By Jim Puplava
President, Financial Sense® Wealth Management
September 29, 2022
“Those who fail to learn from history are doomed to repeat it.”
—George Santayana
“We must always look forward, but we have to understand our history in order to not repeat the mistakes of the past. I have seen too many instances where people continue to pursue wrong courses of action because they do not take the time to think critically about what has happened in the past.”
—Dallon Christensen
One of the key points I’ve been discussing for the past two years is that the commodity markets are facing a unique set of policy-driven imbalances. Unlike the recession of 2008-2009, when commodities were in abundance due to major capital inflows and investment into this space, today, we have the opposite: aggressive policy opposition to fossil fuels and mining, lack of institutional capital and investment, and a decade-long build-up of record-low inventories across the commodity complex.
From a longer-term geopolitical perspective, the commodity complex is also facing unique policy-driven imbalances as most Western governments have now made themselves completely dependent on China and Russia for a long list of strategic resources and metals, which are not only essential to green energy policies and mandates, but, as we see in Europe today, can be quickly shut off or come under export restrictions whenever such leverage is required in war or trade.
When it comes to shortages across the fossil fuel space, the multi-year low in oil inventories has been only temporarily alleviated by the massive sell-off of US strategic petroleum reserves. Again, this was a policy-induced event and was the only politically-feasible recourse since the current administration has constrained its policy options to fight tough against oil companies and moving away from fossil fuels. Thus, when faced with an energy crisis—as we see today—Biden made the political calculation to “Sell, baby sell!” rather than “Drill, baby drill!” Of course, since we are still faced with historically low inventories, as Bloomberg recently reported, officials are now going to have to “Fill, baby fill” the massive drawdown in strategic petroleum reserves (see Biden Officials Weigh Buying Oil at Around $80 to Refill Reserves).
The monumental impact of policy and politics in today’s markets may make some laugh or cry but it was just last week that I was reminded of how zealous US policymakers have become to follow in the footsteps of Europe. Sitting before Congress, the heads of all our major banks were hauled before Congress and told to stop all lending to the fossil fuel industry. Just to make sure there was no confusion, House Representative Rashida Tlaib asks each banker in turn what they are doing to make sure there is “no new fossil fuel production starting today…zero.” The exchange has since gone viral, as Jamie Dimon at America's largest bank, JP Morgan Chase, responded to the inquisition by stating, “Absolutely not and that would be the road to hell for America.” (Click here to watch)
Because of the policy-induced pressures we see today on energy and mining, as we head into a recession next year as I believe, we will likely do so with a continuation of record low inventories and shortages. The recession will reduce demand as the economy contracts, bring supply and demand in greater balance, but it will be insufficient to alleviate the supply-side of the equation, which is where most of the political policy pressure is targeted. Furthermore, this will only make the United States and many other countries more vulnerable to the dictates of China, which has become the new version of OPEC on steroids in its control of rare earth elements and key strategic metals crucial to all forms of green energy.
I will now detail a number of startling facts and hard realities regarding our present situation, some of which are taken from a must-read book, “The Rare Metals War: The Dark Side of Clean Energy and Digital Technologies,” written by the award-winning investigate journalist, Guillaume Pitron, For example, take the case of wind and solar. Guillaume explains that the expected number of wind turbines needed to reach a net-zero carbon emissions goal by 2050 will require a herculean mining effort to extract 3,200 million tons of steel, 310 million tons of aluminum, and 40 million tons copper. Because of this Guillaume points out that, in direct opposition to the dominant narrative and thinking by most environmentalists, wind turbines guzzle more raw materials than any previous energy technology. Together, both solar and wind will require up to 15 times more concrete, 90 times more aluminum, and 50 times more iron, copper, and glass than fossil fuels or nuclear power. By some estimates, this will require up to at least a 1,000% increase in current mining production.
Because global metal consumption is growing annually between 3-5% per year, in order to meet mandated climate goals by 2050, we will likely need to extract more metals from the earth than humanity has extracted since the beginning of time. Our current population of 7.5 billion will consume more mineral resources than the 108 billion humans who have walked the earth before us.
As I mentioned earlier, the key problem of “going green” is not just that it will require a massive ramp-up in new mines, which many countries are unwilling to do, but because China now controls 95% of rare earth elements and many strategic metals, which are critical inputs to our smart phones, iPads, laptops, EVs, wind turbines, and solar panels.
In a testimony before Congress, Mark Mills, senior fellow at the Manhattan Institute, explained that to replace fossil fuels with wind and solar, we will need to grow our mining sector by more than 1,000%. This is not happening—at least here in the United States or in Europe—as new mining proposals are continually shut down, often for environmental reasons. A recent example is in Minnesota, where the government turned down a new copper and cobalt mine, and in Maine where the discovery of the richest known hard rock lithium deposit in the world faces roadblocks and strict mining laws.
