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Mining stocks: How low can they go?

Andrew Mickey
0 Comments| October 24, 2008

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Recession fears have taken their toll on almost everything. Even popular recession-proof stocks like Wal-Mart (NYSE: WMT, Stock Forum) and McDonald’s (NYSE: MCD, Stock Forum) have taken their lumps too. The worst place to be invested though has been in commodity stocks.

No one knows how bad this recession will be, how long it will last, and how great an impact it will have on the once-quickly growing economies of China and India which have propelled the commodity boom. Frankly, it all depends on when the world’s shattered confidence can be rebuilt. But with credit markets remaining tight, a stock market that has tanked, and unemployment on the rise, you can bet we’re not going to see the light at the end of the tunnel for awhile.

This uncertainty has been a huge drag on commodity markets. After all, a deep global recession would send commodity prices plummeting further and could push them all the way back to historic norms. So far, recession fears and reduced demand for commodities have caused the Reuters/Jefferies CRB Index to fall 33% in the past few months.

The CRB Index is made up of a wide basket of commodities. Everything from oil to gold to livestock prices has an impact on the CRB Index. Energy and agricultural commodities are off anywhere between 5% and 60% from their recent highs. The biggest drag on the index has been 50% to 70% drop in base metals over the past few months.

Base metal prices are down…way down, and a global recession may push them down even further. As a result, I wanted to take a look at the “worst case” scenario for base metals and what impact it would have on energy on mining stocks. After all, if the recession really took a turn for the worse, base metals could return to their 2002 lows.

Think it can’t happen? Just take a look at zinc.

Zinc is used primarily in steel production. The downturn in the global has economy sharply reduced demand for steel. Falling auto sales and lack of new construction projects will have (and have had) a very negative impact on steel demand.

A commodity like zinc, which doesn’t have many other uses outside of steel, would naturally have its fortunes closely tied to steel. Right now, that’s not a very good place to be. Zinc prices continued their fall to 52 cents a pound earlier today. That prices marks a 75% decline from zinc’s peak of more than $2.00 per pound in 2006 is the lowest zinc price since mid 2005.

It’s not just zinc though; similar drops have occurred in nickel and aluminum prices. The world’s largest aluminum giant, Russia-based RUSAL, now says, “75% of aluminum producers in Europe, the United States and China were operating at below break-even with the metal trading at or below [current prices of] $2,500 per ton.”

The downturn in base metals has caused a tremendous sell-off in mining stocks. Leading the way down has been zinc, uranium, and fertilizer mining stocks. The combination of forced selling by hedge funds and falling commodities prices has pushed energy and mining stocks to new 52-week lows.

If we look at the current lows, they’re still not as low as they could go. If we consider the start of 2002 as the previous bottom in energy and mining share prices and use it as the “worst case” scenario, there could be some more downside left.

Take a look at the chart below.

Historic Mining Share Price Snapshot
Company Recent Share Price 104-Week High % Decline So Far Jan. 2002 Share Price How Low Can They Go?
Rio Tinto (NYSE: RTP) 154.27 554.93 72% 77.85 50%
Freeport-McMoRan (NYSE: FCX) 33.11 124.83 76% 13.28 61%
Hecla Mining (NYSE: HL) 3.22 13.03 76% 0.93 71%
Teck Cominco (NYSE: TCK) 13.20 52.61 75% 6.43 52%
Southern Copper (NYSE: PCU) 11.50 47.12 76% 11.75 --
PetroChina (NYSE: PTR) 74.92 263.70 71% 18.09 75%
Occidental Petro. (NYSE: OXY) 42.84 97.85 56% 26.51 39%
Aluminum Corp. of China (NYSE: ACH) 10.12 88.05 89%% 5.25 48%

As you can see, there could be a lot more downside left in commodity sector stocks. These companies are highly leveraged to underlying commodity prices and there is still plenty more room to fall if the world economy gets really ugly.

Of course, when analyzing the individual companies we also have to consider expansions, investments made over the past few years, and the general price level increases resulting from inflation over the past few years when determining the true bottom for these stocks. And I think the 2002 lows will not be reached, but in a market like this where uncertainty reigns and markets would rather err on the low side, it’s certainly not impossible. When earnings, fair value, and future growth are unpredictable, watching many of these stocks swing a bit lower over the next few months is not out of the question.

I realize most of these mining stocks are at the lowest prices they’ve been in a couple of years. But considering the overcapacity in the automotive industry, sharp fall-off of industrial production and the unknown impact of a global slowdown on base metal prices, there could be even more downside to come.

Most mining stocks have incredibly low P/E ratios and very high yields. For instance, Teck Cominco sports a current P/E of 4 and a dividend yield of 6%. But if copper and base metals prices continue their downtrend, earnings will decline sharply and the company will be forced to slash its dividend payments.

For now, it’s best to take a “wait and see” approach for mining sector stocks. For investors that do want to start nibbling away at mining stocks, it’s probably best to use a more conservative investing strategy. One that will allow you to start buying today, have you positioned to enjoy the inevitable and likely sharp rallies, and still benefit from any further sell-offs. Although with markets as volatile as they are, there could be more downside to come.

Good investing.

Disclosure: Andrew Mickey has no position in any of the stocks mentioned in this article.

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