Green Bubble & The Commodity Supercycle

(Haris Mohammad and Tian Adam)

In recent years, the consensus view on Wall Street has become that the fossil fuel demand is in terminal decline. Notable events, such as Saudi Arabia’s endeavours to reduce its stake in the oil company Saudi Aramco, have all contributed towards the belief that the world will have to increase its reliance on renewable energy in the future. Recently, we have seen investors pouring capital into the clean energy shares, taking many of them to unusually high valuations. In this article, we look to touch on the potential ‘green bubble’ that is brewing up as well as how commodities as a whole is a strong beneficiary which could lead to a potential ‘supercycle’.

Green Bubble

With 2020 being the hottest year to date and global temperatures expecting to rise 3 to 4 degrees Celsius by the end of this century, there has been a huge emergence and shift in investing towards ‘green orientated’ stocks and sustainable investments. Global funds have clearly demonstrated this interest in ESG-related stocks, investing over $350bn last year, a 47% increase from last year.

This shift has also been seen on an individual level, where consumers are purchasing goods that are ‘environmentally friendly’. For example, wind and solar energy grew faster than any other renewable resources, with solar growing 22% globally since last year. This increased household demand has been reflected in renewable energy companies such as NextEra Energy (largest electric utility holding company), with growth in excess of 16% year-to-date. Another really popular trend that is taking the market by storm is the increased demand for Electric Vehicles (EV’s). An ever-increasing amount of car manufacturers are changing their models to ‘electric-only’. Most recently, Ford has decided to pull the plug on combustion engines by 2030, investing over $22bn in electric technology by 2025. The stock market is also heavily forward looking when it comes to EV’s. The Chinese electric car manufacturer Nio trades over 62 times its revenue with a market cap over $111 billion.

The S&P Global Clean Energy index captures this trend succinctly (as seen below), by collating 30 companies around the world that are involved in clean energy-related business. The growth seen below since the pandemic is tremendous, peaking at over 50 times forward PE ratio, heavily outperforming the S&P 500 index. Such high forward PE ratios are reflective of similar bubbles seen in the past. For example, the ‘dotcom bubble’, which involved the speculation of internet companies from 1995 to 2000, follows similar trend lines. PE ratios also peaked around 44 times. These high levels of market sentiment and confidence should be taken with precaution, as and when investors realise their profits, huge sell offs are at risk.

Ultimately, with cash sloshing around in the financial markets, capital is extremely cheap and accessible, further fueling a bubble. Other market participants have also been able to benefit from the energy bull run, in particular, copper and its applications with renewables.

The appearance of Doctor Copper?

Copper is nicknamed “Dr Copper” in commodity markets because it is a good gauge of economic activity, thanks to its numerous and ubiquitous applications, whether that is in industries such as car-making, electrical goods or in the building trade.

Having dropped sharply during the onset of the coronavirus pandemic, copper has since recovered to over $9,000 per tonne. More than half the world’s supply of copper is bought by China, that being said, demand-side factors aren’t the driving factor towards the sharp rise in price. Many analysts have pointed out that the rally at that time was apparently driven by drawdowns in copper stocks from warehouses and concerns that miners in Chile and Peru, the world’s biggest two copper producers, could be afflicted by the virus. John Meyer, head of research at commodities specialist SP Angel, has told clients that there were specific factors influencing the price of copper in particular, not least a shortage of containers, which he believes has the potential to disrupt metal supplies into China.

Other factors that might have contributed to the rally are a weakening US dollar and rising inflation expectations. As copper is priced in US dollars, a weaker US dollar makes the commodity cheaper to those buying in foreign currencies. Increasing inflation expectations, which are the result of unprecedented central banks interventions and record fiscal stimulus agreements, are also increasing demand for commodities such as copper since they can serve as a good hedge and store of value if the consensus inflation expectations actually materialise.

Goldman Sachs predicts that the price of copper could reach $9,500 a tonne by the end of 2021 due to supply shortages and a rebound in demand. In the long term, one of the most important factors affecting the price of copper is the extent to which electrical vehicles will take off around the globe. An electric car uses about three times as much copper as a traditional petrol or diesel engine. Higher take-up of electric vehicles would also, in turn, will spur demand in industrialised nations for copper in cabling up and operating charging points. More copper will also be needed as economies across the world transition to renewable energy sources – both in construction of these new generating sources and also wiring them up to power grids and transmission networks.

