The Energy Transition
As the global energy sector transitions to renewables, there has been a drastic increase in demand for raw materials. The transition coinciding with evolving environmental, social, and corporate (ESG) constraints and an explosion of Artificial Intelligence (AI) has pushed demand to unprecedented levels (for example, every gigawatt of energy AI uses, an additional 30,000mt of refined copper is needed). These recent changes have not been factored into supply and demand calculations, leaving millions of tons of raw material unaccounted for.
The United States is now playing catch-up as far greater volumes of raw materials are produced outside the US. Vast quantities of the world’s critical materials are mined in countries that are not direct allies, creating an environment rife with dramatic price swings outside of the sphere of US influence. The below graph illustrates the main sources of extraction and processing of the materials critical to the energy transition.
The influences on price volatility can be split into several key factors
Geopolitical volatility:
The impacts of a volatile geopolitical environment on raw material prices are wide-ranging. The world continues to fracture into trading blocks in the post-pandemic, war-ridden landscape - BRICS being a prime example of this issue. Additionally, recent Russian sanctions have led to a run on aluminum and copper prices, with both metals approaching multi-year highs. In an uncertain geopolitical landscape, price shocks will become more common and volatility will continue to increase.
Production constraints:
Demand for raw materials continues to increase at a much higher pace than production can keep up with. The lead time between greenfield exploration and discovery to actual production is upwards of ten to twenty years. With a decrease in CAPEX across the raw materials space since 2012, we are likely to see further spikes in pricing. The below chart shows just how dramatic this reduction in spending has been.
It must be noted that we have also seen a rapid acceleration in protectionism since the pandemic, exemplified by ongoing Asian tin embargoes, and Australia halting coal exports during the early stages of the Ukraine war energy crisis.
ESG Policies:
Banks are increasingly stringent with their lending guidelines for exploration and mining companies which must comply with strict ESG policies and mandates, putting limitations and extra costs on material production. This will have a deep inflationary impact on prices vs. the way companies have been mining/producing material over the last 50 years.
How to manage price uncertainty and volatility
A key component of handling the energy transition effectively will be the ability to hedge forward prices of these raw materials and understanding forward curves and pricing pinch points. Having the expertise, the right people, and procedures in place to correctly hedge the US’s interests against these volatile prices will be vital and could potentially save billions (see recent Citibank article on Copper hedging).
Hedging correctly allows you to take the guesswork out of where the cost of your materials will be weeks, months, or even years into the future. There are very few people who have experience in both the physical production/trading of raw materials and the derivative instruments that are intrinsically linked to the prices consumers pay. It is these derivative instruments that provide a way to prevent paying extreme prices or having budgets run well over expected costs.
Having worked at major trading houses that buy and sell commodities globally, including trading directly with the US Strategic Reserve, we believe that the way commodity transactions are currently handled by the US government is leaving millions of dollars on the table. Whether it is a lack of market knowledge from those who are executing this business, an archaic system in place to track and monitor trading, or a combination of both - if the same errors are made on critical energy materials the cost is likely to run into the hundreds of millions if not billions, at a direct cost to the US taxpayer.
As the world stands on the precipice of a new age for energy, production, and consumption, the US cannot afford to watch on without the right people and strategy in place to protect the nation and its people. Teams need to be established now, must be well funded, and well managed by industry experts to ensure that the US does not face similar issues to those it did during the COVID-19 pandemic. Having a full and complete understanding of commodities and materials from the ground to end user (producer to consumer) and every stage of the journey between is absolutely crucial to not only our finances but also homeland security.
Written by:
Samuel Basi - Founder, Perfectly Hedged LLC. Author, Perfectly Hedged: A Practical Guide To Base Metals.
Anthony Pears - Founding Partner, Gaspara Asset Management LLP. Senior Metals & Macro Trader, Levmet S.A.M.
