Materials Risk

Cocoa prices: The top 10 most important drivers

1) Concentrated production: Two thirds of the world production of cocoa comes from West Africa with Ivory Coast the biggest world producer. This means that price is chiefly driven by supply issues in cocoa’s major producers. Any hint that supply may be worse or better than expected can have a disproportionate impact on the price of cocoa.

2) The weather: The right mix of rain and sunshine, at the right time, is needed for cocoa pods to mature properly. Climate disturbance at any phase of the growth process (from flowering to the maturing of the pods) can have a direct impact on crops by yielding shrunken or rotten pods. For example, long periods of dry weather are not conducive to cocoa bean growth.

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Cocoa traders need to be on the watch for winds from the Sahara desert that typically bring dry weather and coolness to the largest producing countries from December to February. Known as the Harmattan winds, strong dusty winds can dry out pods and damage crops.

3) Disease: Fungi and various diseases can also reduce output by reducing the yield from cocoa plantations. The most damaging disease is known as ‘Black Rod’ which was estimated to have resulted in the loss of almost half a million tonnes of cocoa in 2010. Its not just diseases afflicting the cocoa pods that can affect supply. The Ebola outbreak in 2014 forced farmers and their families to flee cocoa plantations in Sierra Leone while international buyers of cocoa refused to visit the producing areas.

4) Geopolitics: The major cocoa growers are accustomed to geopolitical uncertainty. When previous economic booms have led to bust, unrest has typically followed. As with many other countries that rely on commodities as a major part of their export revenue, the Ivory Coast has been plagued by corruption and unrest in the battle for power. Although citizens may be placated when times are good, as soon as the economic tide turns the population can turn if they do not feel that they are getting a good deal compared with those in power.

5) Infrastructure: The biggest producers of cocoa do not exactly have world class infrastructure. Something as seemingly benign as unexpected rain in December has proven to be a significant bottleneck in Ivory Cost. When crumbling roads are unadapted for trucking in the rain, transportation becomes costlier, and additional costs are shifted onto the commodity.

6) Consumer tastes: The trend towards dark chocolate (particularly in light of potential health benefits) has helped drive demand. Dark chocolate requires a higher cocoa content than milk chocolate. Meanwhile, chocolate has become increasingly popular in many emerging economies, adding to demand for cocoa.

7) Farmers: The price paid to cocoa farmers is set by the industry regulator. If farmers incomes are cut (perhaps due to a decline in the price of cocoa) then they are less likely to invest in new trees and are likely to cut back on fertiliser and other important inputs that ensure high quality cocoa beans. All of which means that both near-term and future supply prospects are lower. Lower incomes for farmers also raises the risk of civil unrest.

8) Flowering cycle: It takes cocoa trees 3-5 years to yield a crop. But before that significant investment needs to take place by the farmer to clear and prepare the land for planting. The long lead time between decision to expand supply and the eventual harvest, combined with the risks (many of which are described above) means that supply does not expand quickly enough to respond to higher prices and / or signs of higher demand. This can result in a boom-bust market where farmers only feel confident enough to expand right at the top of the market.

9) Currency movements: Cocoa is typically priced in British pounds while the London cocoa futures contract long been used as the global benchmark for the pricing of physical cocoa. Since consumption of cocoa centred in continental Europe, and a large part of the cocoa processing industry based in the Netherlands and Germany a drop in the Pound versus the Euro increases demand for cocoa since it is now relatively cheaper to import cocoa for processing into chocolate.

10) Stocks: As with other commodities high stock levels may indicate that demand for cocoa is weak, putting downward pressure on the price. Cocoa is perishable however, and depending on how it is stored the quality (and the value) of the stocks may quickly deteriorate.

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Sugar prices: The top 10 most important drivers

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What lessons does rhodium have for commodity investors?

All investors should occasionally look to the past to guide their views on what could happen in the future. For as they saying goes history doesnt repeat itself, but it often rhymes. Almost ten years ago the eyes of many commodity investors were focused on a little known precious metal called rhodium. What are the similarities to the present day surge in cobalt prices and can investors learn anything from that episode and others like it?

