Capturing the commodities comeback

History never repeats precisely, but if you look back 11 years to the early days of 2002 you will see interesting parallels with today’s financial markets. This is especially the case in the resources sector, where early signs of rising demand for commodities can be detected.

And one doesn’t need to look too far to see where the demand is coming from. Remember that China remains the world’s growth engine, with last week’s trade data released in Beijing showing exports rose by 14.1% in December when compared with December of 2011, and imports picked up by 6%.

The trade numbers will flow into China’s overall economic growth, which remains on track to rise back above an annual 8%.

Growth in China and the rest of the emerging world means that even if the western world, led by the US and Europe, remains bogged axle-deep in debt, the emerging world is growing and it’s the emerging world that is full of commodity-intensive economies.

For Australian investors jaded by domestic economic and political issues, including the looming national election and an election in WA, the biggest of the resource states, it’s time to beef up exposure to basic raw materials and the companies that mine them.

Before looking at particular commodities and companies, it’s worth considering a few more events that help paint a picture of resource sector revival:

• Tin, a metal with essential uses in electronics, last week hit an 11-month high of $US24,600 a tonne.
• Aluminium demand is rising. The world’s biggest maker of the light metal, Alcoa, is forecasting a 7% increase in demand for the light metal in 2013, which will help its Australian associate Alumina.
• Nickel is similarly forecast to enjoy a 7% rise in demand this year, perhaps explaining an increase in the nickel price from less than $US7 a pound in August to just below $US8/lb today.
• Copper, the bellwether of base metals, has also been firming to around $US3.70/lb, and
• Lead and zinc, two generally unloved industrial metals, have staged a largely unreported recovery in demand. The lead price has risen over the past six months by 27% to $US1.05/lb. Zinc has been a slower mover, rising a few cents to US92c/lb.

Why a resources boom re-run won’t happen

No-one, least of all me, is forecasting a return of the resources boom. That was a once in a lifetime event caused by the first flush of China’s own version of the industrial revolution.

In 2002 copper was trading at around US75c a pound, but was poised to make a dash to more than $US4.50/lb within five years. BHP Billiton was trading at $10 a share, and was poised to make a run to $48 within six years.

But this time (and don’t laugh if you’ve heard this one before) it will be different. Demand and prices will rise more slowly, thanks to the new pressures of a world overloaded with debt and because many consumers are focussed on deleveraging instead of boosting their borrowings.

The fundamentals, however, of a world deficient in many raw materials that can be supplied at a commercially viable price remain the same as in 2002, and investors with the patience to build (or rebuild) a resource-heavy portfolio will be well rewarded over the next 11 years.

As with 2002, the best early-stage entry points for the resources revival underway now are the lowest-cost producers with growth options, and on the ASX that boils down to the sector leaders; BHP Billiton, and Rio Tinto.

For more adventurous investors there are the two London-listed diversified miners entering interesting times. Anglo American is charting a new course under its freshly-appointed Australian chief executive, Mark Cutifani, and Glencore as the world’s first “all commodities” business model, which is attempting to mix mineral, food and oil-trading operations – and has Anglo American on its takeover wish list.

While the resources upturn this time will not be as spectacular as the 2002-to-2008 boom, it has the potential to be longer lasting and better suited to genuine investors rather than get-rich-quick speculators.

The reason for this new-found optimism is that the market has absorbed the bad news, the global economy is stabilising, and the emerging world is continuing to grow rapidly.

It is also becoming clearer that the prolonged downturn triggered by the US banking crisis of 2008 is finally passing through the financial system, admittedly bringing its own challenges such as a gross excess of liquid cash, historically low interest rates and fears of an inflationary outbreak.

In theory, that could trigger sharply higher demand for gold, the world’s ultimate reserve currency, though the slow decline in the gold price over the past three months, from $US1791 an ounce in early October to around $US1660/oz is a sign that fear of a catastrophic financial event is fading. So too is the Volatility Index (Vix) of the Chicago Options Exchange, which has slipped to a five-a-half year low.

From my perspective, it is far better in the early stages to invest in commodities with deep markets, leaving the exotics to later in the cycle.

One big difference this time around is the energy price. Back in 2002, the choices in energy were essentially oil, gas, coal and nuclear. Today, there are also new sources of energy supply extracted from once uneconomic hard rocks such as shale, plus the added competition of renewables (wind and solar), which are eating into energy profits. There is also great uncertainty around uranium and the on/off nuclear fuel cycle.

