Which technologies will prevail? What materials will be required to enable those technologies? These are just two of many questions yet to be answered.

One thing we know is that decarbonisation will be mineral intensive. The world is switching from a fossil fuel-based power system to one which is essentially metals-based. The power source may be wind and solar, but wind turbines are 70% steel, while copper is required to generate and carry the electricity.

It amounts to what we might call a ‘shock of the old’. In the 1980s, a BBC television series titled ‘The Shock of the New’ explored European society’s encounters with modernism in art. In today’s economy, the clash of cultures is closer to the opposite: an economy increasingly focused on transitioning to a clean-energy future is having to grapple with old industries with old business models and old technologies that are essential for enabling that transition.

The intensifying focus on tackling climate change has combined with other, nearer-term factors to put the spotlight back on commodities:

• Pandemic stimulus packages have led to consumers buying durables and to governments promising green infrastructure.
• Logistics bottlenecks have highlighted the weaknesses in just-in-time global supply chains, leading companies to consider larger inventories and even on-shoring.

It adds up to a complex backdrop for materials markets. We believe there will be many opportunities for commodity investors as the energy transition progresses, but they will not always be obvious. And those looking to capture them need to be active and careful, because supply/demand balances are volatile and long-term structural themes will continue to crash into short-term stocking cycles.

As active investors, our aim is to pinpoint where capital is most needed and will generate the best returns. That does not only mean identifying the right technologies and materials. We also need to work out which companies are making a success of the decarbonisation-driven trends in their sector and are able to generate good returns on capital.

This report examines two commodity markets that are essential to the net-zero transition, copper and steel, and considers the investment outlook.

Everywhere one turns, someone seems to be giving the bull case for copper. From electric vehicles (EVs) to wind and solar farms, copper is required to generate and/or conduct the electricity – so it must be a winner from the energy transition, the argument goes. Of course, copper has always been used for these purposes. But as the energy system electrifies, more of the metal is needed than ever.

The new intermittent and distributed power sources use more copper because they need more capacity (as utilisation is not 100%). The International Copper Association (ICA) estimates that solar and wind generation consume 3 and 6 tonnes of copper per megawatt (MW), respectively, compared to 1 tonne per MW for thermal power. As for electrified transport, on average (again according to the ICA) about 80kg of copper is used in every pure-battery EV, compared to 20kg in an internal combustion engine (ICE) car. EVs also require a new charging network, which will be built partly from copper.

With Western governments committing to spending on renewable energy and its infrastructure, we appear to be entering a cycle where demand for metals such as copper will be strong not just in the emerging East but once again in the West. Not surprisingly, copper prices have recovered rapidly from the pandemic-driven downturn in the first half of 2020. They have hit record highs in recent months, surpassing the levels reached in 2011 as a consequence of the Chinese infrastructure and construction boom unleashed following the 2009 Global Financial Crisis. Of course, prices in real terms are nowhere near these peaks, and many market-watchers expect much higher levels before this cycle ends.

These arguments are simple and powerful, but they are only part of the picture. As commodity analysts learn early in their careers, prices are determined by supply as well as demand.

Confidence in copper demand is influencing supply

Because miners have come to regard adding copper capacity as a no-brainer, what little capital they have been spending has been on copper. BHP is commissioning Spence sulphides this year; Teck is building Quebrada Blanca 2; Anglo American and Ivanhoe Mines are developing Quellaveco and Kamoa-Kakula, respectively; Rio Tinto is plugging away at OyuTolgoi; First Quantum has just brought on Cobre Panama; Glencore has rebuilt Katanga and restarted production, with Mutanda to come on next year; and Oz Minerals is ramping up Carrapateena in Australia. This adds up to approximately 2.5Mt per year of predominantly new production, or over 10% of demand, which will come on over 3-4 years. There are many other smaller projects and expansions.

In 2021, supply expansion looks set to approximately match the strong recovery in demand, with the consensus forecasting growth in the latter of over double the long-term average at over 6%. New and expanded mines are the main source of supply, but scrap will also rebound, after collections were disrupted last year by lockdowns. Growth in industrial production will result in more scrap and higher prices, which in turn will incentivise old scrap collections.

