Commodities go green
The energy transition is paving the way for new favourites
The ups and downs of energy commodity prices are partly a symptom of the ongoing transition to green energy
Decarbonisation efforts in the energy sector are triggering a super cycle for industrial metals
Commodities remain an attractive asset class over the long term
Green commodities (r)evolution
The commodities markets are in a state of upheaval, and nowhere is this more evident at present than in the energy segment. This sub-sector has always played a dominant role – given the significance of energy as the fuel that keeps the global economic engine running – but is now being turned on its head by the global push for decarbonisation.
Structural trends are shifting and affecting not only energy. The general view of commodities as an asset class is changing. What will be the commodities of the future? Which sub-sectors will gain in importance, and which will lose? In this paper, we aim to provide an overview.
European gas prices have been on a rollercoaster ride, the like of which has not been seen in the commodities markets for a long time. Since the start of 2021, Dutch futures, considered the primary indicator for this commodity, have gained more than 300 per cent. On 6 October alone, the volatility range was over 50 per cent. Market participants were willing to pay almost any price in order to stock up on gas. This trend is attributable to a variety of reasons. For example, the spike in energy demand that resulted from the reopening of the economy after coronavirus-induced lockdowns coincided with scarce supply. Following a cold 2020/2021 winter season, inventories are at below-average levels. Uncertainty about gas supplies from Russia – partly in connection with discussions about the new Nordstream 2 pipeline – is creating additional upward pressure on gas prices in the short term. Last but not least, gas-fired power plants will remain on the grid for a long time yet because of the high level of flexibility in energy generation that they offer, for example to balance out fluctuations in the supply of renewable energies.
The expansion of renewable energies and the volatile nature of their supply to the grid also constitute the greatest potential driver for fundamental change in the energy sector and, by extension, the commodities market as a whole. More specifically, the decarbonisation of energy supply is setting in motion an energy transition that will affect not only fossil fuels but also industrial metals. This will push up prices overall and it will also reshuffle the deck with regard to favourites in the commodities sector. The asset class will therefore generally remain attractive for investors, but the focus will shift.
Is the transition to green energy triggering a new super cycle?
The commodities markets are shaped by super cycles that can extend over several decades. The dawn of industrialisation at the end of the 19th century and the rise of China as an economic superpower at the start of this millennium are examples of events that supported demand for commodities in general for more than a decade. They triggered a long-term increase in prices that made investments, for instance in new oil fields or mining operations, much more lucrative. This did not result in a sudden, huge jump in supply because large-scale mining projects, for example, tend to take five to ten years to become profitable. But phenomena such as the fracking boom in the US show that investment in new technology can change market conditions fundamentally (e.g. the dwindling power of OPEC).
However, if supply increases too much as a result of investment and innovation, prices begin to drop and the super cycle ends. The last super cycle reached its peak between 2011 and 2014, depending on the commodity. Since then, the dynamic has reversed, i.e. strong supply and muted demand have been causing prices to fall, which has discouraged investment. In the past seven to eight years, hardly any new oil fields and mining sites have been developed. A factor that contributes to this trend is growing pressure to decarbonise, which is further diminishing the appeal of investing in assets that may well become 'stranded'.
In the phase of economic reopening that began when coronavirus containment measures were lifted (and continues despite a renewed rise in COVID-19 cases), the implications of this trend have become very tangible, as rapidly rising demand is coinciding with limited supply. The outcome is a surge in prices. Since the start of the year, the price of Brent crude oil has gone up by around 90 per cent while copper and aluminium have gained nearly 30 per cent and 37 per cent respectively.
But decarbonisation is also a driving factor behind these price increases, especially in the industrial metals sector. A drastic reduction of greenhouse gas emissions is an indispensable part of the fight to mitigate climate change. Cuts in energy-related emissions offer the greatest potential leverage because, in Germany, these emissions account for more than 80 per cent of total greenhouse gas emissions. Electricity and heat generation is the biggest contributor with a share of more than 40 per cent. This is due to the fact that fossil fuels are still used very widely. In order to effectively decarbonise the entire sector, an even more rigorous shift from fossil fuels to renewable energy sources would be required.
The implications of this fundamental transformation are complex and extend beyond traditional 'brown' energy sources. After all, electricity is at the heart of the new energy era that is now dawning. And that shifts the focus from individual commodities such as oil or gas to a wide array of other materials. The generation, transmission and storage of electricity requires a whole host of different commodities. As a result, the cards are being reshuffled in this asset class. Traditional energy commodities are falling out of favour as certain industrial metals that play an essential role in the energy transition move into the spotlight.
