328. Investment goldmine: capitalising on the demand for essential metals

29 August 2024 (pre-recorded 21 August 2024)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. We’re covering the intricacies of investing in the commodity sector this week, focusing on how global economic trends, supply and demand dynamics, and technological advancements shape portfolio decisions.

Chris Salih (CS): I’m Chris Salih, and today we’re joined by Evy Hambro, co-manager of the Elite Rated BlackRock World Mining Trust. Evy, once again, thank you for joining us today.

Evy Hambro (EH): No problem. Thank you very much for having me on.

[INTERVIEW]

CS: No problem at all. I wanna start just with a bit of sort of look at the construction of the portfolio. So obviously you invest in a number of different commodities within the commodity sector, and maybe just talk us about how you judge what’s going on in the economy and how you decide based on that, what metals to invest in and essentially what to favour and and what not. That’s the first half of the question. I guess the second half is, are there certain metals or well metals in general that you hold throughout the cycle?

EH: Yeah, so yeah, just to be clear, we don’t actually invest in the metals themselves. We invest in the companies that produce them. And so we have exposure to the metals via the companies or their shares that trade on the exchange. And so that’s how we get our exposure and typically investing via the companies rather than commodities themselves, either physically or through commodity futures, contracts and so on.

There are benefits and disadvantages. You know, the equities tend to be a little bit more volatile. They come with operational risk and and so on, but to compensate you for that, they have the chance of growing. They have the chance of expiration success. They have the ability to pay dividends and so on.

Whereas the commodity futures tend to have other benefits and disadvantages. They trade for specific periods of time under futures contracts. They can go positive or negative relative to their value during those periods of time. They’re subjected to interest rate risk and and so on. And so that’s typically how we build our portfolio. We do have the flexibility to have commodity futures, but they’re an incredibly small part of what we do, and we very rarely use that flexibility in terms of how we think about building the portfolio.

In answering your question in relation to the kind of commodity exposures that we seek, we do that when we look at kind of the outlook for supply and demand for commodities. So we start off by looking at the supply, because that’s actually one of the, kind of the areas that you’re most likely to get right. If you model the production of commodities from existing assets as a very high chance that you’ll overestimate supply. Because very rarely do mining companies exceed their production forecasts. In many cases, they fail to meet them and for lots of different reasons, whether it could be weather or strikes or production issues and so on.

And then you look at demand and obviously with demand, you have to have it at that kind of top down perspective when looking at the global economy. And so we build a framework around what we’re likely to see in relation to GDP growth, industrial production, so on and so forth, inventory management and where they’re moving around the world and we get a kind of picture of demand and supply. And then we will typically try to build our commodity exposure to those commodities that are likely to see prices at levels where there’s a healthy level of profitability for the producer over the medium term.

Trying to second guess commodity exposure in the short term is very, very challenging. And that’s not really what we do at all. So we build our exposure trying to extract that kind of maximum total return through the investment cycle.

Where are we in that investment cycle? Well, it varies by commodity. Some commodities today are in oversupply. You could consider a commodity like nickel that has had some fundamental changes in the supply and demand dynamics where you’re seeing lots of new supply coming on from certain parts of the world that have exceeded demand. And therefore prices are low. Other commodities like copper, you know, we’re seeing very healthy prices for copper. We’re seeing very healthy prices for gold right now. And all prices have been volatile around their kind of long-term averages. So it varies in terms of what we do, but what we try to do is focus on that kind of medium term or through the cycle positioning in the portfolio.

CS: You mentioned two of them there, but let’s talk about copper and gold because both of them obviously have gained a lot of headlines and traction in the market. We’ve seen breakout prices for both. Could you maybe just talk us through a bit on both of those? Let’s maybe start with gold and how the trust is positioned in that respect with regards to gold equities.

EH: Yes, absolutely. So the portfolio has always had a fair amount of gold in it. And for most of the last few years we’ve been underweight relative to the commodity the implied commodity exposure via the equities. In our kind of reference index – we don’t have an index as such – the board uses a reference tool amongst many other measures to decide whether we’ve been successful. So we look at it a little bit like that.

The reason for that has not been because we have a negative outlook for the gold price itself. We’ve just been very cautious in terms of the ability of the gold producers to capture these higher prices and turn them into rising levels of profitability. What we’ve seen over the last few years is that the costs have escalated faster than the prices have gone up. And therefore, despite the rising prices, you actually seen margin deterioration.

