Of all the problems South Africa faces at the moment, and there are many, commodity prices is not one of them. With some exceptions, the coronavirus shock did not hit commodity prices as hard as you would have expected given the economic collapse.
The most high profile exception was of course oil, with US prices briefly turning negative in one of the more bizarre moments of financial history. Notably though, the slump in oil prices was massively compounded by Saudi Arabia’s decision to launch a price war against Russia and other producers in an already panicked market environment. They have since kissed and made up, and in the process cut back on production to prop up the oil price. Though well off its lows, the price of a barrel of Brent crude is still around 35% lower than at the start of the year.
From South Africa’s point of the view, the lower oil price is largely good news since we are an importer. A lower oil price translates into a reduced import bill, lower inflation and indirectly, lower interest rates. Where it did hurt was the steep decline in Sasol’s share price, necessitating the heavily indebted petrochemicals group to commence restructuring. Today it trades around 80% below its all-time high, and 60% below its January level. Though a staple of domestic portfolios, the fact that it didn’t drag down the whole market is testament again to the importance of diversification.
Another area where the oil price collapse indirectly impacts South Africa is the currency. The rand is highly correlated with commodity prices and is viewed by investors as a commodity currency. Big declines in oil and other commodity prices tend to weigh on the rand (even though we don’t produce oil). This does have the benefit of somewhat offsetting dollar price declines from the point of view of local miners. However, miners and investors think and plan in dollar terms, and the prices and price changes below are quoted in US dollar terms, as is convention.
Coal prices have also been negatively impacted by the pandemic, and are trading about 30% lower than at the start of the year in US dollar terms. This is hardly surprising given the declines in electricity demand here and abroad. But South Africa’s other three major export commodity prices held up well. These are gold, platinum group metals and iron ore. Before looking at each in turn, it is worth noting that the combination of lower oil prices and decent commodity export prices have contributed to a R13 billion trade surplus for the first five months of the year. The same period last year saw a R7 billion deficit.
Iron up
Iron ore prices are up about 15% in dollar terms since the start of the year. This is surprising at first glance since it is used in steelmaking, and steel demand in turn is heavily tied to the global economic cycle. But the red rusty dusty mineral has benefited from the fact that China’s recovery from its pandemic-related shutdown is rapid and leads the rest of the world by a month. Being the largest steel producer, China is the also the main importer of iron ore. On the supply side, the coronavirus has disrupted production and logistics in Brazil, the number two producer (behind Australia). South Africa, also a major producer (though far behind Brazil), saw iron ore output fall 68% year-on-year in April for the same reason.
When it comes to platinum group metals (PGMs) palladium is flat year-to-date and platinum around 15% lower in dollar terms. However, palladium is still 25% above where it was a year ago, and 130% above where it was three years ago. Palladium is used in catalytic converters in petrol and hybrid vehicles to reduce toxic emissions. It is usually produced as a by-product of platinum and nickel, and with emission standards tightening, it is in short supply. It has become the more glamorous of the PGMs, with platinum losing its shine, so to speak. The latter is used primarily in diesel cars, whose reputation has not recovered from the Volkswagen emissions cheating scandal.
South Africa is the world’s largest producer of platinum by far, but only number two for palladium (behind Russia). Predictably, the platinum miners are trying to shift their focus towards palladium, but it is a slow process. The main reason why commodity cycles are so pronounced is that supply takes a long time to catch up with demand since building a mine can take many years. This tends to lead to a period of high prices which incentivises more production form new or existing mines. This invariably comes on stream more or less at the same time demand starts to wane, leading to falling prices and excess capacity. Wash, rinse, repeat.
Chart 1: Platinum and palladium prices, $/ounce
Shining like gold
The real excitement, however, has been in the gold market. The past week saw the price of gold close above $1 800 per ounce for the first time in nine years.
Gold’s new highs are strongly related to the collapse in real interest rates in the US and other major markets. Since gold does not pay any interest, the opportunity cost of holding it rises with real interest rates. When real interest rates are low or negative, investors don’t lose out on income if they choose to hold gold over bonds or cash.