These stories are not anomalies, but the norm. It has become almost impossible to open new mines in this country even as the government issues new laws and mandates that necessitate opening a massive number of them. Because of this longstanding policy dissonance, the US has outsourced much of its mining and processing to other countries, and is now “100 percent import dependent for at least 20 critical and strategic minerals.” Unfortunately, NIMBY (Not In My Backyard) has been replaced by BANANA (Build Absolutely Nothing Anytime Near Anybody).
As I am writing this, the Senate just advanced a stopgap funding bill after removing Joe Manchin’s proposal to speed up permitting of energy projects. Not one Republican voted for his proposal, so it was defeated. Democrats worried by speeding up oil and gas projects would bring risk to the environment and climate change. A day after the permitting bill was defeated an analysis conducted by the Rapid Energy Policy Evaluation project led by Professor Jesse Jenkins of Princeton found that it will lead to the burning of more fossil fuels such as coal and natural gas, which is exactly what we see happening in Europe today. We are expanding our grid at a glacial pace of 1% a year but we need to double or triple that rate in order to handle the strain that will be placed on our electrical grid as a result of green energy and EV mandates. Again, our lawmakers are aggressively pushing in one direction without making the necessary domestic investments to power this transition.
China now dominates the processing of key elements necessary to power the Green Utopia. China not only dominates rare earths as the largest producer, but they are also on a quest to control deposits around the world. They are heavily invested in Africa and are now moving into South America in their quest to dominate the production of all green raw materials. They have become the OPEC of green.
As author Guillaume Pitron writes in The Rare Metals War, “This transition to renewables will cripple entire swathes of your economies, and the most strategic at that. It will plunge hordes of workers into retrenchment, triggering social upheaval that will shake your democratic foundations. Even your military sovereignty will be compromised.”
As bad as this may sound, it is much worse. In doing my research I discovered that we need rare earth magnets for our digital economy. Those magnets are necessary to power our electric motors and they are made with rare earth minerals. Three-quarters of magnet manufactures in the US are gone. The leader in magnets used to be a US company, called Magnequench and Crucible Materials. Magnequench was sold to the Chinese and Crucible was sold to the Russians. The Pentagon and Lockheed Martin can no longer build the F-35 Lighting II fighter jet without the necessary magnets built in China. Those magnets are also necessary for building our guided missiles, M-1 Abrams tanks and other high-tech weapons in the US arsenal. We no longer control the market for magnets; we sold them to our adversaries.
The point of bringing up these issues is electric vehicles and renewable energy sources may be technically feasible, but their production will never be environmentally sustainable. This gets back to Professor Charles Hall’s concept of EROI (Energy Returned on Investment). A century ago, it took one barrel of oil to produce 100 barrels of oil. Today, as major oil fields go into decline (peak oil), that same barrel of oil only produces 35 barrels of oil and for unconventional oil, such as shale, one barrel only produces five barrels at most. The same applies to rare earth elements, which require vast amounts of earth and energy to get them out of the ground. Mining is energy intensive. Those big earth moving machines require diesel fuel to dig, move, and transport rocks. Our limitation to mineral extraction is not limits of quantity, but limits of energy and regulatory policy.
Green Is Expensive and Dirty
I want to cover another issue you will seldom hear in the news. Green is dirty. Dirtier than fossil fuels. We are constantly being lectured by politicians for the need to go green and clean. However, going green is dirty and more carbon polluting than fossil fuels. The Greens talk about how wind and solar will reduce our carbon emissions and reduce the apocalyptical risk to our planet from climate change. Of course, when you see solar panels or windmills, you see no visible pollution as you would from a refinery, or the exhaust fumes emitted from a diesel truck or an automobile. So, it is easy to believe—at least on the surface—that green energy means clean energy. What you are not told, and what many environmentalists conveniently ignore, is what is behind the production of those windmills and solar panels. Feeding the green leviathan requires vast amounts of cheap energy, the cheapest of which is coal. Most of our solar panels are produced in China. Why is that? Because they produce them using cheap coal and very cheap (possibly forced) labor. Could you imagine just how much more expensive solar would be if they weren’t all produced in China?
Clean energy is a dirty business. The mining of rare earth elements (REEs) requires moving gargantuan amounts of earth (literally, in some cases, entire mountains or mountains’ worth of earth) where REEs appear in small concentrations spread out over large areas. We will also need to increase mining and processing of REEs by leaps and bounds, but this comes with a whole host of environmental impacts that the green lobby won’t be able to stomach…thus, allowing China to become the main processer instead. Green is looked upon as carbon free, but it takes prodigious quantities of electricity from power plants to operate and run a mine, refine minerals, and transfer those raw materials to a manufacturer to be used in making a wind turbine or solar panel.