Rhodium is similar to cobalt in that it has a very small, very concentrated supply base. Around 80% of rhodium supply comes from South Africa, while around two-thirds of cobalt comes from the DRC. Much like cobalt, the supply of rhodium is also an indirect supply – the precious metal being a byproduct of platinum and nickel mining. That means that supply doesnt typically respond in the same way to high prices. Since the economics of the mine is governed by the value of the predominant metal rather than the byproduct supply tends to only respond after a big step up in prices. The relatively low prices for both nickel and platinum at the present time do not bode well for cobalt supply.

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Like cobalt which is predominantly used in batteries, the demand for rhodium is also very concentrated. Eighty percent of rhodium is consumed in autocatalysts, with the remainder in chemicals, glass and the electricals industry. Meanwhile, in the same way that Tesla and other companies are keen to get their hands on as cobalt now amid supply risks in its main producing country, the same was true for rhodium in the eary 2000’s. From a $440 low in January 2004, prices ballooned near 23-fold to more than $10,000 over five years as industrial users hoarded the metal amid concern that South African mine supply would fall.

You could argue that the straw that broke the camels back for rhodium prices was the start of the global financial crisis. With car manufacturers holding large stocks of rhodium procurement decisions resulted in large swings in prices. Indeed, it is rumoured that the decision by one car manufacturer in the US to offload its rhodium stocks in 2008 set off the subsequent price collapse. Due to the ultra small nature of the cobalt market the same thing could happen there if one or more manufacturer becomes a forced seller for whatever reason.

The financial crisis was the final straw for rhodium, but it can be argued the crash would have come soon enough as car manufacturers were substituting with other materials. As the price of rhodium soared car manufacturers looked to cheaper alternative metals and reducing the amount of precious metals that they needed to use in catalytic converters. Could the same happen for cobalt? A complete shift away from high-energy batteries looks hypothetical at this stage with all high energy batteries currently requiring cobalt. However, there has been recently efforts to produce other types of battery chemistries that do not require cobalt. Tesla has reportedly also been trying to remove cobalt from the equation and add nickel instead. So far attempts for substituting cobalt resulted in a loss in product performance. But nothing is set in stone.

At least until recently there was little way that retail investors could gain exposure to rhodium directly. At the moment the only way for investors to gain exposure to cobalt is by investing in a company that mines it (e.g. eCobalt Solutions). There have been rumours that some financial institutions who have built up large stocks of cobalt are looking to create a product that would allow retail investors to ‘gain exposure’ directly. This should, in the same way that the launch of the rhodium ETF as a sign that some are trying to take some profit.

The rhodium market has seen several price spikes. The most recent being a major rally in the early 1990’s, a smaller one around the millennium and then the enormous 2004-08 boom. The cobalt market is no different. The last major spike in cobalt prices occurred in 2006/07 when prices surged from around $30 per tonne to over $110 per tonne.

One major factor that characterises rhodium, cobalt and a range of other minor metals is the short time in which prices spike and then fall back to earth, quite often right back where they started. How long do minor metal super-cycles typically last? Not very long is the answer. Prices typically increase sharply for 1-3 years before prices crash, often back to where they started 6-12 months later. What does that imply for cobalt? Well, cobalt’s rally is still relatively young by these standards, but come the end of this year it may start to look a little weathered.

Investors take note. By the end of 2008 the price of rhodium had declined by 88% to $1250 per oz. Remember miners are often (but not always a very good one) a leveraged bet on the underlying commodity. Trying to pick the peak in the price of rhodium will probably be just as difficult with cobalt. But by the time that happens the share price of a cobalt miner may have already gone in reverse.

Ride the narrative for as long as you dare.

Batteries now included: You’ll meet a bad fate if you extrapolate

“The course of human history is strongly influenced by the growth of human knowledge…But it’s impossible to ‘predict’, by rational or scientific methods, the future growth of our scientific knowledge because doing so would require us to know that future knowledge and, if we did, it would be present knowledge, not future knowledge.”

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This was how philosopher Karl Popper described the struggle to anticipate future innovations. Yet to understand the potential price dynamics of oil, lead, cobalt and every other commodity we need to make some assumption about how technology will make it easier to extract these commodities and how technological development will affect their demand.