Chart 2: Gold and US real interest rates
At the same time, there is a fear that all the money being created by monetary and fiscal authorities to combat the global recession could lead to runaway inflation. This fear is overstated, since accelerating inflation would require continuous money creation (a policy error, in other words) and for all the ‘money’ to be lent by banks and then spent by businesses and households, rather than being hoarded. Nonetheless, there is a strong belief that gold is the ultimate inflation hedge. This too is overstated. Gold lagged inflation for 30 years between 1982 and 2012, even as inflation rates were declining. Where it has shone, so to speak, was in the period of very high inflation in the late 1970s.
In other words, historically gold has been a good inflation hedge in that one extreme scenario, but does not necessarily keep up with gently rising inflation. There is no reason why it would. Equities are a far more reliable inflation hedge since there is a direct link to inflation. What you spend is the income of the companies that sell you goods and services. If your spending rises (i.e. inflation) their incomes rise too.
The US dollar is also important as gold and commodity prices tend to move inversely to the greenback. The dollar surge since 2011 has coincided with weaker commodity prices, while it has recently pulled back. There are a number of reasons for this relationship. The simplest explanation is usually that since commodities are priced in dollars, as the dollar rises commodity prices will decline to maintain the purchasing power of all global consumers. (For instance, if the euro falls by 10% against the dollar, commodity prices would also have to decline by 10% to keep the real cost of the commodities the same for European consumers.)
The relationship is not absolute, but when something becomes conventional wisdom it can move the market whether true or not. Another, often overlooked, factor is that the commodity trade is financed through the global banking system but largely in US dollars. A scarcity of dollars (which is what a higher exchange value of the dollar suggests) puts pressure on funding sources that impede the trade in commodities and other goods. In other words, a strong dollar is a sign and a cause of global economic weakness, while a weak dollar is sign of global economic strength.
Chart 3: Gold in inflation-adjusted terms
Gold shares flying
Predictably, the JSE-listed gold mining shares have been flying. The index of gold mining companies has almost doubled this year, and it feels like old times. Gold is after all the reason the JSE was first created in 1887, and it gave birth to a modern, albeit highly unequal economy. However, today gold is a very small part of the JSE. From a level of around 40% in the early 1980s, gold miners fell to less than 2% of the JSE’s market cap before this recent rally. This reflects the fact that most of the ore has simply been mined out, and what is left is generally very deep, and expensive to extract. Total gold production has declined by more than 80% since the heydays of the 1980s. From being the number one global gold producer, South Africa is no longer in the top five.
Mining headaches
The sad reality is the mining industry in total has struggled. Excluding the recent coronavirus-related slump, Stats SA data tells us that overall mining production has flat-lined for 10 years at levels well below the peak of the 2002-2008 boom. There are a number of reasons for this.
Electricity supply and cost has been a major headache for the mining industry, and unfortunately load-shedding is back on the table since this weekend. Transport infrastructure is also not up to scratch. Regulatory uncertainty and tumultuous labour relations are also major impediments to mining investment. Sinking a shaft costs billions, and to recoup the cost and make a profit over time for shareholders, mine bosses need to know they can count on the rules of the game remaining more or less the same.
Under the Ramaphosa administration, the levels of engagement between mines and government have improved tremendously, but there are still outstanding regulatory issues that constrain investment appetite.
Having said that, in the end it is all about risk and reward. If the expected reward is great enough – if commodity prices are high – history shows miners will invest even under tenuous regulatory arrangements and with shoddy infrastructure. And investors will shower them with capital.
This point applies generally for policymakers hoping to stimulate economic growth: if the expected return from a given investment is on the low side due to weak consumer demand or any other reason, the focus needs to be on lowering the cost and risk side of the equation to make the numbers work. This includes more stable labour relations, reasonably priced and reliable electricity and other basic public goods, cheaper broadband connectivity and efficient transport networks. Whether this point has been fully grasped remains to be seen.
Major driver
Regardless of the state of the domestic mining industry, resources shares have been a major driver of the JSE over the past year, just as they were a major detractor of the performance of the local market between 2014 and 2018. It is somewhat ironic in our technological times that the market is so dependent on a smoke-stack or “old economy” industry, but that is the way it is. This is an important reason to spread risk beyond local equities, but by the same token a reason not to write the asset class off.
Izak Odendaal and Dave Mohr are investment strategists at Old Mutual Wealth