The Capital Cycle Podcast - Copper Turns To Gold

Episode Date: August 2, 2024

An exploration of the capital cycle in copper, how long it might last, and the investment implications. Presented by Edward ChancellorWith Alex Duffy, Portfolio Manager Emerging MarketsFor more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Welcome to the Capital Cycle podcast from Marathon Asset Management. My name is Edward Chancellor. I'm a financial historian, journalist, and former investment strategist. In these podcasts, I will talk to the authors of Marathon's Global Investment Review about their current investment thoughts. So with me today starting, I have Alex Duffy, whose Marathons Emerging Market Fund Manager, and we're going to talk about red gold, copper, Dr Copper, as they sometimes call it, which has been in the news a lot recently.

Last week, the Wall Street Journal had a piece pointing out that the copper price on the London Metal Exchange had gone up 34%. from February before falling 14%. And the Wall Street Journal seemed to be in two minds about whether the outlook for copper was positive or negative. They talk about supply constraints, which we're going to talk about.

But they also worry about unconventional copper sources coming on and worry about China's real estate decline, so forth. So, Alex, I want to start with a piece you wrote. in December 21 on the copper miners. You discuss in this piece the mining capex boom of the early 2010s, and then what happened afterwards? I think when we look at sectors, when we analyse industries here at marathon, we're very focused on supply-side dynamics,

and particularly the flow of capital into and out of particular sectors. And a key principle of the investment philosophy is quite simply, the long-termism that we take. Capital cycles tend to be long-term in nature, and it takes a good while for the capital allocation decisions of companies and indeed entire sectors to have an impact on the returns of those sectors, or indeed the price of a particular resource in this instance, copper. And I think that what we witnessed over the 10-year period leading up to 2014 was a very classic capital cycle that was rooted in underinvestment from the prior decade that led to increases in price as mines couldn't respond to the demand boom that came from China.

And inevitably, that attracted capital into the sector. And I vividly remember those trips to the Congo and we were experts on the coal-wazy mining belt and all of these sort of unique mining assets that attracted lots of capital and then were unable to deliver. and ultimately capital started to exit the sector. And management teams and shareholders bore the scars of that experience for many years that subsequently led to a period of very constrained capex and investment. In that earlier piece, you mentioned a capital cycle metric, which I think is useful. You talk about the capital spending as share of operating cash flow.

Do you remember what happened with the mining Cappex to cash flow? As that sort of Cappex boom prior to 2012 took off, what we witnessed was a high degree of overinvestment. So companies been rewarded for reallocating capital back into new supply that led to Cappex in excess of operating cash flows north of 120% of the operating cash flow is being invested back into the businesses. As that cycle washed through, then Cappex was restrained. And we've been through a significant period.

where mining CAPEX has been around 40% of the cash flows of the companies. So that inevitably led to that excess cash being returned to shareholders, which creates its own value via dividends and buybacks. Dividends and share buybacks, particularly importantly at low share price valuations, but also actually restricting the investment in existing mines that has created a situation today where those mines are unable to keep up with the required mine supply of the industry. So you inevitably get to a point where capital investment declines below depreciation. And so the mines are not investing enough to sustain base levels of production,

never mind enhance supply and increase output. And you referenced the Wall Street Journal article earlier on, and clearly what we've witnessed is sort of dislocations in commodity prices. but that's really just a consequence of the capex cycle within the industry and the fact that these mines are unable to respond to the sort of demand responses. And I think probably what's interesting about the fact you wrote this quite bullish piece on Outlook for Copper Miners in December 21 is that since then, China's property market has been in turmoil and China is the single largest consumer of copper.

I think what this illustrates, tell me if I'm wrong, is that it is, If you buy a stock in a benign capital cycle, it is robust even when its major customer actually runs into trouble. That's exactly the point. There have been many reasons to be anxious on the demand side of the equation when it comes to cover. Yeah, we can throw in electric vehicles not meeting demand or problems in wind turbine sector as well. And the impact of that and the duration of it is very difficult to. predicting is uncertain. And so the principle of the capital cycle framework here at Marathon is that we don't worry about the areas that we have an inability to forecast. And actually, if you look at the

supply side of the equation, it's relatively straightforward. The industry is consolidated over the last 10 to 15 years. We've seen a dearth of investment in exploration and production. Can I ask you, you mentioned in both pieces about the lack of greenfield expansion, why that say down, what are the impediments? So they've evolved over time. The initial impediment has just been that mining companies, because of the experience they've had previously, have reduced overall investment. Increasingly, however, we've been mining copper assets for well over 50 years in terms of the low cost reserves, and those reserve bases are now being depleted. Thus, you need to see investment in areas either from a geopolitical perspective, which are more difficult

to mine, so where you have less certainty over tax structures, left certainty over regulatory regimes, or increasingly mining jurisdictions, which are at altitude. So there's a big new project on the Argentine and Chilean border, but it's at 5,000 metres. And that has huge implications for your ability to actually access that reserve base. And added to that, it's been increasing environmental considerations. And that has, you know, meant that it's taken the development curve for mines which was once seven to 10 years, well north of 15 years to develop and has huge implications for your ability to bring new mines into production even if the capital were available. And that gives you, as an analyst, greater visibility of the capital cycle, giving these

long lead times. Indeed, it does. You can see where the capital's going. You can reasonably predict how that capital may result in future production growth and the time that it takes for that to come on. It also has implications, however, how we value companies within the sector. I know that's a slightly sort of different area of focus. But when you have increasing capex budgets, capital costs, increasing costs of capital and increasing time horizons, the value of producing assets goes up disproportionately relative to Greenfield. And that's what we're witnessing. I think that's a very good point. And this is contained in your more recent piece, which is that as the cost of developing new mines increases,

the value of the legacy assets rise in tandem. And what you seem to be saying in your second piece is you're trying to build that into your updating the valuations of the Marathon Copper Holdings. And also the other point you made was looking at the residual assets. You mentioned that the saleside analysts have a sort of 30-year mining project spreadsheet and they don't put in a residual value, whereas you have some interest in the residual. or value? Absolutely. As long-term owners of the companies that we invest into, we are interested in the intrinsic value of the entire asset base. And when you have a very large, low-cost mining asset,