One investment thesis posits that copper investors will enjoy better returns as the world recovers from the pandemic and as demand strengthens further once the promised infrastructure spending materialises. However, the concern is that we are actually witnessing a normal restocking cycle. While the green-transformation structural story is attractive and real, this spur to demand may be balanced by supply growth as miners focus on the seemingly more certain areas of future commodities demand (i.e., including copper), and as sustainability-focused investors rush to back the ‘good guys’.

The pathway to decarbonising copper production is clearer than for many metals

Sustainability concerns have long deterred some investors from the mining sector. But copper in fact ticks a lot of boxes for investors that focus on environmental, social and governance (ESG) factors, not least because its production process is potentially easier to decarbonise than those of some other metals, like steel and aluminium. Copper is extracted either by leaching or smelting: the former produces no CO2, the latter very little (the exothermic reaction created by sulphides produces SO2, but that is all captured and turned into acid, which is needed for leaching). Thus, the CO2 emitted in refined copper production is largely from the diesel required to power mining trucks and drive crushing/grinding, concentrating and refining circuits. This is not to say the CO2 produced currently is insignificant – estimates range from 1-8kg of CO2e/kgCu – but by switching to renewable power and then electrifying trucks, there is a clear pathway to decarbonising copper production.

The long-term case for copper is robust, but the short term is more uncertain

Overall, the fundamentals of copper look strong to us in the long term. With such a powerful structural story behind it, the outlook for copper demand appears very positive. Yet the simple nature of this story is a problem for those considering investing in copper companies now, because the market has latched onto this theme and run hard with it. Copper projects/companies have been, and will continue to be, the first to get the capital they need to develop.

Investors should be wary of getting carried away by the hype. The copper market will remain cyclical and volatile, and once this restocking cycle has run its course, prices could come back viciously. But long-term investors need not worry. As long as they really are long term.

Steel is one of the highest carbon-emitting industries in absolute terms, due to the volumes produced and because coking coal is required both as fuel and support in the blast furnace. Coking coal’s dual function makes it hard to substitute. Steel’s pathway to decarbonisation is therefore uncertain, which has made investors, already wary of poor returns, even more reluctant to engage. So just as everyone is clamouring for steel to build green infrastructure, no one seems to want to invest in it.

Demand growing to meet infrastructure needs

Steel demand in recent decades has been driven by China’s growth, as the charts show. But the 10-fold increase in Chinese steel consumption over the past 20 years has masked very weak demand elsewhere. Western demand peaked in 2006/7 and never fully recovered from the Global Financial Crisis, held back by austerity measures in many countries and a focus by a lot of companies on shareholder returns, which discouraged capital-intensive investment.

Figure 1: Steel demand

Source: Worldsteel, BMO Capital Markets December 2020

Figure 2: Crude steel consumption, year on year

Source: Worldsteel, BMO Capital Markets May 2021

Now, for several reasons, the tide is turning on steel demand in the West. First, in response to the economic shock resulting from the pandemic, politicians have been looking to infrastructure projects to stimulate their economies. Second, the urgent need to transition away from fossil fuels has added to the impetus for the kind of infrastructure spending that characterised China’s recovery from the Global Financial Crisis. Finally, increasing trade tensions and COVID-related supply disruptions have encouraged US and European politicians and companies to look to develop more independent supply chains, which in turn may drive up steel purchases.

While it is still unclear how quickly infrastructure programmes like the Next Generation EU Fund and the American Jobs Plan can be implemented and by how much they will boost materials consumption, cross-party political support for both of these initiatives is strong, suggesting a likely increase in steel demand over the next five to 10 years in the targeted areas.

