In the current market environment, there are some sectors that are benefiting disproportionately due to macroeconomic trends. The resource and material sector and the commodities sector are two examples. Commodity prices have surged across the board in recent weeks due to Russia's war against Ukraine constricting key supplies. Any businesses producing key commodities that Russia is a leading supplier of, such as copper, nickel, or oil, are almost certain to achieve blow-out profits over the next couple of quarters.
But it is not just what I would call the primary commodity producers that are benefiting from the current environment. Companies that produce secondary resources, resources manufactured out of things like nickel, are also set to achieve record profits. US Steel (X, Financial), for example, is set for one of its most profitable years this year, and CF Industries (CF, Financial), a fertilizer producer, is also on track for blow-out profits. All of this presents an exciting but risky backdrop for investors.
First and second-level thinking
To use an example coined by value investor Howard Marks (Trades, Portfolio), a first-level thinker might presume that commodity prices lead to higher profits for commodity producers. Therefore, these companies are a good addition to a portfolio in the current environment. So far, this has been a good trade, although to get the best returns, one would have had to have taken a position long before the current cycle began.
A second-level thinker would take a step back. Rather than taking rising profits as a given, they would ask why commodity prices are rising, and if trend can continue. To answer this question, I think one must first understand why commodity prices are reacting in the way they are today.
A brewing crisis
The war in Ukraine and resulting sanctions on Russia are just one piece of the puzzle. This crisis has been building for years and should come as no surprise to those who have been keeping an eye on the news.
Before the financial crisis, the commodity sector minted money. Spurred on by cheap profits in high commodity prices, the industry dived into new projects, ramping up output to meet what seemed to be insatiable demand from China and the U.S.
That all changed pretty quickly when the financial crisis began. Demand fell away in the western world, even though it persisted in China for several years thanks to massive economic stimulus plans.
Between 2010 and 2015, two things happened. One was the U.S.'s boom in shale oil production, which caused a global glut of hydrocarbons. As a result, the prices of oil and gas collapsed, and producers worldwide started to reel back expansion plans.
A few years prior to this decline, the mining industry had realized that it was expanding too fast. As a result, many mining companies mothballed projects, raising tens of billions of dollars in value. After 2015, the materials and resource sectors changed significantly. Cash generation and strong balance sheets became a priority. Breakneck growth was discouraged by investors. This had a significant impact on the global economy. Not only were producers scaling back output, but they were also scaling back investment. Companies that made machinery for these businesses had to adjust to the new environment. Capacity has also fallen in other sectors of the global economy.
Optimize production
From chipmakers to automakers and from steel producers to miners, the goal for the past couple of years has been to optimize production. Therefore, when demand spiked after the world started ramping up spending plans and printing money to preemptively combat the Covid-induced recession, many companies were ill-placed to meet this rising demand.
The current geopolitical situation has only exacerbated the shortages that have been brewing since 2015. This is without placing any consideration to green energy policies or other political changes that might have discouraged investment in oil and gas over the past couple of years.
So, how should investors react to this environment? There is no correct answer, but considering the sheer scale of underinvestment that has taken place over the past decade, I think higher materials prices are here to stay, at least for the next year or so, assuming there is no demand destruction. If there is an economic downturn, then demand might slump.
And this is why it is so hard to invest in this sector. There are so many moving parts. Prices are rising today, but they might start falling tomorrow. The capital discipline the sectors have exhibited since 2015 may also vanish as profit surges. That is why these markets sit firmly on my "too hard pile."