It is important to note that the valuations of many ‘clean energy companies’ such as EV makers look stretched which is the consequence of record-low interest rates and ultra-easy monetary policy. A sudden rise in interest rates poses a considerable risk to such richly-valued companies as we have seen during the past week when the US 10-year treasury yield rose from little over 1.35 percent to almost 1.52 percent. An EV maker Tesla has declined close to 15 percent in that period. Any material declines in ‘clean energy shares’ could also impact the price of copper and related commodities.

Copper is up more than 15 % since the beginning of 2020. The Panglossian view is that it might have more upside potential, given the prevailing optimism about the vaccine and reopening of the economy. On the graph below, it can be seen that copper has shot through multiyear resistance level at around $7,000 per tonne in the final quarter of 2020 and is now headed towards the next resistance level at around $10,000 per tonne, where it traded in the aftermath of the Great Financial Crisis.

(Source: The Financial Times)

Conclusion

Short Term

In the short run, it is possible that many commodities which are related to renewable energy will continue to gain in value. This is the result of the optimism about the global economics reopening once the vast majority of the population has been vaccinated. It is also worthwhile to note that consumers have built up enormous cash savings during the past year because of unprecedented fiscal and monetary stimulus. Consequently, many investors, experts and economists are worried about the re-emergence of inflation later this year as a result of the pent-up demand. Commodities have traditionally served as a good protection against the inflation which could increase their demand in the coming months. Even though, many risks remain. If the inflation forecasts turn out to be inaccurate this could reduce the appeal of many commodities. Furthermore, since commodities such as copper are widely used in the green energy sector, any material decline in share prices of highly-valued ‘green companies’ could also impact the price of copper and related commodities.

Long Term

One of the key determinants as to whether the bull run in equities will continue to persist is whether 10-year global interest rates will continue to rise. The likes of the US, China, UK and Japan are now at their peaks in nearly a year. This general shift from low to higher bond yields is reflective of a prosperous economy and high confidence in the private markets. 

Investment firms have also foreseen this shift, with hedge funds such as Man Group and Caxton Associates implementing ESG as a key part of their investment process. In fact the most successful funds had put a focus towards ESG investment strategies. Invesco’s top two exchange traded funds (ETF) delivered returns of 238% and 220%.

All the above paired with stimulus packages (the US alone has generated stimulus packages in excess of $5tn), governments promoting renewables as well as implementing pollution and drilling limits, means a long term shift towards a more efficient and environmentally friendly world.

Summarising thoughts

Although we see the trend towards investing in clean energy and ESG-friendly companies, the valuations seen are arguably ‘overheated’, with true value being exhausted. These Panglossian views have resulted in herd behaviour, where investors are placing capital on their speculative view of these stocks. The consensus is a short term bubble is appearing in the market, and we expect the market to correct itself in the coming months.

References

Hume, N. (2021). Copper breaches $9,000 a tonne in bet on economic bounce and supply limits. [online] http://www.ft.com. Available at: https://www.ft.com/content/ce8405d9-b932-44e9-a965-ab7dc6d1e26f

Nauman, B. (2021). ‘Green bubble’ warnings grow as money pours into renewable stocks.

Financial Times. [online] Available at: https://www.ft.com/content/0a3d0af8-7092-44c3-9c98-a513a22629be 

King, I (2021) Sky News. COVID-19: Why “Dr Copper” offers an encouraging prognosis for world economy. [online] Available at: https://news.sky.com/story/covid-19-dr-copper-offers-encouraging-prognosis-for-world-economy-12166455 

‌Mackenzie, M. (2021). Should equity investors worry about rising interest rates? [online] http://www.ft.com. Available at: https://www.ft.com/content/054d7d05-ed69-445b-bfa3-c64397d5fa74 

Saleheen, J. (2021) Too early to call a commodities supercycle http://www.ft.com. [online] Available at: https://www.ft.com/content/484dc82b-9b28-4f8c-bda8-1a708e2aff6d

‌Mackenzie, M. (2020). Green energy funds top league table in banner year for ESG. [online] http://www.ft.com. Available at: https://www.ft.com/content/cad6fcf9-f755-4988-9c75-d41a9b6ff6d8

Glossary

Commodity Supercycle – An extended period of booming demand for a wide array of commodities, leading to a surge in their prices, followed by a collapse of demand and eventually prices.

Doctor Copper – Market lingo for this base metal that is reputed to have a “Ph.D. in economics” because of its ability to predict turning points in the global economy. 

Panglossian – Marked by the view that all is for the best in this best of possible worlds (excessively optimistic).

Herd behaviour – A phenomenon in which individuals act collectively as part of a group, often making decisions as a group that they would not make as an individual.

Green shares – Shares of companies which are operating in the renewable energy sector.


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