Positive Outlook
04/04/05
Nick Majendie's mining sector strategy
Last week we interviewed David Thompson, the CEO of Teck-Cominco. In our interview, we asked for his perspective on the long-term outlook (3-5 year) for the three main commodities produced by Teck, namely: zinc, copper and coal.
His first response was that a lot depends on China since it represents 20% of total global demand, for base metals at least. In terms of copper, he said that China was very reliant on the West, and were it not for China’s requirements, we would be “ankle deep in copper”. He noted that there were a number of brownfield expansions hitting the market but no new large copper mines to speak of. Inventories are low currently, so he thought long-term bullishness on the outlook for copper was justified.
However, over the next three years, he would be more optimistic on zinc than copper because the demand side for zinc is less dependent on China. The West is in surplus for copper but in deficit - by 800,000 tonnes - for zinc. LME inventories are still above normal – at 580,000 tonnes – but should be down to 250,000 tonnes by year-end.
The shutdown of 5 refineries over the last three years (four in Europe and one in Australia) has created pressure on the supply side for refined metal and a stronger Euro has made the economics for European refineries very tough given today’s level of treatment charges (the Chinese are paying $70 vs. $190 three years ago). In sum, he could not see a bearish case for zinc over the next three years because you would need $0.60-$0.65 prices (for an extended period) to bring on any new production in the US, Canada and Australia and he did not see any new Red Dogs or Century mines on the horizon. In addition, the world’s top ten producers would have difficulty maintaining production at current levels over the next few years. Unlike copper, there are neither greenfield nor brownfield expansions to come on stream.
As for coal, David pointed out that the short-term looked very positive with strong pricing over the next year. In the old days, the cycle-to-cycle duration for coal was 4 years; this time around it is likely to last longer. Steel mills will sign up for three years’ future volume (not price) because there is the need for feed for a lot of new coke oven capacity. There also may well be delays in bringing on new capacity because of the lengthening backlogs for shovels and trucks.
However, he said that there was lot of coal in the world and we knew where it was, thus, he would be less optimistic on longer-term pricing than for copper, and zinc in particular. However, he did say that in the next down cycle, he thought it unlikely that coal would fall to more than half the current level of US$125/tonne. In other words, it would not get back down to the US$40/t level.
Our meetings with Alcan and Inco late last year indicated longer-term optimism about pricing for both aluminum and nickel. China was a key to each, the first in terms of Chinese supply being less than most observers’ forecasts and the second because of continued need to supply furnish for new Chinese stainless capacity and less substitution from lower grade product.
Derek Pannel, the CEO of Noranda, made similar optimistic comments in our recent conversation with him. Although the negotiations with China Minmetals were abortive, he felt that Noranda’s and Falconbridge’s contacts and sources of information had been improved through the process and their best information was that they had not seen any indications of the need to temper optimism for long-term Chinese demand for base metals.
Thus, it seems to us that at least industry participants remain optimistic that both the short-term and long-term fundamentals for base metals are sound. In addition, we have just read an interview with Chip Goodyear, the CEO of BHP, which has recently made a friendly offer for Australia’s WMC Resources (valued at A$9.3 billion). In the article, the author notes that analysts have been surprised by Goodyear’s decision to make the offer at the top of a commodity cycle and questioned him on it. Goodyear’s response was that there are two types of mining cycles. The first relates to a business cycle and typically lasts a couple of years and results in shortages in a few commodities with a consequent jump in prices. The second cycle was “more secular” and the last such one was after the Second World War.
“The demand for commodities from Japan, America’s baby boomers and other countries that were rebuilding after the war, led to a surge in demand and rises in commodity prices that continued for nearly three decades”. Goodyear is uncertain whether we are in a secular cycle now. He says: “What we’re seeing in China and India with their large populations is an intensive use of commodities. We’re seeing trends that we haven’t seen in the developed world in the past 30 or 40 years. The question is how long it will continue. Unfortunately, we can’t answer that.”
