What to look for after the interest rate storm passes

After the storm of rising interest rates passes, investors will have learned two important lessons, the first is that energy is tops in the resources sector (old energy and new), and that fundamental valuation rules have changed because costs are exploding.

The energy lesson should be well understood by now thanks to soaring prices for the raw materials that power a modern economy and that roughly translates into whatever can generate electricity, preferably with as little pollution as possible.

But until the perfect world of zero-emission power generation arrives the truth is that coal, oil, and gas are the best performing commodities, rivalled only by new energy materials such as lithium, nickel, copper and graphite, with uranium staging an overdue return.

High prices driven by record demand for electricity, even as the global economy drifts towards a significant downturn next year, are what makes energy stocks a go-to investment choice.

Energy demand remains high

Quite simply, the world wants it and there isn’t enough to go round.

So, rule one after the storm, increase your exposure to energy it’s one of the greatest ever investment themes and it’s going to run for decades.

The second lesson is harder to apply because it’s all about the negative effects of higher costs, which are starting to inflict significant damage at all levels of the economy, especially among resource stocks and partly because of rule one: energy.

At the small end of the mining industry, pips are already squeaking, and we’ve only just started down the road of rising costs and falling prices, which is what could be the big negative event of next year.

Three iron ore projects in Western Australia are examples of what happens when costs rise, and commodity prices fall – they close or are delayed.

The Mount Mason project in WA of Juno Minerals (ASX: JNO) is the latest to hit the costs wall, with management last week delaying an investment decision “until stability returns to the iron ore price and freight markets, and there is a clarity on a complete logistics solution”.

In August, it was the same story for Strike Resources (ASX: SRK), which shipped out a maiden cargo of iron ore from its Paulsens East project in WA’s Pilbara region and then put the mine on hold until market conditions improve.

Last year it was a similar story with Kimberley Metals’ Ridges iron ore mine in WA which restarted when the ore price was around US$220 a tonne and closed when it halved to US$110/t. It’s now US$97/t.

What’s happened in iron ore, which has traditionally been a commodity dominated by big miners such as BHP (ASX: BHP), Rio Tinto (ASX: RIO) and Fortescue (ASX: FMG), is that small producers are finding falling prices and rising costs a bruising combination.

Universal cost hikes

The real lesson, however, is that iron ore is not alone.

Cost increases are universal as are the challenges of increasing government taxes, increasingly complex and expensive project approval processes.

Morgan Stanley, an investment bank, took a close look last week at what it calls the “cost push” and its effect on incentive pricing – the price required to justify new production.

Every commodity examined had a higher incentive price in both real and nominal terms, the bank said, reflecting “inflation in wages, raw materials, energy and more, as well as challenging permitting”

Morgan Stanley said it had examined 170 projects to update its long-term commodity price forecasts out to the year 2029.

“As updated feasibility studies are released, capital expenditure estimates are being revised higher across commodities, while cost curves have been rising too, on higher energy, labour and raw material costs,” the bank said.

Because of investor focus on balance sheet discipline, Morgan Stanley has also raised targeted internal rates of return (IRR) from 10% to 12%-to-15%  – a move which is effectively raising the hurdle height for a project developer to clear.

“We are seeing significant cost inflation across commodity markets of between 10%-and-30% year-on-year for key metals,” the bank said.

“As well as operating costs, capital expenditure (capex) estimates are also rising, with recent feasibility studies leading to higher capex estimates or reduced scope.”

Pincer squeeze

Morgan Stanley then looked at projects in different categories, those which completed a feasibility study in 2018 have had their capex cost inflated by 17.2%, while other years have been increased by smaller percentages with feasibility studies completed last year 8.5% higher.

What the bank has done, and it’s an important guide for investors, is to highlight the pincer squeeze of falling prices and rising costs which, in the case of the three iron ore projects mentioned earlier had serious consequences.

More of the cost/price squeeze examples can be expected in the new year as central banks ratchet up interest rates (which are a cost in themselves) to fight inflation which is running at a 40-year high and could stay elevated through most of next year.

“With the recent (commodity price) correction, spot prices for many commodities have moved closer to or even below incentive prices,” Morgan Stanley said.

Changing investment landscape

For investors the investment game is changing.

It is no good simply looking at the size and quality of a discovery. Other questions are more important, including the cost and time taken to win development approval. Capital costs of all developments are rising as are operating costs.

The sector most likely to dodge the cost bullet in 2023 will be energy, especially if the Ukraine war drags on and Russian oil, gas and coal is blackballed by the western world raising the potential for record energy prices.

But overarching everything is the corrosive effect of inflation and rising costs which are eating future potential profits.