For Australian investors, that means the once booming coal sector has become something of a graveyard for one-time high flyers such as Whitehaven Coal’s Nathan Tinkler and the chief proponent of the China First coal project, Clive Palmer.

With coal missing in action, but perhaps oversold, the starting point of a resources revival has to be gold, even if it is the least likely commodity to benefit from the rise of the new (boring) normal of steady growth, and it remains the metal with the most opaque production costs.

So, here is an assembly of resource stocks to watch in 2013:

Gold:

King of the metals sector, gold is loaded with risk but it remains an essential insurance policy in any portfolio.

If there is an inflationary outbreak gold will be the “last currency standing” in a widespread devaluation of paper money – in which case all investors will need some exposure.

If there is a steady recovery then the gold price could fall sharply, especially if there is a sudden rush for the exits by investors exposed to exchange-traded gold funds.

It’s for the second reason that the key to a future investment in goldminers is grade – the higher the better.

For too long Australian miners have fiddled about with ore assaying 1 or 2 grams a tonne. Forget that marginal material, and focus on stocks mining 8 grams a tonne and better.

The best way to treat gold is to follow the advice I’ve been handing out for several years; use it as a back-stop or sheet anchor for a portfolio in case bad times return, which they have a habit of doing. But it is unwise to have more than 5% or 10% of a portfolio in gold.

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Pick of the ASX-listed gold pack:

1. Northern Star (NST), a long-term favourite even if I sometimes annoy the chief executive, Bill Beament, has been hit by an exit of major shareholders. The high-grade ore body at the company’s flagship mine, Paulsens, is the key to Northern Star, with the bonus of a look-alike structure emerging nearby and a new mine in the planning stages at Mt Olympus. Over the past few weeks Northern Star has been on a roller-coaster ride, soaring to $1.58 before plunging to $1.15 as foundation investors took their profits, leaving room for new arrivals.
2. Kingsrose (KRM), another stock I have followed for some time and which remains high on my watch list because of the grade of its ore bodies on the Indonesian island of Sumatra. Problems at the Talang Santo mine, the second project developed by Kingsrose on Sumatra, have slowed progress. But as 2013 unfolds, Kingsrose should deliver a superior profit and share price, rising from its currently depressed 85c.
3. Medusa Mining (MML), a London favourite that has blossomed and faded thanks to the ebb and flow of the gold price and problems at the company’s Co-0 mine in the Philippines. There, it enjoys the advantage of ore bodies averaging about 8 grams of gold a tonne, four-times the material mined by most Australian mines. Over the past 12-months, Medusa has fallen from a high of $6.70 to a low of $4.36, and is now on the way back up at $5.14.

Iron ore:

Iron ore hitting a 15-month high last week was a significant tell-tale that, for whatever reason, China’s steel mills had allowed stockpiles to run too low. This is possibly because they underestimated demand for steel, or because they mistimed Australia’s port-closing cyclone season.

This could be the signal investors needed to highlight the fact that the resources boom didn’t end last year. It merely switched to a different (and slower) gear. If the cause was Chinese steel mills rushing to rebuild their stockpiles, that serves as a fresh pointer to ongoing worldwide interest in commodities and the “Asian century” theory of future economic growth.

An iron ore price correction in the next few weeks is a near certainty, if only because the price has risen by more than 80% in five months from a crisis level $US86 a tonne to the recent peak of $US156/t. Even Australia’s iron ore miners believe the current price is too good to be true.

From a short-term investment perspective that makes most of the pure iron ore plays such as Fortescue, Atlas, BC Iron and Mt Gibson, stocks to sell rather than buy. After all, Atlas was up by 50% at $1.94 a few days ago (and back now to $1.73). BC was up by 35% to $3.80 (now $3.60) and Mt Gibson was up by 51% to 94.5c (now 85c).

Fortescue Metals Group (FMG) is the biggest pure-play entry into the rejuvenated iron ore sector, and its shares are up 30% since Christmas, but if the iron ore price falls, as expected, the stock will come under renewed pressure.

Since a September scare when the iron ore price was in free-fall, Fortescue has undertaken a major financial reconstruction, swapping short-term debt for long-term debt. The debt deal enabled the company to re-start work on a new mine which should cut average production costs, but it will remain one of the industry’s higher “total cost” producers, and is yet to finalise its balance sheet repair work which is expected to include the sale of some assets, such as its railway and port facilities.

