Every economic cycle is the same: growth, slowdown, decline, growth, slowdown, decline, etc. However, each cycle is also different, with its own set of nuances and areas of possible investment. For example, in the current downturn, there's a raging debate over just where economically sensitive commodity prices are heading -- the resolution of which either makes stocks like heavy equipment maker Caterpillar (CAT 0.07%), oil services provider Baker Hughes (BKR -1.00%), and copper miner Freeport-McMoRan (FCX 0.52%) raging buys or stocks to avoid. Here's the lowdown.
Supply and demand
It boils down to supply and demand considerations. In typical cycles, high prices induce investment in supply expansion (in this case in oil and industrial metals like copper), which leads to overcapacity when end demand starts to wane with slowing economic growth. That's why specific commodity prices tend to be highly volatile and cyclical. One year, demand is soaring, prices are soaring, and the industry is struggling to keep up; the following year, even a slight drop in demand produces a steep fall.
An example of this cyclicality comes from the price of oil dropping to around $19 a barrel at the height of the lockdowns in the spring of 2020 and rising to over $100 a barrel in 2022.
The chart below shows how these cycles play out regarding oil, metals, and minerals prices. Furthermore, I've included a chart of the global oil rig count to show how investment in supply tends to ramp up in response to rising prices; the 2010-20215 period is a great example.
Data by YCharts.
The bears see the current cycle as inevitably playing out similarly. Moreover, the growth of renewable energy challenges the long-term future of oil exploration and production companies.
It's different this time
In a nutshell, the bull case is that the current cycle will be different. Starting with supply. The bulls tend to see it as being constrained by a variety of factors:
- Increasing environmental concerns and NIMBYism (not in my backyard) make it increasingly difficult to get mining and drilling permits.
- After losing money following the slump in commodities prices after 2014, oil and gas and mining companies are hesitant to invest and are taking a cautious approach.
- It's not just about global supply; it's also about who supplies whom on a regional basis, and a lot of oil and copper production comes from countries experiencing instability.
In this scenario, there will be a slow and measured increase in supply, which supports relatively high prices. It's a viewpoint supported by Caterpillar's management on its last earnings call. Caterpillar CEO Jim Umpleby noted, "While our mining customers continue to display capital discipline, commodity prices remain supportive of investment despite recent moderation," and oil and gas "customers remain disciplined." Caterpillar's role in the debate is why everybody is talking about the stock right now.
According to Baker Hughes CEO Lorenzo Simonelli, "Due to years of underinvestment globally and the potential need to replace Russian barrels, broader supply constraints can realistically keep commodity prices at elevated levels." And the recent evidence is that if commodity prices remain elevated, then oil and gas majors will keep spending, albeit at a slowly growing rate -- great news for Baker Hughes.
Meanwhile, for Freeport-McMoRan's management, political uncertainty in crucial copper-producing countries like Chile and Peru (together responsible for around 40% of global output) means investment in mines could be constrained, and global difficulties in acquiring permits will also restrict supply.
Furthermore, bulls see oil and gas investment as being constrained because of the long-term threat from renewable energy taking over as a source of energy. For example, consider that the CEO of process automation company Emerson Electric is looking to divest the company's upstream oil and gas businesses.
On the demand side, oil and gas bulls point out that the relevance of these commodities to global growth offsets any retraction in demand coming from the energy transition. Meanwhile, Freeport-McMoRan bulls argue that copper is a play on the energy transition because copper is used more in electric vehicles and renewable energy (storage and transmission and distribution networks). Meanwhile, the trend toward electrification continues.
Stocks to buy?
Ultimately, your view on whether these stocks are buys or not largely depends on your opinion on the debate above. Of the three, I think Freeport-McMoRan is probably the best stock for long-term investors because there's little debate over long-term demand for copper as part of the energy transition. However, it's hard to deny that Baker Hughes looks like a good value, while Caterpillar looks fairly valued.