More recently though, that view has changed. We have seen a higher level of capture of profitability from the rising prices as cost inflation has slowed. And in actual fact, companies are becoming a bit more productive and efficient in terms of how they’re operating. And so the portfolio has moved to a more positive tone towards towards gold equities. And we’ve had that bias and that’s been a driver of recent performance over over the kind of first half or within the first half of this year.

With regards to copper. It’s really been one of those classic phrases: t’s been actually a first half of two halves. We’ve had a period of copper price weakness at the start of the year. A very strong period of copper prices moving to kind of new all time highs some months ago. And then the typical kind of summer lull where prices have have been a bit weaker and actually, just in the last few weeks, copper prices have kind of roared back to life again. And so we’re seeing that kind of a bit of a rollercoaster volatility.

But having said all of that, the actual average prices that we’re seeing this year have been pretty strong and should be a driver of profitability. And we’re certainly seeing that in terms of some of the company results.

CS: Okay. Just touching on copper, I was gonna mention it just before there, obviously we saw China buying up huge amounts of copper early this year. Maybe just for the listeners, explain a bit behind that and what was sort of the thought behind that and did that impact the market significantly at the start of 2024?

EH: Yeah, I know we’re probably gonna go on to talk about it in terms of the energy transition and AI and and so on, but copper is one of those metals that is likely to be and has been a major beneficiary of those huge kind of mega forces that have been kind of driving some of the themes across, you know equity markets.

I’m sure we’re all familiar with the success of many the AI related companies that have done incredibly well. You know, copper is one of those commodities that is likely to be a major beneficiary of that because of the way that companies are deploying capital, spending on things that are very materials intensive. And if we’re gonna go forward into this kind of digital world, we’re gonna have a rising dependence on cloud and semiconductors and data storage and going to need more high quality energy with lower levels of disruption and obviously lower carbon footprint to its production.Then copper’s gonna be a major beneficiary of that spending.

I think what we’ve seen over the last few years, not just the period you mentioned, is some of these metals are becoming increasingly strategic at a national level. And we’ve seen lots of plans put in place by governments to recognise that where they are out there trying to secure supply for their own domestic needs not only supply, but also encourage investment into production of new sources of these commodities as as well. So copper is one of the ones that kind of stands out with the biggest, I guess, gap between supply and demand over the next few years based upon what people are expecting demand growth to be and supply is pretty benign in terms of the outlook. So that gap or that shortfall is likely to have a pretty big impact on pricing.

CS: Okay. Evy, you mentioned a couple of the underlying themes that are already sort of focused on the portfolio, but let’s try and go into it a bit more as a sort of a block at the moment. I mean, it has a number of key themes, the likes of digital transformation, infrastructure, AI, energy transition, and some of them overlap to a degree, but how does the trust sort of tap into these trends? And where’s the sort of main appeal today, if there is any? Or is it across all of them really?

EH: Yeah, it’s a good question. I think it’s one that’s very prescient at the moment. The thing that I find quite startling just broadly in equity markets is the valuation that companies that are considered to be closest to or have the cleanest exposure to some of those themes, the valuations they trade at is eye watering. I’m sure that many resource companies would love just one additional multiple point on their earnings or valuation because the difference it would make would be enormous. So the cost of capital of the company is at the, kind of the furthest point down the chain, the semiconductor companies and so on is eye watering. And the more you come upstream, you know, back up that supply chain, the cheaper the companies tend to be.

And when you get right to the very, very end of that, you get the resource companies that, none of the downstream from that could happen if the copper wasn’t there, and so on. So I think that valuation arbitrage or anomaly or disparity is something that we find intriguing. And we hope that some of that gap starts to close.

I think as people become more concerned about where they’re going to get the things they need from then people might start to pay up for it. It’s a little bit like what happens in the oil market when you get disruption at oil supply based on, I don’t know, war or some other thing. You get what’s called that premium pricing coming into the market. We haven’t seen that yet, but when you look at a commodity like copper, you look at the world’s largest producer of copper by country is is Chile. Chile produces, you know, more than double the market share in copper that Saudi produces in oil. Peru produces the same amount of copper in terms of percentage that Saudi produces in oil. But people don’t really care about them.

You’ve got strikes going on, you’ve got political changes in those countries. You’ve got an inability of those two countries to be able to grow production substantially. And yet the world is dependent upon them in this race towards AI and so on, because of the copper intensity of it. So we find that intriguing that this area is so easily overlooked and the risks are so easily ignored that at some point people are going to have to start paying out for them.

CS: Okay. You mentioned a number of things there. I want to touch on AI specifically in a moment, but is there another theme perhaps you can elaborate on? I mean, I was thinking infrastructure comes to mind because it’s just such an ongoing theme. Is that something that is just a constant theme that sort of underpins the portfolio?