Implicit in any forecast of commodity prices is an assumption of how technology could evolve and how its adoption will affect commodity prices. Yet true to Popper, innovation is unpredictable. No one predicted the invention of pig iron and how it would affect the nickel market. Neither did anyone anticipate the introduction of hydraulic fracking and how it would turn the market for oil on its head.

Commodity prices provide the incentive for new technology, yet also influence commodity production and consumption. Innovations, once introduced, may lead to higher yields from agriculture, more oil being extracted from offshore wells and deeper and deeper mines to extract metals and minerals. All of which could eventually lead to rising commodity supplies.

Technology doesn’t just affect the commodity in question, there are substitution factors too. Consider the outlook for coal prices. Anyone looking into the future of coal needs to consider the potential competitors to this fuel source. But how do you decide how current renewable energy technologies will evolve and its impact on costs and competition between sources of energy?

One example from the 1970’s is instructive. Late in the decade OPEC’s Long-Term Price Policy Committee recommended that the price of oil should be increased gradually until it was just below the cost of the nearest substitute.
OPEC identified its main competition as synthetic diesel and gasoline fuels processed from coal. Since the cost of producing synfuels was thought to be near $60 per barrel, almost $200 in today’s prices, that became OPEC’s implicit long-run target.

OPEC pushed average prices to a high of almost $37 per barrel in 1980 (around $107 per barrel in real terms). But then the market slumped over the next six years, hitting a low of just $14 in 1986, about $30 in real terms. As it turned out, the main competitors to OPEC’s were not expensive synfuels plants but rival oil producers in Alaska, the Gulf of Mexico and elsewhere that were much cheaper.
The same could be said now for the cost of renewable energy technologies such as solar. It is a mistake to draw the connection that just because the cost of solar is coming down the price of a barrel of oil will also come down.

Recent attention has focused on the potential growth of electric vehicles (EV’s). Recent estimates from UBS suggest that in a world where EVs reach 100% of the market demand for lithium will increase by 2,898%, cobalt by 1,928% and rare earths by 655% relative to today’s global production.

However, just as high oil prices arguably helped enabled the development of EV’s, so higher prices for those metals and minerals currently considered essential for the growth in EV development will also have their own impact. This could involve their substitution with other metals and minerals not currently thought economical or a product change resulting in a less resource intensive design. Or if neither of these are possible, demand for the final product (e.g. a Tesla) may not grow as much as anticipated if it costs too much relative to the alternatives.

Uncertainty over how current technology can be utilised and how technology could evolve that makes forecasting commodity demand under rapid change very difficult. This creates a problem for executives of resource companies trying to match supply with anticipated demand many years into the future. The allure for investors of many of the companies operating in the supply of ‘energy metals’ (those metals that could be used in applications as diverse as renewable energy, electric vehicles, batteries, etc.) is that the pace of innovation and therefore our demand for metals such as rare earths, lithium, cobalt and others could increase at a much far faster pace the ability to supply.

Just as earlier this decade rare earth miners and their investors extrapolated several months of price gains years into the future, there is a risk now that investors in the ‘EV theme’ and the commodities that could underpin it extrapolate the past year’s growth in EV use and commodity price gains ad infinitum over-paying for assets that may never generate a return.

Expectations matter elsewhere too, which can create opportunities. For example, if oil producers are worried about the growth in EV’s they may decide to postpone large scale, multi decade, multi billion dollar investments. If they get it wrong and EV’s don’t take off as fast as expected then oil prices may rise sharply if there isn’t enough supply to meet demand.

Rapid change inevitably involves lots of failed experiments as the market weeds out those most likely to survive. Its often said that you could have lost your shirt betting that the internal combustion engine would replace the horse and cart. While that was certainly the case for the early automobile manufacturers that era also holds some important lessons for today’s investors in cobalt, lithium and other metals. If you had bet that crude oil and its derivative was the fuel of the future back in 1908 when the Model T Ford was introduced the price of oil was about $15 per barrel in today’s money. Oil prices doubled in real terms over the next ten years, but fast forward to 1927 when production on the car stopped oil prices were back to where they had been less than 20 years earlier.

I’ll finish with a great quote from George Soros.

“Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited.”