Bottom line, what we have done in the West is outsourced the mining, refining, and production of all these critical “green” inputs (and accompanying pollution) to poorer or less environmentally-restrictive areas of the globe like China, Africa or South America. Essentially, we have created a system that has allowed us to transfer our pollution far and away from where it is visible in the West, helping to create the myth that green = clean, which is very far from reality.
You may never have heard of the city of Baotou. It is located in the autonomous region of Inner Mongolia. It is the biggest rare-earth production site on the planet. The hundreds of tons of rare earths extracted annually by the mining giant Baogang is responsible for 75% of global production of rare-earth minerals. The city looks clean and pristine, but it belies the toxic pollution that lies just a short 100 kilometers away from the city, a highly toxic waste dump, which occasionally flows into the Yellow River. The water in the rivers is whitish-green and sometimes red. The thousands of villagers that still live there breathe, drink, and eat the toxic discharge of the reservoir. The village is known as a “cancer village.” Young men grow grey hair at an early age, children grow up without developing teeth and the cancer death rate in the village goes unreported as the government monitors access to the region.
More importantly, to the Chinese leadership is the money and power that comes with controlling the 21st Century’s most important elements. China is intent on not only controlling the production of these essential elements but also developing the vertical integration of high-tech products of our digital world from smart phones, iPads, laptops to the production of magnets essential to the production of windmills, solar panels, to high tech fighter jets and supersonic missiles. China has become the equivalent of the OPEC of strategic inputs in the 21st century.
There is a movement in Congress to rectify these issues and try to restart the mining of rare earth elements as they are essential to our digital and green economy, but the pushback and obstacles are quite large.
Because of the commodity bear market of the last decade as well as the increased political pressure and threats to the energy and mining industry, many of these companies have scaled back their investments, whether it is exploring for new oil or developing new mines. Demand for raw materials will be growing at 3-5% per year even during a recession as our politicians push through green mandates. That is what will make this recession different as demand for energy and minerals will continue to grow unabated this entire decade in what I believe will be the commodity bull market of a lifetime. Unless the green agenda is abandoned, we will have no choice but to massively ramp-up our drilling, mining, and production efforts in the years ahead. It is a major reason why commodities make up 30% of our portfolios. We own major mining stocks, oil drilling and service companies, agriculture companies, uranium, and precious metals. We intend to own them this entire decade as I believe we are entering a major commodity cycle of rising demand, constrained supplies, and rising prices that will carry over into the next decade.
Commodities were flying high until last May when they began to sell off anticipating an approaching recession. What is being ignored is that many of these strategic commodities are in short supply, and this is likely to persist for many years to come. The good news is many of the companies we own are raising their dividends, buying back their stock, and offering yields anywhere from 5 - 12%. So, we are being paid to wait patiently for the markets to wake up to the fact that demand continues to grow—not contract—as would be expected during an economic downturn.
From a historical perspective, commodities are cheap. One of the greatest investors in history, Warren Buffett, has made energy stocks his largest investment next to owning Apple. I want to share again a graph of commodities over the last 100 years from our friends at Goehring & Rozencwajg that reflect the very point I am making here: relative to financial/paper assets, commodities have never been this cheap in the last 100 years. The graph shows what happens when they become this undervalued—an explosive bull market follows until they become overpriced again. The most extreme periods of undervaluation were in 1929, 1969, 1999 and in 2020. In 2008, mining and energy stocks made up 20% of the S&P 500. Today they are barely 5%.
It is understandable why investors are skittish and reluctant to invest, thinking a recession is just around the corner, which it is. But we’re embarking on a new capital cycle for commodities that is far more important to understand as it offers the potential for huge rewards this decade and next. The reason is the commodity cycle follows a specific pattern that repeats itself. Given the fixed costs of mining, higher commodity prices fall directly to the bottom line as prices rise. We have seen this in many of our energy and mining stocks whose profits are up 100-300% over the last year. One reason why dividend yields are so high is those profits are being passed on to shareholders. As these profits increase with rising prices, the higher returns attract new capital to the sector and a new cycle of exploration and development begins. This new investment over time leads to increased spending and new supply, which eventually outpaces demand growth and ushers in a period of commodity surpluses. We are a long way from that happening as we have shortages of key commodities, including oil, and historically low inventories, as shown in the charts below.
I saw this same undervaluation back in 2000 when I sold all of our tech stocks in December of 1999 and began investing in commodities the following year buying gold, silver and oil. That served us well during the ‘00 decade and I strongly believe it will do the same this decade as well. In the ‘00 decade, the commodity bull market was largely driven by the massive growth and build-out of China’s economy to become the manufacturing hub for the entire world. That process is now reversing itself as the West and the rest of the world now sees how damaging it is when you make yourself completely reliant on one country. This is especially true when they continue to pursue a multi-year ‘zero covid’ strategy with regional lockdowns and restrictions more aggressive than anywhere else in the world, which exerts tremendous pressure on the global supply chain.
