Summary: Although this year is going to be demanding for most resources, aluminium appears to be starting a long-term cyclical recovery. Gold is another bright spot, with currency, rather than the US dollar gold price, driving Australian gold stocks.
Key take-out: The lower Australian dollar has already boosted the local price of gold, which topped the $A1500 an ounce mark recently. Some local gold stocks have also staged their own mini-boom.
Key beneficiaries: General investors. Category: Commodity strategies, gold.
Let’s be realistic … 2015 is going to be demanding for most resources most of the time.
The recent collapse in the oil price, following collapses by coal and iron ore, has cut deeply into the profits of every company exposed to those commodities.
But there is always somebody making money is this diverse sector where Australian investors have a particular interest. For my money the key to investment success in resources this year will be in exploiting currency changes. Indeed we have two bright spots which have barely been noticed by market commentary.
First, take a look at aluminium, it appears to be starting a long-term cyclical recovery, but that’s largely because it was first into the downturn and is proving to be first to benefit from production cuts which have started in coal and which must follow in iron ore and oil.
What makes aluminium especially interesting is an international deal consummated just before Christmas when David and Simon Reuben acquired the US-based Metro International metal warehousing and trading business from the investment bank, Goldman Sachs, at an undisclosed price.
One of the most important commodities held by Metro is aluminium, which is the hottest metal in the car industry because of its use as a lightweight replacement for steel. Ford has even started producing an aluminium version of its F150 pick-up.
But it’s the return of the Reuben brothers to aluminium which is the real story, because they became billionaires when they took the plunge into Russia’s aluminium sector 20 years ago, and then sold out when the price of the metal peaked. The return of the Reuben brothers is a significant vote of confidence in metals by two of the world’s richest men.
Excess production, rather than a decline in demand, is the big issue in the commodity complex today and it will only be fixed by production cuts and project deferrals to remove excess (and that means high cost) material from the market.
Before I detail the second bright spot I want to make a wider point.
The immediate future for resource-stock investors will be like a trip through the 1990s (or 1970s), a time when commodities played second fiddle to technology and other market sectors, such as healthcare, and second-tier mining and oil stocks were forced to find ways to survive.
Many mining and oil stocks did ride out the grim 1990s, a time when copper sold for US60c a pound (compared with today’s $US2.69/lb) and gold was trading below $US300 an ounce, a quarter of today’s $US1231/oz.
The survivors were either exposed to a commodity which enjoyed the benefits of a strong price thanks to its relative scarcity, or a high-grade orebody, and the same will happen this time making scarcity and grade the first two factors that investors should look for in a resource stock.
Back in the 1990s, the resources world was in the final stages of a long-term correction caused by excess investment in new mines and limited global demand, a phase which ended with the rapid growth of demand for basic raw materials in China, a spectacular event made the more remarkable because it came at the end of the project-development cycle when there was a shortage of almost everything China wanted.
That phase is very much over and China has done what Japan did in the 1970s and 1980s; it has successfully engineered a surplus of the commodities it wants and it can now enjoy a long period of low prices – a process which can be seen in buy tips for Chinese steel makers and sell tips for the Australian companies supplying the iron ore to make the steel.
As they say, what goes around comes around, and nowhere is that more true than in the cyclical world of commodities.
It is, however, significant that the Australian mining industry did survive the dreary 1990s because it was able to keep costs down and because it enjoyed the benefit of another critical element, a cheap currency.
The currency effect can be seen at work in Australian resources today, and it will become more important as the Australian dollar retreats further, perhaps down as low as the late 1990s when US65c was the ruling rate, a level which some analysts see as fair value today.
What that means for investors with an eye on the resources sector is that as share prices descend into bargain basement territory, a point already reached by some, it is currency values which will become more important than commodity prices.
And just as it was in the 1990s the test of that situation is the ultimate commodity that is emerging strong as our second bright spot : gold.
Since late last month, a time when most people are holidaying, I have been tracking the gold price in its conventional US dollar terms, and on conversion to Australian dollars.
