Resources: a post mortem
The instinct of value investors is to hunt in areas that most are ignoring – to be greedy when others are fearful. Many times, this instinct serves us well. But right now, playing the contrarian in the resources sector is dangerous.
Both commodity and equity prices have fallen dramatically this year. As Chart 1 shows, base metal prices are significantly lower. Nickel and zinc prices have been hardest hit but copper, last year’s hottest metal, has also tumbled. Gold, coal and fertiliser prices all tell the same story: the resources boom is over.
In The commodities conundrum on 5 May 11 we argued that commodity prices were now being driven by global monetary conditions, rather than by the fundamentals of supply and demand. In other words, the actions of central banks were pushing prices higher. This has been a key reason we’ve largely avoided the sector. But with prices now falling, is it time for another look?
Key Points
- Commodity prices are rapidly falling
- With a few exceptions, we still recommend avoiding the sector
- Big miners starting to look interesting
Not quite. Although prices of both commodities and equities have fallen, they remain historically high (see Chart 2). Moreover, Mr Market's main concerns today – Europe and China – could get a lot worse. We’ve already argued that the Chinese economy is dangerously unbalanced and could wobble at some point (see The coming China crash). Yet prices still anticipate considerable growth. Iron ore, for example, still trades at over $130 a tonne when it has averaged closer to $20 a tonne for the previous two decades. Similarly, copper prices are about three times their historic average.
Avoid mining services
Some parts of the sector are less attractive than others. In particular, mining services stocks are to be avoided. These are almost universally terrible businesses. With no barriers to entry, high cyclicality and wage inflation eroding profits, the boom masks how risky the sector is.
Take Monadelphous for example. The share price has had an incredible run, rising from less than $2 in 2004 to more than $20 today. Profits have rocketed; earnings per share have grown from 11 cents in 2004 to $1.09 last year. It’s tempting to credit the company with achieving stupendous success.
Monadelphous is a good business. As we highlighted in Is Monadelphous the greatest?, it’s the pick of the sector and deserves kudos for performance. Profits, however, have been driven by record levels of mining investment, not organic growth (see Chart 3). This is a cyclical business masquerading as a growth stock. Investors have fallen for the ruse – it currently trades on a PER of over 20. Should mining projects be cancelled – and make no mistake, that is exactly what will happen if commodity prices fall – growth will evaporate. This will mean not only falling profits, but PER compression – a double whammy that will ensure the stock falls swiftly and far.
And that’s the best in the sector. Lower-quality peers would be hit even harder. Those that have taken on debt would face a mortal threat.
Without exception, mining services stocks are to be avoided. If all goes well then this warning will be hailed foolish. Fine. It's better to be foolish than to be broke.
Base metals
Base metals stocks should, at some stage, yield opportunity. We estimate that zinc and nickel prices are already close to marginal production costs. That usually arouses interest, but not this time. Global stockpiles of both nickel and zinc are large, so low prices can be sustained for some time.
Several miners have reported cash losses, including Mirabela Nickel and BHP Billiton (in its nickel division). Kagara Mining has already gone bust. Prices will recover as losses mount and production is cut. We expect this will start to happen at some stage. The best producers in the sector are Independence Group and Western Areas. Both boast low costs, substantial resources and successful management teams. Both stocks are on our radar.
Coal
The coal sector has borne the brunt of investors' wrath. In From ash to cash: an introduction to coal, we highlighted that the sector appeared overvalued. Today, the situation is very different. Shale gas explains the change.
Dramatically lower gas prices in North America – prices have fallen from over $10 a gigajoule in 2006 to $2 a gigajoule today – now allows gas to compete with coal as a fuel source. American industry is responding as you would expect, by supplanting coal generation with gas.As this trend continues, there is concern that the coal that once went to power America will ultimately be sold into Asia, lowering prices.
This is already happening: US coal volumes into Asia are at 20-year highs. A significant freight cost – perhaps $40 a tonne – is the only protection local coal miners have against an even greater flood of supply. Coal mining profits are at the mercy of global shipping rates.
Equity values are starting to reflect this risk. The hyper-valuations of just a few years ago have been savaged. The two highest-quality independent coal miners, Whitehaven Coal and New Hope Corporation, have seen share price falls of more than 30% each in the past 12 months.
Coal prices may not reclaim previous highs, but high-quality, low-cost coal, both thermal and metallurgical, remains valuable. Whitehaven and New Hope operate quality assets with excellent infrastructure. Both companies are now on our radar, although further falls would be needed to trigger an upgrade.
Rare earths
Special situations can still be found in the industry. Many investors remain enthusiastic about rare earths; not us. As explained in Beware the boom in rare earths, higher prices are encouraging new supply and lower demand. Prices of most rare earth elements have already fallen more than 50% and we don’t anticipate a rebound.
Alumina and tin
In the alumina sector, structural change may be more enduring. A chronic lack of new supply combined with expected higher prices should increase the value of low-cost, large-scale assets, such as those owned by Alumina. We reiterated a Speculative Buy call in Alumina: down, then up on 15 May 12 (Speculative Buy - $0.96).
Tin is a commodity we introduced in a Friday Fishing article on 19 Mar 2012 and, for the adventurous, Venture Minerals remains a stock to watch.
Gold and energy
Although the commodities rout has not spared gold or energy, we remain far more upbeat on these sectors than others. Gold is, as we’ve argued before, a currency rather than a commodity. If you agree, An instant gold portfolio will help you construct a portfolio of miners that are worth attention right now; Silver Lake Resources, Kingsrose Mining and Azumah Resources.
In the oil and gas sector, Origin Energy, Santos, AWE and Tap Oil remain on our buy list. Cue Energy is close to being upgraded and Antares Energy , introduced in a Friday Fishing expedition on 27 Apr 2012, is interesting for those with iron stomachs.
Big miners on the radar
With these exceptions, the sector still lacks appeal despite the price falls. The Chinese economy has slowed slightly, but is still growing at a relatively swift pace. Should the structural factors we’ve sweated on create a deeper recession, savage price falls would follow.
The giants of the industry – BHP Billiton and Rio Tinto – might become attractive in such a scenario. Over the coming weeks, we’ll be reviewing valuations for these businesses. Given their size and complexity, that’s no easy task. But low expectations are starting to be reflected in their valuations. Contrarian instincts are starting to stir.