Bottom line, I believe there will be three key drivers for the ongoing bull market in commodities:
- Green energy and ESG policies, which demand much larger amounts of strategic elements and metals.
- Deglobalization and manufacturing at the source of customer markets. Factories are being rebuilt here in the US.
- China’s monopoly of rare earths and key minerals will eventually lead to new mines here and in the West to avoid being overly dependent on China, as Europe is for energy with Russia.
Green energy and ESG policies will be one of the main drivers as that is all many politicians focus on. The Administration just passed a green energy bill of $800 billion following an infrastructure bill last December of $1.2 trillion. That’s a lot of money, which is going to be spent on commodities to build out green as well as the grid that will be necessary to support all of those EVs that are being mandated by Washington and state governors.
Deglobalization means that manufacturing will be coming back here. We saw this with the $400 billion chip bill passed this year to encourage companies like Intel to start building factories here vs in China. That means those factories are going to need the inputs of raw materials to start building goods here in the US. This deglobalization trend is a big macro event that was covered extensively in Peter Zeihan’s latest book, The End of The World is Just the Beginning: Mapping the Collapse of Globalization.
More important to our understanding is over the last 100 years, the business cycle and the commodity cycle have not been in sync at all except for the 2000-2010 period. For most of the last 120 years, they have traveled different paths. The best example I can give is a point that Goehring & Rozencwajg make in their recent commentary on investing during a recession. They bring up the example of the Great Depression. A period where 1 out of 4 people were unemployed and wholesale prices collapsed by 30%. Equities fell by 86% and did not regain their former high until 1954. During one of the worst economic depressions in history, natural resource investments did not collapse during that period. In fact, they turned out to be the best performing asset class, doubling in value a decade later. The reason was the commodity resource capital cycle. Commodity prices fell throughout the 1920s as money went into the technology stocks of that day like radio, airlines, motion pictures, electrification of homes and cities.
The commodity sector was starved for capital as it is today. By the end of the war, the Dow Jones Industrial Average would not return to its former peak until 1954. During that same period, oil stocks went up 300%. We have already gone through that bear market in the last decade. It is my belief that we are at the early stages of this cycle and very few investors see it. I believe Warren Buffett does, however, which is why he has made massive investments in oil making energy his second largest position between Berkshire Hathaway and his privately-held positions.
I see this as a decade-long investment as it is going to take massive amounts of capital to restore energy investment and bring new mines online. The good news is that we are being paid for our patience with dividend yields of 5-12% while we wait for the markets to wake up to the facts presented here. This reminds me of when I bought commodities back in the 2000 decade or when we bought oil stocks in the spring of 2020. We got 6-8% in dividend yields while we waited for the markets to wake up to the fact that energy was cheap and underpriced and that demand would come back sharply as it has since the lockdowns. I see oil prices rising after the election when we will no longer be draining the SPR and will need to replenish it. OPEC has fallen short of its production goals and we may be short nearly 2 million barrels per day when the cap on Russian oil goes into effect next February. But our patience will be rewarded by dividend yields equal to or half of the annual long-term returns from equities. Until then, enjoy the dividends.
A Final Note to Clients:
When I started the Income portfolio three years ago, it was done with the idea of filling a void in our portfolio lineup. I wanted to start a portfolio that was designed to deal with low interest rates and the oncoming inflation I wrote about. Ten-year treasuries were less than 0.50% at the time and the government’s policy was highly inflationary. The goal was to invest in dividend aristocrats, companies whose dividends rose each year. The objective was an annual dividend return of 10% a year made up of dividends and dividend increases. This was a long-term portfolio based on rising income each year that would help clients keep up with inflation. I also wanted to make it tax efficient since dividends are taxed anywhere from zero to 23.8% for federal taxes, state taxes, and Medicare taxes for those on Medicare. Since its inception, we have exceeded those goals averaging annual dividend increases of 9% a year.
The resource sector has been on the downside since June. I don’t expect that this will last, and I expect these stocks to continue to reward shareholders in the years ahead with dividend increases and, eventually, I believe, much higher stock prices as well.
I wanted to share with you why we own commodities and how the economics are playing out in this sector as reflected above with the massive dividend increases. I have never been able to buy commodities this cheap in my entire 42 years in the business. Our consumer staples companies have been increasing dividends 6 - 8% and our drug stocks have also been increasing their dividends at the same pace. I expect to see another year where we hit our overall dividend return of 10%.
Coming up next: The Story of Money, Paper Gold and Silver vs Physical Gold and Silver
Best,
Jim Puplava
Founder, President
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