Examples include steel, which is needed for the tower and foundations of wind turbines, and silicon, which features in the production of solar cells, among other applications. Further industrial metals such as nickel and aluminium are required for electricity storage solutions. And finally, copper and rare earths will be needed, especially for the production of electric vehicles. Industrial metals will therefore ultimately eclipse traditional energy commodities.
Even the International Energy Agency (IEA), which is traditionally known for a fairly benign stance towards fossil-based energies, anticipates an almost fourfold increase in demand for copper in its scenario for net zero emissions by 2050.1 Demand for nickel could even increase by a factor of 60 and demand for lithium by a factor of 30. Similar projections have been published by the International Monetary Fund (IMF) in its latest World Economic Outlook.2 The expansion of electric-powered transport and the increased use of renewable energies (see chart) are key drivers in this respect.
Clean energy technologies are driving up demand for industrial metals
Demand by sector
Demand by mineral/metal
However, the associated energy transition also poses a number of challenges, especially in the field of electricity storage. After all, one prominent characteristic of renewables is that their supply is more volatile than that of traditional fuels. In the first half of 2020, wind power was the number one energy source in Germany, accounting for 29 per cent of power supplied to the grid, followed by coal with a share of 21 per cent. By contrast, wind conditions in the first six months of 2021 were very calm and the proportion of wind power in the energy mix fell sharply to around 22 per cent. The resulting gap was bridged almost entirely by electricity generated from coal (27 per cent).
This shows that we will continue to need fossil fuels to secure the baseload, at least during a transitional period during which we do not yet have sufficient storage solutions to manage the volatile supply of power from renewable energy sources. In particular, modern gas-fired power plants that can supplement supply to the grid in a flexible manner will probably remain in operation for some time yet.
In the medium to long term, success in managing these challenges will crucially depend on three factors. The first is the general expansion of renewable energy capacity. Soon, the mere availability of green energy will have a major impact on the pace at which many industries will be able to reduce their carbon footprint. Current capacities are far too limited to cope with future demand. The second factor is a rapid and significant expansion of the infrastructure for electricity distribution in order to avoid a scenario in which the grid itself becomes a constraining factor for the supply of green electricity to the economy. The third factor is the development of and investment in storage solutions. These will be indispensable for ensuring that excess power generated from renewable sources during peak production periods can be used to bridge periods in which supply is relatively low.
Governments will also play an active part: Without public funding and direct investment, especially in the necessary infrastructure, transition efforts are doomed to fail. It is no coincidence that the European Union (with its NextGenerationEU scheme and its Green Deal) and also the United States are taking action to combat climate change, specifically through research into and the development of new technologies. In addition, US President Joe Biden's 'Build back better' programme aims not only to boost renewable energies but also to strengthen the country's electricity infrastructure. Investment in fossil fuels, on the other hand, is likely to decline further going forward. Thanks to its ability to act as a bridging technology, gas may initially be less affected than oil and coal, which will play only a minor role in energy generation in the long term. In Germany, these changes will probably manifest sooner than, for example, in China.
Climate impact becomes a cost factor for the first time
A key reason for the shift away from fossil fuels is that there is now a price to pay for the climate impact of using fossil fuels to generate energy. European CO2 emission allowances currently trade at a price of around €63 per tonne – up by more than 90 per cent compared with the start of the year. The complexity of the emissions trading system, which includes a whole catalogue of exceptions, means that these rises are not fully reflected in the price of energy. But these additional costs, which emissions have technically always been causing, will now increasingly be reflected in prices. Economists call this phenomenon an internalisation of external effects.
Energy prices can thus be expected to go up in the medium term. But for companies, for example, this will still be more affordable than the costs they would incur as a result of a fully-fledged climate crisis. Over the long term, higher prices – especially on fossil fuels – would act as an incentive for increased use of renewable energies in any case. Ultimately, renewables will come not only with lower emissions but also with more attractive prices.
The European Emissions Trading System suggests that governments will probably play an even more prominent role going forward. They will establish the framework – and within it, the market will regulate prices.
For investors, this means that the prices of commodities will remain well supported. However, choosing the right type of investment will become even more crucial. A number of industrial metals will be the focal point for upcoming price rises. In future, demand for real estate and conditions in the engineering sector will no longer be key performance drivers in this sub-sector. Instead, metals that are essential for the production, distribution and storage of electricity will stand to gain the most. Moreover, the lack of investment in recent times means that supply is currently not only limited but also relatively inelastic, which should further support prices. Setting up a new mine, for example for copper or nickel, takes time. It will not be possible to ramp up production at short notice. This makes it likely that new super cycles will emerge, at least for specific materials. All in all, commodities remain an attractive asset class.
- 1 IEA – Word Energy Outlook, October 2021
- 2 IWF – World Economic Outlook, October 2021
Thomas Benedix, Janis Blaum
As at: 15 November 2021.