Supply not growing after years of poor returns and consolidation

Even before these infrastructure plans have been implemented, steel prices have reached all-time highs in every market. As with copper, this has been driven largely by strong ‘restocking’ demand as automotive, appliance, home-related and warehouse/data centre markets have all bounced back. This is partly because lockdowns drove consumers to switch spending to consumer durables, given the lack of opportunities to spend on services such as travel and leisure. Clearly, these effects would be expected to wane as economies open and consumers can resume taking holidays and going out. However, unlike with copper, supply chains for steel have become so destocked that a return to normal levels could take longer than usual, for several reasons:

• Industry consolidation: The recent surge in steel demand has come as the US and European steel industries have undergone a further round of consolidation. Cleveland Cliffs’ acquisitions of AK Steel and ArcelorMittal’s North American operations in 2020 have reset the US industry, and given steelmakers more market power than they have had in decades. In Europe, the impact of the deal between ArcelorMittal and the Italian government over control of Ilva should not be underestimated. It came after several years of slow consolidation and closures in Europe, where oversupply had previously been endemic (the legacy of nationalised and protected industries).
• Uncertainty over emissions targets and poor returns have deterred investment and restarts: There have been several years of underinvestment in supply – partly as declining demand and poor returns forced steel companies to focus on survival, and also because the growing focus on emissions has made steelmakers cautious. Average emissions from steelmaking in the West are around 2 tonnes of CO2 per tonne of steel. While this is lower than for many metals, the volume of steel produced means that in absolute terms the steel sector is one of the highest emitters (as we noted earlier), and it is consequently the focus of many climate-focused NGOs and investor groups. With such pressure on steelmakers to limit and reduce emissions, many have been reluctant to restart their older, less efficient plants, despite margins being at record levels.
• Stronger balance sheets have empowered steelmakers to pursue value over volume: In response to poor returns in recent years, many steelmakers had reduced their debt. As prices and margins have risen, the resulting surge in cashflows has in many cases eliminated their debt burdens altogether. Thus, steelmakers are under less pressure to chase every marginal tonne to generate cash and pay off debt, and can instead pursue the ‘value over volume’ strategy that miners have been extolling for the past five years. This has had a further limiting effect on supply expansion.

China no longer wants to import emissions and export deflation

Another limitation on the supply of steel to the West is China’s increasing focus on tackling pollution. Heavy industry’s impact on air quality and emissions has been a growing problem for a number of years, leading to much stricter controls. In the new Five-Year plan, which began this year, tighter targets for CO2 emissions have been set and provincial authorities, keen to show Beijing that they are aligned with them, have been quick to restrict steel production.

With domestic demand still strong, the Chinese government has begun to try to reduce steel exports, by removing a 13% VAT rebate. There is now talk of export taxes being introduced, both to safeguard supply for domestic buyers and to reduce emissions. China has for some years been the marginal supplier of steel to Western markets, so these developments should push up long-run steel prices in the West.

Prices will fall, but look likely to base at higher levels

Of course, the restocking cycle will end at some point, and steel inventories are rising in China. But they remain near record lows in the US and Europe, and downstream inventories of products such as automotives are also very lean. As the tightness eventually eases, steel prices should fall back. But it seems likely that in the US and Europe, they will settle at a significantly higher base level than previously.

We think developments in recent years provide a major opportunity for the steel industry to modernise. Governments keen to promote infrastructure investment and accelerate the clean-energy transition need to ensure the steel industry can support these objectives. That means higher margins will be required to attract capital to the steel sector. This may be the time for investors to set aside their understandable historical reluctance to consider allocating to steel.

Energy transition should provide many opportunities for companies and investors

As the basis of the world’s energy supply shifts from fossil fuels to mainly metal-based technologies, we face upheaval in many commodity markets – the start of which has been seen in the past 12 months. COVID and its aftermath are partly responsible, but the impact of years of changing patterns in capital investment is also becoming evident. Typically, price expectations must rise to entice investors and producers to add supply, and that is exactly what is going to happen for a number of commodities.

We believe there will be many commodity-related investment opportunities as the energy transition progresses, but the issues are complex and continually evolving. We think an active investment approach will be crucial for managing them successfully, while also giving investors the chance to engage with companies to help them navigate this crucial economic transformation. After all, the world will only achieve its climate goals if the heavy emitting industries transition to low-carbon models. Avoiding the issue by divesting will not get us to net zero.

For policymakers and society, there is a broader lesson. To decarbonise the world and make the transition to net zero, abandoning ‘old’ industries will not work. We have to invest to decarbonise. Otherwise, the ‘shock of the old’ risks upending the birth of the new, modern economy we all want.