metals, It's as simple as that.

James Marlay: Okay. Well, let's get into a couple of the opportunities that you guys are finding. We'll talk a couple of stocks. We have short-term issues, which we've just discussed. There are also long-term thematics; Decarbonization, and transition to renewables. Luke, I'll start with you. Can you share a tactical position that you've identified, and then share a long-term opportunity that you've got conviction in?

Luke Smith: I think we've talked around a range of the issues that are playing out within the resources space at the moment, and clearly this discussion around acceleration in China and acceleration in activity within China. That's what we're expecting to play out in the second half. Clearly, markets seem to be losing some patience with that. But from our perspective, Xi Jinping has set the tone and he wants economic growth, he's managing COVID, but once he gets on top of that, he'll be pushing for economic growth in the second half. So we've got a demand backdrop, in which ex-China is potentially decelerating, but China that's core to commodities will ultimately accelerate. On top of that, you got this decarbonization theme that I highlighted in my last answer, which feeds into this discussion around a positive backdrop for metals as well. You got the points that Tom highlighted, I think I highlighted as well, around a lack of investment in new supply. I'm probably giving you a long-winded answer to saying everything. 

James Marlay: Can I pin you on it? Can you give me a couple of names, a short-term name on that China theme, and a longer one that you like?

Luke Smith: So, again, if we'd call out the battery materials complex as an area that we feel has been unfairly treated through the last month, that the demand backdrop is accelerating and the supply response is taking time, among the most obvious names within that complex that we'd call out, Allkem (ASX: AKE) would be one. It's a combination of Galaxy and Orocobre that has played out developing three growth assets. That puts it on the path with some of the major producers out there. 

Another within that same complex would be Syrah Resources (ASX: SYR), a graphite producer in the natural graphite space. The synthetic graphite price continues to strengthen on the back of the energy crisis, on the back of high petroleum prices, and it feeds into a positive backdrop for what is a more opaque commodity, but ultimately feeds into a strong conviction within that name as well.

James Marlay: Okay, great. Tom, same question for you to finish up. A tactical short-term position and maybe something that you really like longer term. 

Tom Richardson: All right. Tactical is lithium. As Luke mentioned, there were a couple of broker reports out this month that basically highlighted that we're going to get flooded with lepidolites. Now, do you know what lepidolites are?

James Marlay: No idea.

Tom Richardson: Don't worry. Half the market didn't know two weeks ago either, but it's very low-grade lithium, and our expectation is that they're going to take longer to come in and they're going to be very high cost. And it is not surprising that material's coming into the market because the price is six times incentive and that is absolutely what the commodity price is trying to do, is trying to get this material in. So the stocks have been completely hammered on that, and then also on the backdrop of slowing global growth. 

Now, here's a bit of insight. If you look at the Chinese battery materials complex, there's a whole bunch of names that I can't even pronounce, but they're integrated into the battery material complex. 

They peaked in November, they fell 50%. They bottomed in April, they're up 60% in the last six weeks. Our stocks look like they're lagging, and it looks ripe for a big rally. And a big short squeeze in lithium

James Marlay: Carry on. That's right now? Sounds pretty tactical.

Tom Richardson: That's right now, right now. And if you look at the long term, interestingly, I'm going to go with the LNG. So despite the demand outlook for batch and materials and LNG probably being vice versa, my long-term pitch is on the LNG. And the reason I say the longer term is because the stocks have done very well short term. Everyone's been pushing into energy, covering short positions and so forth. And they might look a little bit vulnerable short term to me, they've outperformed a lot. But I think in three to five years, they're going to do very well. Maybe you'll get a better entry point.

James Marlay: Okay. Well, Livewire readers voted. They thought it was closer to 11:00 on the resources clock. They're a bit more bearish than our two bulls here who think this resources rampage has more to run. Thanks very much for watching, ladies and gentlemen. Remember, if you enjoyed that video, give it a like, hit subscribe on our YouTube channel. We're bringing fresh content to you every week.

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