Sands shift as conditions improve

Mining shares have staged an impressive rally over the last three months as fears of a Chinese hard landing have abated.

The miners were sold indiscriminately last financial year on the basis that China would rebalance its economy away from investment in favour of consumption, and commodities would suffer accordingly.

However, on closer inspection the fundamental outlook is quite different for each commodity, and as shares in mining companies have been sold across the board an opportunity exists to invest selectively in companies exposed to those commodities with sound fundamentals.

A good place to start is a chart produced by BHP Billiton at its result last year (Fig 1).

You can see how different commodities have different life cycles, with the demand profile varying with industrial development. In the early stages of industrialisation, a country will invest heavily in steel-intensive infrastructure as this has the highest productivity pay-off.

As the infrastructure is built out and an economy becomes more industrialised, the growth batten passes from infrastructure to manufacturing and plant. Eventually, as a country becomes more developed and living standards improve, growth in these commodities will slow and demand for consumer items accelerates. This forms the basis of my cautious outlook for iron ore, but also highlights opportunities to invest in commodities leveraged to China’s next stage of development.

The mineral sands complex is a good example. The key commodities of zircon and titanium dioxide are consumed in tile manufacture and pigment production respectively.

Global zircon demand is 1.5 million tonnes annually, with China consuming 40% of this. Higher urban living standards and larger floor plates will drive higher demand for zircon going forward, even as the Chinese economy matures.

As shown in Fig 2 below, demand for paint (and hence pigment) will continue to rise along with living standards in China.

It took many years for the price of these commodities to respond to Chinese demand, as many of the larger pigment manufacturers were on favourable fixed priced contracts. You can see in Fig 3 how prices finally reacted in 2011 as these contracts rolled off.

With lower prices for so long, there was no incentive to bring on new supply, leaving the industry with few expansion options at a time when demand was strong. We also have a highly favourable industry structure in mineral sands controlled by a handful of players that have successfully managed supply. This was evident in 2012 when Rio and Iluka suspended production, keeping the market tight.

Two Australian companies, Base Resources and Mineral Deposits, are at different stages of developing two world-class projects.

Base Resources is close to first production at its Kwale mine in Kenya, with early shipments expected by Christmas. While not without risks, the shares are trading at roughly half our valuation. It is also worth mentioning Iluka Resources, the global leader in zircon and a major player in the titanium market, which will clearly also benefit from the strong fundamentals for these products.

Justin Braitling is portfolio manager at Watermark Funds Management and the chairman of the Australian Leaders Fund. www.wfunds.com.au.