EH: Yeah, I think it varies. If you go back into the China cycle of the early 2000s, that was about the industrialisation and urbanisation of that economy. Obviously that was very, very materials intensive. So you had this huge economy that suddenly was changing very rapidly at an enormous scale as well. And the amount of commodities they needed to be able to achieve that was staggering. The world couldn’t respond fast enough, and you had this explosive reaction in prices.

Are we seeing something similar today? The energy transition itself, the move away from a carbon intensive or fossil fuel driven global economy towards one that’s greener requires an enormous amount of materials. We all know that you need way more metal in renewables than you do in a coal-fired power station. And so you are swapping fossil fuels effectively for a higher intensity of use of materials. We all know about the batteries. We need to be able to reduce that intermittency risk of renewable power generation as well. So you’ve got this energy transition theme, which is an enormous theme globally. And at the same time, you’ve got this AI theme and you mentioned earlier on about how some of these things often overlap. Those two things very much overlap.

And I think this rising dependence on materials is not reflected in the valuation or even the scarcity of some of these assets. And so when you look at the kind of cost of capital these businesses trade at, that cost of capital could change very, very quickly when you end up with strategic needs.

CS: Just for the listeners who perhaps haven’t looked into too much depth in this, just how is AI impacting demand for metals? You talked about it there – the idea of, for example, copper for electrification or data centers – just give us an idea of just how much that landscape has changed and do you expect demand to sort of change or stay consistent for this in the future?

EH: Yeah. So I think what we are seeing obviously is a rising energy intensity per unit of GDP. So for many years now, we’ve obviously had energy demand as a whole relative to GDP hasn’t risen that much, but we’re going into a more digital driven global economy. And as we do that, we’re gonna see more and more need for energy units. If there’s energy units are going to be coming from cleaner sources, then we need more materials attached to that.

So we’ve got, I guess the AI bit acting as a demand for energy consumption. And we’ve got the energy transition, which is the delivery of those energy units requiring a lower carbon footprint. A combination of those two things together means that the shape of the global economy in the future is gonna be much more materials intensive than the one that we have, than the direction of travel we’ve been going in over the last few years.

And when we think about the power consumption of data centers, as you mentioned, the impact it has on some of the regional economies. I mean, I was reading just a few weeks ago about 18% of power demand in Ireland now is, comes from data centers. That’s an enormous number. Imagine the infrastructure that’s being put in place to be able to support that and then in turn the materials that go into that infrastructure. So the two things are very much intertwined.

CS: Okay. Obviously the past couple of years have sort of been dominated by the sort of impact of inflation on markets. I mean, it’s started to abate a bit now, but maybe could you just explain to the listeners what persistent inflation has does in terms of an impact on the commodity sector? Does it make your job a lot harder? Just give us a bit of insight into that, please.

EH: Yeah, so inflation obviously has an impact on the operating costs of the companies that we are invested in. So if the price of oil was to go up or the price of diesel and through oil goes up or the cost of the chemicals that they use or the labor costs and so on, that increases the operating cost. And therefore the cost of production. If the price of the commodity doesn’t change, then you have a reduction in the profitability that you have when you produce each unit of those commodities.

What we also tend to see though with inflation is that the price of the commodities also rises, but these things can happen out of tandem. So you could have a rise in the price and no inflation for a while, and then a massive expansion in profitability. Or you could have a rise in cost without the commodity price going up and have a reduction in profitability until those commodity prices rise to reflect those inflationary pressures. And those two things tend to move around. Sometimes you get one and sometimes you get the other.

What we’ve been through over the last few years actually has been a pickup of inflation and commodity prices haven’t really kept the pace with that. And I mentioned earlier on about gold and how some of the challenges for the gold producers have been to be able to capture that higher profitability when you have that rising cost profile. Now we’re seeing the other side of the equation. We’re seeing cost inflation start to weigh and we’re seeing that price of of the commodity continuing to rise and therefore that expansion in profitability. So that is one of the things that we look at on obviously trying to build the portfolio to make sure we’re not exposed to any of those risks as one of the roles that we have.

CS: And just to use gold equity as a sort of example of it. So, for example, we saw the physical price of gold rising, but gold equity companies were sort of lagging a bit. Did you look for sort of catalyst across the sector; or is it a specific company by company thing that you say, right, there might be something that dictates that in one company the lag is completely rational and there is gonna be a reason why the price will surge at some point; or is it more of a macro piece across the sector that you wait for something across it to happen as a catalyst?