Once the iron ore bubble deflates a clearer picture should emerge of a commodities sector that is at the start of what could be a long-term revival. This can be seen by looking back to 2002, when the resources world was emerging from the shocks of the 1997 Asian financial crisis and there was bad publicity associated with the financial failure of four laterite nickel-processing plants in Western Australia.

Copper:

1. Hot Chili (HCH) is one of the growing band of Australian copper explorers active in the home of world-class copper deposits, South America. Recent drilling at the company’s Productora project in Chile has produced excellent results, which could lead to a major resource upgrade in the next few weeks. On the market Hot Chili has been on the move, rising from a pre-Christmas 55c to recent trades at 70c.
2. Sandfire (SFR) is one of the recent copper stars, and this is the year when it hits full production at its DeGrussa mine in WA. It also will post its first significant profits and probably reveal its dividend policy, which could boost its share price. Sandfire also retains takeover interest but its most likely suitor, OZ Minerals, might have left its run too late. At a recent price of $8.50 Sandfire looks fully priced, but a generous dividend policy could add the appeal of yield to the stock.
3. Marengo (MMC), despite a recent change of name to Marengo Mining Canada and a change of home exchange to Toronto, retains its ASX listing and ownership of the giant Yandera copper project in Papua New Guinea. Greater North American investor interest in the stock can be expected this year, potentially lifting it well above it current low price of 14c.

Nickel:

1. Sirius Resources (SIR), one of last year’s favourites, is set for a fresh run this year as it accelerates exploration at its Nova discovery near WA’s south coast. At least seven drilling rigs are being mobilised to try and expand the original discovery and find extensions of the ore body. On the market, Sirius has pulled back from last year’s high of $3.28 to be trading around $2.31 with exploration news flow the likely driver in 2013.
2. Mincor (MCR), heavily sold off early last year after problems at its Kambalda mines in WA, has regained lost ground over the past six months and should do even better if the nickel price continues to rise. The primary appeals of the stock are its low production costs, high cash backing, and strong dividend policy. On the market, Mincor rose rapidly in November to a peak of $1.23 but has since pulled back to around 98c.
3. Direct Nickel (DIR), a wild card in the sector, is currently not trading on the ASX while it undergoes a capital reconstruction. It is a company to follow, however, because of a new technology being developed with the help of the CSIRO to process low-grade nickel ore using nitric rather than sulphuric acid. A major trial of the process has just started, and if it works as promised the company (and its process) could revolutionise the nickel sector.

Zinc and lead:

Perilya (PEM), because of its leading position in the historic Broken Hill mineral fields, and Ironbark (IBG), because of its potentially world-class Citronen project in Greenland and strong support from major European zinc producers.

Tin and tungsten:

Venture Minerals (VMS), because of its promising discoveries in Tasmania, and Wolf Minerals (WLF) for its Hemerdon project in Britain, which has recently secured development funding.

Oil and Gas:

Beach Energy (BPT), for its existing Cooper Basin cash flow and its potential to be the early winner from Australia’s embryonic shale gas reserves. Other shale gas players to watch as imported US technology unlock oil and gas trapped in Australian shales include AWE, Buru and Drillsearch. The three dominant ASX oil producers, Woodside, Santos and Oil Search deserve a position as core components of a balanced resources portfolio.

Uranium:

To be treated with extreme care as it too could become a victim of a worldwide increase in the production of low-cost natural gas.

Exotics and minor metals:

As has been seen in the rise and fall of stocks attempting to enter the rare earths and lithium sectors, the problem with exotic and minor metals is the marketing challenge. In most cases markets are thin, controlled and opaque, making it hard for the companies to carve out a niche, and even harder for investors to pick winners.

The fall of rare earths leader Lynas Corporation from a high last year of $1.62 to a low of 55c (and back recently to around 69c) is an example of how even the pick of the sector can have problems in entering a difficult business.

In most cases, exotic and minor metal stocks are for trading, not to buy and hold in the hope of a future dividend.

At this stage of the resources sector getting a second wind thanks to solid growth in China and other commodity-intensive emerging market economies, it is best to focus on the basics. And that means iron ore (when it returns from its current unsustainable run), copper, nickel, zinc, coal (with care), and the petroleum twins, oil and gas.