Southern Copper's copper mines as a casing point in Mexico and Peru, what the 30-year DCF fails to capture is the fact that you have another 50 to 100 years at least of mining reserve at the end of the DCF period. So what do you do with that value? And interestingly, a number of these, what we call tier one assets, large, low cost copper assets, tend to produce well below the potential of the reserve base. Yeah, you say that southern copper is only operating at 50% of its potential. Correct. Delivers roughly a million tonnes a year of copper output, but clearly has projects if they were able to bring them into production, which would be able to double that output. And from an MPV perspective, the backdating of that value means that the current share

price doesn't really reflect the value of the reserves in the ground thereafter. What you say in the piece is Southern Copper might look optically, reasonably, highly valued on what price earnings, price to book or whatever. On a price to cash, current cash flow basis. Okay, but then on your model, when you factor in the long-term reserves, then it looks still reasonably priced. Absolutely. So to put that into context, it would cost roughly $25,000 to $30,000 per ton of production to build a new mine on a good day in this current environment. And if you were to apply that valuation framework to the reserve base at the end of the 30-year DCF of Southern Copper, you get significant sort of underappreciated value in the shares. So you mentioned Southern Copper in your December 21 piece,

and what I thought was interesting is I then looked to see how stock had performed against the copper price, movement of the copper price, and bearing in mind what we've also discussed, the collapse, the China property market. And so you'd say that southern copper is sort of bearing out your positive view on the capital cycle. Well, I think so. And we've seen that across the copper complex more broadly. The unique thing about a southern copper asset base, however, is that it's at the bottom of the OPEX and capex curve in known resources. So this is not geology that we don't understand. It doesn't require new mining methods. The capex cost is relatively well understood versus incremental supply that comes in at the top of the cost curve that's exposed

to far more variability in terms of OPEX costs, CAPEX cost, tax regimes and so forth. And so we think that that greater certainty in terms of the return metrics of Southern Copper's asset base warrants a lower discount rate and has greater value to it as well. Right. In that second piece, you mentioned the famous capital cycle adage, that the best cure for high prices is high prices. The idea being that high prices will bring on new supply, but you're saying that copper cycle still looks potentially benign.

We've seen excitement in the area, the BHP failed bid for Anglo-American. Do you want to discuss that briefly? What about that signal to you? I mean, I think that we have witnessed increasing investor attention, media attention, on copper as an asset, as an asset class as well. And I think that if mining companies were able to bring new supply to the market in terms of greenfield, they probably would do.

There's still reticence on the part of shareholders for mining companies to go on capex splurges. But when you add together the inflation of capital costs, the environmental permitting process, the time to first or in terms of production, it's quite clear and evidenced by the behaviour of Glencore's bid for tech, BHP's bid for Anglo, that it's far more economically rational to buy assets than it is to build new ones. Which is on the whole positive sign. So final point, the Wall Street Journal, as I say, was sitting on the fence after the copper price.

after the copper price fell 15%. And they tried to drum up some negative thoughts justify the decline in price. And they mentioned the supply of copper scrap might exceed expectations. They also drew attention to lithium. As you know, lithium has collapsed. And there, there have been new supplies brought on.

And I think it's true of nickel too. Am I right in saying, Indonesia nickel production today? So just briefly, how copper stands out against these other energy trials. transition materials. Yeah, so I think the key distinction is that lithium supply, and to a degree the nickel pig iron that comes out of Indonesia, that supply constraint is really a capital constraint. There's plenty of lithium, known lithium reserves. They just haven't been developed because

there hadn't been a need or a use case for the commodity until recently with the advancement of battery technology and lots of excitement around that particular area. And so it's a capital issue. The distinction with copper is that it's really a geological issue and an environmental permitting issue. So, yes, capital will come into the sector and we're acutely aware of the risk of that and follow it quite closely. The time frame to bring for that capital to actually result in new production is far more extended than what we find in lithium. And I think that, you know, you've seen that that's why Glencore, you referenced earlier on, they've always made this point is that there's no resource constraint in lithium, whereas there is a resource constraint in copper.

And so what makes us slightly more nervous would be technological change. Yes, in electricity transmission. We don't see that yet. We haven't seen that yet. So at certain prices, you do get substitution into aluminium, but the properties of copper as a conductor of electricity, we haven't yet come up with anything better. And increasingly, when you look at the application, whether it's data centers or AI or elsewhere, they require high levels of energy intensity.

Finally, it's not just you at Marathon who takes a cop bet. Some of the other portfolio managers also have copper bets across their portfolios and other regions. Yes, so exactly. We've talked about it today in the context of emerging markets, but obviously the capital cycle in copper is a global event. And so we have that exposure across our various regional portfolios, whether it's the developed Asia portfolios, European portfolios, or indeed the US portfolios. And I think that that really amplifies the capital cycle exposure for our clients through our multi-counsela model that we operate here at the firm.

Thanks, Lord of that, Alex. Thank you for your time today. I hope you will listen to the next edition of the capital cycle. This communication is provided for information purposes only. please refer to Marathon's website and the Global Investment Reviews for further information, including important disclosures.