EH: You’re absolutely right. You know that’s one of the things we spend a lot of time on, and I think the example you referred to in gold, is spot on. You know, we had I guess a lack of trust or belief that the company, the gold producers were gonna be able to capture these higher prices and turn them into additional profits because we hadn’t seen any evidence that they’d been able to manage the pressures of inflation. And it turned out that we were right, the gold companies did lag the rise in prices and lag materially. But that view that we had started to fade as we saw more evidence that companies were being better able to manage the inflation pressures, but also some of the inflation pressures were falling. And therefore, if prices were to continue to rise and our view was that that was likely to be the case, then you would see that expansion of profitability. And I think some of the latest results for the mid-year numbers of these of the gold companies have has shown that. And so we have seen some pretty strong performance in the gold names during the last few months.

CS: Okay. And finally, just a bit of a look at how you’re positioned at the moment with a view to the future. Maybe just give us an idea of the outlook for the supply and demand for different metals and where you feel the best opportunities are at the moment.

EH: Yeah, I think it really comes back to some of those themes that we mentioned earlier on. One of the things that we’ve been so focused on is trying to work out what’s gonna be a driver of supply and demand over the medium to long-term. And when we look at the supply side, the industry seems very constrained. We’ve got huge pressures around capital intensity. So that’s the cost of building new mines. That’s risen an enormous amount. We’ve seen the cost of building new capacity and copper more than double over the last few years. And we haven’t seen the price move to reflect that yet. And so that’s probably ahead of us.

We’ve seen some of the time pressures on building new capacity also extend. So whether it’s the ESG pressures, permitting, environmental studies and so on, you all of those are delaying the production or the build of new assets and adding to the cost and risk as well. So the supply side looks increasingly constrained.

We’re also seeing, very low levels of exploration success, which means that the kind of projects that we need to start discovering today that will eventually turn into producing assets in 10, 15 years time. That discovery rate remains very, very low. So the supply side is kind of, I guess, price inelastic in the short term. And also is something that’s building this pressure around this bullish case for many of those commodities.

On the demand side, obviously the global economy is moving along. We see pockets of strengths and areas of weakness. And I think China this year has been an area that has held back commodity markets. The uncertainty around China and some of the ongoing problems related to its property sector, and the inability of the government to be able to kind of get themselves out of the kind of the ditch that they’re in really has kind of taken some of the heat out of of the commodity markets.

But we’ve also been going through this kind of typical summer season of a lower level of industrial activity. And as we move into the autumn, that tends to fade that weakness and we start to get a kind of strong uptick in industrial activity. And therefore prices tend to respond to that. And with this the timeliness of this call is just ahead of that. So we would be hoping for that kind of uncertainty to kind of fall away and the macro picture to become a bit clearer and a bit more robust. And I think if that was the case, then obviously the portfolio given that we are fully invested we would hope that would do well.

CS: Okay. And just quickly on the portfolio, you mentioned it’s fully invested. Where are the sort of overweights at the moment?

EH: As I mentioned earlier on, our single biggest exposure is to the producers of copper followed by the gold producers. We then have large exposure to iron ore in the portfolio as well. And then the other commodities that we kind of tend to have at the fringe, you know, aluminium we have some zinc exposure. We have indirect exposure to some of the industrial minerals. Lithium being one of those.

I think it’s also important just to remind people that it’s not just the securities that we have exposure to, we also have exposure to royalties. And so they are more immune to cost inflation than the operating companies because they don’t have a cost base. They just get a slice of the revenue line or a slice of the commodity price. And so if the company produces more or discovers more, the value of a royalty tends to go up. But it’s not affected by the pressures on operating costs.

And we also have had some private investments in the portfolio as well. Many of those have actually IPO’d now. So they’ve done pretty well over the last few years. But we’re always on the search for that because one of our jobs is to differentiate ourselves from the alternatives that investors can look at. And if we’re just a portfolio of large liquid mining companies then I’m not sure how much value is gonna be created there, but if we do things that other people can’t do and provide that successfully, then we will be able to achieve our goal of delivering that superior total return through the cycle.

CS: Okay. On that note, thank you very much for joining us today.

EH: Thank you very much for your time, Chris. Pleasure.

SW: Managed by one of the most experienced teams in the market, the BlackRock World Mining Trust is a specialist investment trust offering exposure to mining and metals companies globally. In addition to investing in quoted securities, the trust may also invest in royalties derived from the production of metals and minerals, physical metals and unquoted securities. It also offers an attractive dividend yield to investors. To learn more about the BlackRock World Mining Trust please visit fundcalibre.com