Thus, BHP is looking at two possible outcomes. The first is that prices do not flatten out and we have a repeat of what happened between the 1940’s and the 1970’s, when commodity prices quadrupled. The second is the more conservative one and the one that Goodyear is cautiously working with. This approach involves using the futures market as a short-term guide for commodity prices over the next 18 months and then assuming long-term declines in real prices.
In our view, this is not a bad approach to employ. The best proxy is the 15-month futures price for the key base metals, which are currently as follows: Aluminum (Al) $0.83/lb, Copper (Cu) $1.30/lb, Nickel (Ni) $6.32/lb and Zinc (Zn) $0.63/lb. Zinc is the only base metal where the current price is below the futures price but if the other three accurately indicated the future price of those commodities between now and mid-2006, then it would suggest strong earnings for the companies producing those metals.
The longer-term chart of the 15-month base metals futures prices for the four base metals (i.e. back to 1990) tells an interesting story. It suggests that a new secular phenomenon could be occurring both in nickel and copper (but especially in nickel) where futures prices have been above the mid-1990’s levels consistently over the last couple of years. In the case of copper, the most recent level of $1.30 is a new high for the last 15 years but only marginally so. Zinc is only slightly below the early 1996 peak while the aluminum futures’ price is still below the late 1994/first half of 1995 peak levels.
On the demand side of the equation, metals demand has correlated well historically - although in varying degrees - with OECD industrial production, albeit the OECD does not include China or India. The former, as we have pointed out above, has recently accounted for about a fifth of global base metals demand. As we have stated, anecdotal evidence from senior management of the base metals companies that we visit, suggests that Chinese demand is strong and should stay so in the short-term.
Some of the pessimists have pointed to the fact that the OECD leading indicators have a good fit with OECD industrial production and the leading indicators have been on the decline. This was true from late 2003 through to October 2004 but for the last three reported months they have been on the rise. This fits with the ECRI Weekly Leading Indicators, which we have been following for many years as a guide to the direction of the US economy and which have also been on the rise since October; indicating that OECD industrial production should soon be strengthening.
What does all of the above work tell us? In our view, the chances are high that we are in a secular bull market for nickel, copper and zinc although the continuation of strong demand from China is a key ingredient in terms of that turning out to be correct. Even if Mr. Goodyear’s alternative short-term cyclical boom turns out to be the actual outcome, we think that earnings and cash flow levels will continue to be strong this year and next. In historical context, the five base metal stocks in our universe are not expensive currently. Our five stocks saw their cash flow multiples generally higher in the 1990’s than over the last five years when metals prices have been moving to new and in some cases, record high levels. This is similar to, but less extreme than, the oil and gas sector where investors have accorded a lower cash flow multiple to the sector over the last five years on average (relative to the 1990’s), on the assumption that the recent oil price strength was unsustainable.
Despite these new and likely more sustainable high base metals prices, if one accorded these five stocks only the same multiple as has prevailed over the last five-year period (i.e. lower than the 1990’s multiples) and applied Greg Barnes’s cash flow forecasts for 2006, the resultant 2006 targets would all be between 11% (for Falconbridge) and 28% (for Alcan) higher. In addition, other than Falconbridge and Noranda, where the proposed merger has put some recent fire under the price of both, the others are all off of their peaks by double-digit percentages and so it does not appear to be worth trimming our exposure to the sector at this juncture. In fact, on further weakness in Teck, which we sold prematurely in Q4 last year after making about two and a half times our money, we would look to add. The one imponderable risk for the mining sector is the possibility that hedge funds could move en masse away from speculating in base metal commodities as they did in early 2004. Nevertheless, we remain overweight the mining sector, holding 11.0% in our Canadian Equity portfolio as compared with 6.5% for the TSX.
Nick Majendie
Portfolio Manager, Independence Accounts
Canaccord Capital