The results have been startling, and while it is easy to see gold as a special case there is a common thread linking most commodity prices – they’re traded in US dollars and the currency effect on copper, iron ore, coal, nickel and just about everything else is the same at it is for gold (that’s why it’s called a common thread).
Without anyone else seeming to notice there have been a few days recently when the local gold price topped the $A1500 an ounce mark, a level which would once have hit the headlines but which has been ignored because the popular view is that gloom in the iron ore, coal and oil sectors is all-pervading.
With gold, it is not over-stating the case to say that if a miner of the metal can’t make a profit at a gold price of $A1500/oz it should find something else to do.
The currency effect will, in time, also be a factor in the commodities hit hardest by the downturn, including iron ore, coal and oil.
For Australian investors wary of buying directly into international markets, mining and oil stocks with US dollar income are a de-facto way of gaining exposure to the world’s dominant currency, with gold the obvious starting point as a currency play.
Last night I ran a fresh price check to discover that gold was trading at $US1231/oz ($US3 less than the first trading day of last year), but the exchange rate over the past 13 months has fallen from US89.82 cents to US81.65 cents – lifting the local gold price by $A134/oz, or 10%.
Much of the recent rise has come since mid-December, which is why some of Australia’s over-looked gold stocks have been staging their own mini-boom.
Northern Star is up by 80% since early December (from 99c to $1.81) and is close to its 12-month high of $1.91. Sector leader, Newcrest, is up by 41% (from $9.17 to $ 12.95) and did hit a 12-month high yesterday of $13.09.
The gold price, in US dollar terms, is not driving Australian gold stocks. It’s currency which is doing the job.
Currency will continue to dominate gold, and will become a more important consideration for analysts as they look at the effect on other commodities and other resource stocks which have their cost base in Australian dollars and their income in US dollars.
Other big issues will also determine the resource-sector mood in 2015, which is likely to be flat or, as Macquarie Bank prefers to call it: “a long grind”. Issues to watch, which could present investment opportunities (buy or sell), include:
· Tough times for BHP Billiton and Rio Tinto, with BHP Billiton facing a hard sell in convincing its shareholders that a spin-off of surplus assets into a new business is a smart move, while Rio Tinto faces the near certainty of a fresh merger (takeover) approach from arch-rival Glencore.
· Oil stocks will remain under pressure for much of the year as a deadly game of market flooding is played and high cost oil (and gas) is forced out.
· Iron ore stocks face a future similar to oil, but the tough times could last longer.
· Aluminium is in the early stages of what looks to be a sustainable recovery. Rio Tinto certainly sees aluminium as a replacement for falling iron ore profits.
· The base metals of copper, zinc and lead will enjoy more support than iron ore, coal and oil, but will not boom thanks to abundant supply from mines developed during the boom to meet Chinese demand which is slowing.
· Nickel is potentially a big winner, but only if Indonesia sticks to its ban on the export of unprocessed ore.
· Graphite could be a winner, but there is no shortage of the material and only the highest quality producers will survive with many of the early starters likely to fail.
· Uranium is unlikely to perform strongly thanks to competition from other fuel sources, including cheap coal and now cheap oil.
· Renewable energy stocks, once a favourite of the ethical investment community, face a double whammy of competition from cheap oil and the loss of government subsidies.
· Explorers, unless they have a foot on a world class discovery, will remain in the doldrums thanks to what is effectively a capital strike by risk-averse investors.
As an overview, the big events in resources this year will be news of more production cuts, trouble for small and/or high-cost producers, and the entry of bargain hunters such as the Reuben brothers, and possibly from private equity funds which have been sitting on the sidelines waiting for asset prices to fall.
Corporate activity will also pick up as merging becomes a preferred way of ensuring survival, while the falling Australian dollar will help local commodity producers stay in business and start to make Australian resources look cheap to investors with access to US dollars.
There are two final and important points to make about the Australian resources industry.
First, it is never dull (going up, or coming down). Second, it will remain Australia’s dominant export industry for many years. We might not ride on the sheep’s back any more, but we do pay our way by digging and delivering.