Resources outperformed in 2022 and will likely do it again next year

Resources, led by energy, outperformed the broader market this year, and will do it again next year – with mounting merger and acquisition (M&A) action sparking the fire.

Energy, old and new, will remain a dominant theme as the rush to “decarbonise” the environment leads to supply shortages of coal, gas, and oil, while renewables and battery storage will struggle to keep up with electricity demand.

The net result of shortages in one part of the energy system and excess demand in another is a perfect recipe for higher prices, with domestic price controls on coal and gas a complicating consideration and a worrying sign of Australia catching a dose of sovereign risk as it did during the days of hitting miners with a super-profits tax.

Gold, which has been largely unchanged since this time last year (US$1,805 an ounce 12 months ago to US$1,818/oz this week) looks set to move higher as central banks persist with their interest rate increases as they attempt to crush inflation.

The immediate target for the precious metal is US$1,900/oz, with US$2,000/oz possible later in 2023.

Investors will be aware of the warning that past performance is not a guide to the future but the big economic events at work in the world today should make the Australian resources sector a winning place whatever happens.

Energy the star

As a pointer, over the last 12-months, Australian resource stocks comfortably outperformed the broader market with the ASX metals and mining index rising 10.5% as the all-ordinaries index fell by 8%.

Energy, however, was the star with the ASX energy index up 45%.

Australian investors exposed to resources will benefit next year from five factors:

• China re-opening after almost three years of lockdowns;
• The return of resource nationalism in South America and Africa;
• A rising tide of M&A activity can already be seen in the gold and energy sectors with St Barbara (ASX: SBM) and Genesis Minerals (ASX: GMD) merging to create Hoover House, and multiple competing bids for Warrego Energy (ASX: WGO);
• The hunt for critical and new energy metals which is driving local lithium, copper, nickel and rare earth miners; and
• A likely fall in the value of the US dollar, which will have a positive effect on commodity prices because they are largely traded in that currency.

Price drivers

China, assuming it does not reverse its reopening, is a major iron ore price driver while resource nationalism, which is starting to curb exports of minerals and energy from Africa and South America, is a price driver for the way it directs buyers to Australia’s reliable miners.

Copper, for example, has risen by 11% over the past four weeks to US$3.80 a pound – aided by riots in the world’s second biggest producer, Peru, which threaten supplies, while a world-class copper mine recently opened in Panama is vulnerable to closure after the owner refused to accept government demands for a bigger profit share – classic third world sovereign risk.

A cloud on the horizon is the risk of central banks overshooting with their interest rate policies, which could turn a widespread economic slowdown into a global recession, starting in Europe and spreading.

Possible recession?

Deutsche Bank took an early and gloomy look at the year ahead in a report headlined “The looming recession”, a view coloured by the bank’s deep exposure to Germany, which is being hurt by an embargo on Russian energy as it persists with its war in Ukraine.

But the flipside of the Russian energy crisis is that Australia, for the first time in years, is selling liquefied natural gas (LNG) to Europe as well as being bowled over by increased demand for LNG and coal from traditional customers in Asia.

Deutsche Bank is not alone in being wary of the outlook as economic pressure grows with ever-higher interest rates.

Miner outlook

UBS is another big-name bank which is cautious about mining stocks in 2023 though largely because they rose so sharply over the last three months as investors bought early exposure to the economic rebound expected late next year.

“The 2023 outlook is improving,” UBS said, “but miners have run too far, too fast, in our view,” UBS said.

JP Morgan is another bank which reckons the big miners have overshot, especially those exposed to iron ore, while lithium producers could feel the effect of a price correction following this year’s unprecedented boom – sparked by a rush by battery markers to source reliable lithium supply from Australia.

Commodities that are likely to outperform

Morgan Stanley best explained the conflicting signals flowing from the re-opening of China and Europe’s slide into recession.

“Developed market risks are rubbing against the China reopening opportunity,” Morgan Stanley said. “Caught in the cross hairs are commodities”.

The bank’s preferred exposures are iron ore, aluminium and gold, with lithium least favoured after its stellar run.

ANZ, perhaps because it has closer connections to the Australian economy than the international banks, is also the most optimistic.

After allowing for the competing forces of a potential recession and China re-opening ANZ came down on the positive side of the debate because markets “have a potential line-of-sight to both a China Covid exit and moderation of the US dollar “which are both powerful positives for commodities demand”.

Bullish on copper and coal

Gary Nagle, managing director of Glencore, a big miner and commodities trader, is most bullish on copper thanks to its widespread uses and a significant supply shortage.

“The world just doesn’t get it,” Nagle told a mining conference earlier this month.  He argued that the world will need 355 million tonnes of copper over the next seven years to hit zero-carbon targets but there is likely to be a 50 million tonne shortfall.

“Miners are not investing in copper mine development because of financial, environmental social and governance (ESG) issues, disruption and land access risks,” Nagle said.

Coal, despite its poor ESG reputation, could continue to enjoy commodity star status for the same reasons Nagle sees boosting copper with the price being supercharged by strong demand and a lack of new mine development which has led to a record price of more than US$400/t for thermal coal with global consumption hitting an all-time high.

UBS reckons the international thermal coal price will remain around US$300/t next year even as the Australian Government enforces a local price cap of US$86/t (A$125/t).

Once criticised by European and US bankers for having an economy too heavily dependent on commodity exports the shoe is on the other foot today thanks to ESG enforced supply limits in many countries even as demand rises.

As an overall investment theme for 2023 it’s hard to go past resources, Australia’s natural advantage.