Kohler's market caution was right

Alan Kohler's warning to Eureka Report subscribers in late 2011 has proved prescient given last week's stock market sell-off. While Australia’s banks are well prepared for a global funding freeze, it's a different story for the mining sector.


Eureka Report

It was late in December and I was sitting on a bench overlooking the ocean and reading Alan Kohler’s weekend Eureka Report comments as he looked forward into 2012.

Kohler saw dangerous events ahead for 2012 and he alerted Eureka Report readers to be extremely careful in the year ahead. In fact, he went further than that and suggested it was time to substantially reduce the equity content of your portfolio and that’s what he did in his own self-managed fund.

I phoned him later in the day and asked him whether he had perhaps gone too far and I suspect that resulted in a more cautious comment the following Monday. I should not have made that call. His underlying sense of danger was right; his mistake was to underestimate the ability of central bankers and others to sweep the European problems into a corner and flood the market with liquidity, which gave temporary relief. But the underlying problems are still there. I suspect that the authorities will again find a way to paper over the European bank and currency crises and in the short term, all will be well. But the underlying problems Kohler isolated will still be there.

During 2012, the Australian stock market began to rise and it kept rising until it was well over 10 per cent beyond the Kohler alert. I know Alan felt very bad after December 2012. But we have seen the market decline steadily from that peak to the point where it is now not very far from the level where he issued the famous warning.

I know a great many Eureka Report readers are grateful for that warning, because they lowered their risk exposure and took advantage of term deposit interest rates that were higher than currently exist. And they are also grateful for the regular warnings that Eureka Report issued about the state of China and the dangers to resources stocks. Kohler saw danger signs that the professional analysts who dominate our markets simply didn’t see or didn’t want to see.

The professional investment managers’ speculative activity fuelled the market’s rise during 2012 and in the process lost a lot of money for the unfortunates who place their savings in publicly-managed superannuation funds. Overall, many self-managed funds were much more careful and understood the forces far better, helped by our team at Eureka Report.

Very clearly, the global markets are concerned that the Greek crisis will cause another meltdown in the banking system. That doesn’t mean it will happen, but there are forces out there that are very dangerous. Two weeks ago, I had dinner with the CEO of one of our larger banks. The bank CEOs are positioning themselves for the possibility of another freeze in access to overseas bank funds. It is not that they forecast a freeze or that they think a freeze is the most likely outcome – it is just that there is a clear danger which it is prudent to prepare for.

The attraction of quick trading profits that yield big executive bonuses and large shareholder returns has been very hard for many big global banks and institutions to resist. As a result, stupid risks have been taken and the institutions have lost their capital. Only a week ago, JP Morgan reported a $US2 billion trading loss as a result of this risky behaviour. To date, the European banks which were in trouble were given money by the European Central Bank at low rates, and they plonked it on suspect southern European country bonds (it was like backing a horse) and lost their shirt once again.

As far as Australia is concerned, I think our banks are as well prepared as they can be. But in parallel with this banking situation, we are seeing a re-evaluation of our mining investment boom. A lot of projects are going to fall by the wayside. It is simply not going to be easy to get the capital – particularly loan capital – to pursue all the projects that we have on the drawing board. That’s one reason small miners are being punished in the market. It is possible that some of the projects that have started may have to slow down or be suspended if the banks that have supported them get into trouble.

When it comes to coal, only the most foolhardy of operators would want to undertake a major coal expansion unless the marginal cost of extraction was very low indeed. That means all the planned New South Wales and Queensland coal expansion projects are going to be reviewed again, unless they are well on their way. Some will proceed, but many will not.

If you have shares in a company that has coal projects on the drawing board, be alert to the possibility of deferral.

Not only is the cost of additional mines now three times the level of two years ago, but there is a coal price ceiling being imposed, because the US is going for coal and shale gas and that is going to result in a big surplus of coal production capacity, which will put a ceiling on Pacific Basin coal prices. In addition, there are big deposits in Mozambique and other areas. So while the demand for coal may stay strong, the potential of extra supply is very great. The Australian government’s expected revenue from its mining tax on coal also looks far too high.

When it comes to iron ore, both Rio Tinto’s expansion and the BHP inner harbour expansion at Port Hedland will produce very low-cost iron ore and will go ahead. I am much more dubious about BHP’s outer harbour project. There is also considerable iron ore expansion in other countries, so I think that quite a number of the Australian iron ore proposals which are now on the drawing board will be deferred. Aluminium is also struggling because of the high costs of power and the linking of aluminium demand to consumer expenditure.

The metal I like best is copper. Copper prices are going to be soft for a while, because there is too much stock in the bin and a lot of speculators have used the cheap money created by America’s quantitative easing programs (known as QE1 and QE2), plus the European money spray, to accumulate trading positions. That speculative money will need to be run out of the system. And in contrast to iron ore and coal, where there are substantial amounts of material available, there are very few large copper deposits coming on stream and some of the old mines, like those in Chile, have reached their peak. Two of the biggest copper projects are Rio Tinto’s Ivanhoe mine in Mongolia and BHP's Olympic Dam in South Australia. The Oyu Tolgoi mine in Mongolia looks very good and Rio Tinto has manoeuvred brilliantly to gain control of it at an attractive price.

The problem with Olympic Dam is that the copper is mixed with uranium and it is not easy to transport the ore for this reason, so an economic way has to be found to lower the uranium content in the material to be shipped. The economics will depend on the price of uranium as well as copper. Separately, China is making an enormous nuclear power thrust as it attempts to generate electricity without carbon, and India is not far behind. So demand for uranium will be robust, even though Europe and the US are heading in a different direction. The Olympic Dam mine requires about five years to remove the overburden to get at the ore. That is a lot of expenditure without a return, so in the current environment the expected Olympic Dam profits will need to be good.

BHP is almost certain to push ahead with its US liquids and shale gas expansions and that will absorb a lot of capital. Its potash project, however, may struggle, because the price of potash has come down. Later in the year, BHP is going to prioritise its expansion pipeline, so it will need to make a decision on its outer Port Hedland harbour, potash, US coal/shale gas and Olympic Dam projects. The way those decisions fall may depend on just what happens in this current European crisis.

This article first appeared in Eureka Report on May 18 Republished with permission.

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