‘The energy transition will need more commodities than we think’

Inflation is falling and the outlook for global growth is slowing, which does not usually pan out well for natural resources. But there are other factors at play: investors are still underestimating just how many commodities will be necessary to the energy transition, argues Olivia Markham, co-manager of the BlackRock World Mining Trust (BRWM). “While the markets have understood the growth opportunity in the renewables and electric vehicle (EV) space, they haven’t properly connected the dots and recognised you can’t have those end markets if you don’t have commodities,” she says.

BlackRock World Mining invests in mining and metal assets worldwide, with a focus on listed shares but also exposure to royalties and private assets. It had a less than stellar 2023. The mining sector is notoriously volatile, but in the year to 21 December 2023, BlackRock World Mining was down 9.3 per cent, well below the MSCI ACWI Metals & Mining index gain of 3.4 per cent (the trust uses a variation of this index as its benchmark). Over the same period, the MSCI All World Index was up 15.7 per cent in sterling terms, and the FTSE All Share 8.9 per cent.

But whatever the medium-term opportunities offered by the energy transition, the sector has some challenges to contend with in the immediate future. China is near the top of that list. It is the source of around half of global demand for a range of commodities, meaning the sector is overly reliant on the health of the country’s economy. 2023 was supposed to be the year when China finally bounced back from its Covid-19 shutdowns, but the demand from its economic reopening has “somewhat disappointed”, as Markham puts it, particularly regarding the property market – demand from low-carbon sectors such as wind and solar energy has held up better, she adds. 

For a sector that is notoriously cyclical, slumping demand from its main market combined with global malaise cannot possibly amount to good news, and in 2023 miners of all types suffered – although they did partially recover in the late-year rally. The Chinese government has recently unveiled a series of measures to support the property sector, but recent years do not suggest the problems are easy to fix. Muted global growth and the skyrocketing costs for developing new mines add to the list of headwinds, although there are hopes that the second half of 2024 will bring interest rate cuts and perhaps brighter economic prospects.

Markham still sees quite a few reasons for optimism, particularly in the medium and long term. If it’s true that demand has slumped this year, it is now bottoming out, she argues; and supply is even more constrained. “The physical markets are tight. We’ve had almost a decade of underinvestment into new supply and inventories are low,” she says.

The energy transition dilemma

The energy transition means that demand is expected to pick up significantly before the end of the decade. Earlier this year, a report from think tank the Energy Transmissions Commission found that mining “will need to expand significantly” to supply enough metals to support the transition. For example, between now and 2030, the annual demand for lithium, which is necessary for batteries and EVs, could increase by five to seven times, while the demand for copper could increase by up to 1.6 times. Given that new mines take time to become operational, there is a risk of supply bottlenecks for certain metals, the report argues. The mining sector will need significant amounts of investment and capital if it is to keep up.

Markham argues that the energy transition will also gradually reduce the sector’s reliance on China. Beginning in the early 2000s, the urbanisation of China generated huge demand for commodities, while the US and Europe invested comparatively little in infrastructure and demand retreated there. But the energy transition will drive commodities demand across various geographies, which should mean that China will play a less prominent role in the market in future.

The issue, in this framing, is that the mining sector is both essential to the energy transition and exceptionally damaging to the environment. Markham points to the progress made by the industry so far and stresses the importance of focusing on carbon intensity, at least in certain areas of the sector. “For example, if you think about a copper company, where we need its production to grow to enable the transition, its absolute emissions will grow. But its carbon intensity should hopefully come down,” she explains.

If the planet is to achieve net zero by 2050, emissions ultimately also need to come down in an absolute sense – a conundrum that the mining sector (and many others) will have to navigate going forward. Among the bigger companies, Markham points at BHP (BHP) as a virtuous example of a company that has already reduced carbon emissions and “is doing a good job in disclosing information about this and setting out their targets and strategies around decarbonisation”.

While the energy transition is undoubtedly a necessity, it also requires a lot of political will. Markham cites that as a potential risk. “We’ve had some great momentum and support from governments in providing capital to low-carbon technologies and renewables. If that were to lose focus, it would potentially be a negative,” she says, adding that it looks as though the trend is “here to stay”. But a Republican victory in November’s US presidential election could result in less support for the energy transition in the country, for example.

Markham also argues that the mining sector was “better prepared” for the current slowdown than in the past. “If [the current] commodity price volatility and the negative sentiment had appeared five or six years ago, equities would have traded much worse. Today, these companies have balance sheets with less than one times net debt to Ebitda. In the past cycle, that ratio would have been three times.”

Nonetheless, in the current high interest rate environment, that debt has now become more costly than it used to be. Markham concedes that financing costs have gone up, and while they are not “exorbitantly expensive”, the trust is still “making sure that when companies are approving new projects, that we are looking at those returns in the context of this higher rate environment”.

Steel underperformance

The chart below, which compares BlackRock World Mining’s exposure to different metals with that of the MSCI ACWI Metals & Mining index, helps explain where its 2023 underperformance came from.

The trust’s low exposure to steel was unhelpful. Markham says margins in the steel industry remain “challenging”, with low return on capital and a lot of spending on decarbonisation required. But some Asian and Japanese steel companies did very well last year, partly because of the general rerating of the Japanese stock market. Nippon Steel Corporation (JP:5401), Japan’s largest steelmaker, was up about 45 per cent in the year to 20 December.

The other big performance detractor was lithium, whose price plummeted in 2023. “It’s not that the demand outlook has weakened, it’s that supply has been stronger than we would have expected,” says Markham. As of June 2023, the trust was exposed to lithium via a handful of companies such as US-based Albemarle (US:ALB), whose share price was down 38 per cent in the year to 20 December.

In the medium term, Markham describes herself as “a big copper fan”. She expects increasing demand because the red metal is essential for the distribution of electricity, while supply looks “very challenged”. “2023 is probably the last year that we see a decent amount of supply coming into the market, and only because it’s been delayed for the last couple of years over Covid. Looking forward, there just isn’t a pipeline of new copper assets,” she explains. There are a range of issues with the supply, including few exploration successes, a lower quality of new assets compared to the past, permitting issues and higher costs in building and developing projects.

The trust was trading at a 3.8 per cent discount as of 20 December, lower than the one-year average discount of 1.3 per cent. Last year’s sluggish performance also puts its dividend yield at an attractive 6.9 per cent, but it remains to be seen what level of dividends mining companies will be able to pay over the next few months. That will depend on their profitability, and therefore on both commodity prices and capital spending, Markham points out. “We’ve had some exceptional years of high cash flow. Naturally, that is coming down as commodity prices have moved down; you’ve already seen that in some of the reporting. [That decrease] will flow through to the trust,” she admits. 

Overall, Markham’s concerns for this year are mostly about the global economic and political environment. “If we were to see an escalation in some of the conflicts that are going on now, I think that would generate negative sentiment for the sector, or even generally for global markets. That’s my biggest concern,” she says.