Value Investing

Marathon Asset Management 2011 Note: Commodity Supercycle Woes

Commodity Supercycle Woes by Marathon Asset Management, dated May 2011 – another great call. This is discussed in their new book Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 we think – anyway read it below.

Commodity supercycle woes – The commodity industry is showing the classic signs of a Capital Cycle peak

A cursory analysis at the capital cycle for the commodity industry – in particular the huge expansion of commodity capital expenditure in recent years, and the precarious nature of Chinese demand for raw materials – suggests that the much hyped “commodity supercycle” is entering a downturn.

This capital cycle started a few years back after the pick-up in commodity prices led to a material improvement in the returns on equity for mining companies. Initially, the miners’ response to improved conditions in their industry appears to have been quite controlled – capital expenditure relative to cash flow somewhat declined in the early 2000s as commodity prices began to rise. Nor was there a bubble in the stock market. Mining shares performed well because their fundamentals had never been better.

The bad news is that commodity industry is showing signs of a classic capital cycle peak – higher returns on invested capital are attracting more capital and higher share prices leading to more mergers and acquisitions and IPOs. Total mining capex from 124 companies in the MSCI All Country World Index is predicted to rise to a whopping $180bn in 2011 from less than $30bn ten years ago – a six-fold increase.

The impact of all this investment has come with a lag. After a delay of several years, the surge in mining capex, however, has propelled production volumes to new highs. Merrill Lynch estimates that between 2000 and 2014, global nickel production will have climbed from around 1,000 metric tonnes to around 2,000 (a rise of 100 per cent), copper from some 15,000 metric tonnes to over 20,000 (33 per cent increase), aluminium from roughly 25,000 metric tonnes to over 50,000 (100 per cent increase), and most impressively, global iron production is set to rise from 1bn metric tonnes at the turn of the century to around 2.25bn by 2014, an increase of 125 per cent in just over a decade.

This change in mining fortunes has not been lost on investment bankers who, true to form, have brought ever more seductive commodity-themed IPOs to market. Between 2005 and 2010 the number of Metals & Mining flotations rose by climbed by 50 per cent. The bankers have also abetted their mining clients in an M&A frenzy, as deals in the sector have become larger and larger. Large numbers of IPOs and high M&A activity in any sector tend to occur in the later stages of the capital cycle.

Thus, ever rising amounts of capital are coming into the sector at a time when commodity prices are well above marginal costs of production even for the high cost producers. When this commodity supercycle eventually turns, there is potentially a long way for commodity prices to fall before they reach replacement cost. This could pose a problem for benchmark-hugging investors since the Metals & Mining sector – up more than three times from its 1999 low – is currently close to its all time high as a share of the FTSE World Index.

Many commentators enthuse about a “new paradigm” for commodities associated with China’s rise. Almost all of the demand growth commodities is due to China’s insatiable appetite for raw materials. The Middle Kingdom now consumes around half global production of iron ore, nickel, copper and zinc. The commodity bulls, however, seem to be overlooking some troubling signs. The most obvious of these is the inexorable rise of Chinese fixed asset investment to around 50 per cent of GDP – even in Japan, with its penchant for building roads to nowhere, investment peaked at only 30 per cent of GDP. It is not surprising that much of this capital is being wasted. The Chinese industrial sector’s return on net operating assets is low and continues to trend downwards. Low profitability doesn’t stop Chinese SOEs from investing, however. In the power industry, for instance, capital expenditure is running at over 100 per cent of operating cash flow (cement and steel capex relative to EBITDA is running at only marginally lower levels). To make matters worse, all the above mentioned sectors are also over-indebted. Optimists are hoping that Beijing will encourage industrial consolidation and reduce capacity. But even if this does occur, the reduction investment growth in these industries won’t be good news for overall commodity demand.

Investors are ignoring signs of an over-heated Chinese economy and are enamoured of a commodity sector that has attracted, and continues to attract, large amounts of capital and where supply is inexorably increasing. To our minds, all this is clear evidence that the current chapter in the commodity story appears much closer to its conclusion, than the beginning.

Capital Returns Investing Through the Capital Cycle Commodity Supercycle

Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 1st ed. 2015 Edition by Edward Chancellor