Zinc Falls Victim to Commodity Boom 2.0.

It’s set to happen all over again and this time it could be even bigger.

Commodities have had a nice run over the past few years. But after 50% or greater corrections in oil, copper, platinum, and other commodities, the stage is being set for another huge run in commodities.

The last couple of months have been pretty hectic. We’re in a recession. Unemployment is still on the uptrend. Deflation has set in. And no one knows when we’re going to get out of this downward spiral.

It’s been a shock to the financial system. Everything practically shut down. The problems at the banks are dominating the headlines, but the trickledown effect on the mining industry has and will be significant. And if the world economy recovers in the next two years (which given the stimulus packages and free money headed to the U.S. consumer, it will eventually) watch out. The commodity boom will return. And will probably be even stronger.

The commodity industry is cyclical. It has been for a long time. Right now, we’re in a temporary down part of the cycle. Commodity prices are falling from their lofty highs and everyone is running for cover. No one knows how bad this recession is going to be and investors are fleeing once-hot commodity markets. And this is the time investors should start to get interested in sectors, like mining, which have all the long-term fundamentals in their favor despite the big sell-off.

The financial community is not just selling off mining stocks though. It is also putting the stops on many new mining projects. After all, an economic downturn will slash major mining companies’ profits but it would also destroy the economic viability of any new projects.

Here’s the problem though. If the economy can recover fast enough, we’ll be right back where we were two or three years ago when supply couldn’t keep up with demand. It's Commodity Boom 2.0.

The cycle has already started and zinc is the first victim. The Financial Post, in Supply Issues for Zinc, Lead, and Copper explains:

With zinc prices falling to US$0.504 per pound on the London Metals Exchange Friday, current prices suggest at least 1.3 million tonnes of production will shut down by 2009, according to Octagon Capital. If that happens, the lead market will also see a huge deficit, analyst Hendrik Visagie said in a research note...

As for copper, its depressed price is expected to keep new mines from being financed, so look for long-term shortages there.

“As a result, we are confident the current price of lead is overdone, and metal prices in any future scenario would be significantly higher than they are today,” the analyst said.

The perfect example of all this is in the zinc market. Zinc is used primarily for steel production. And zinc prices have been absolutely crushed.

As you can see in the chart above (click to enlarge), zinc prices have returned to their average price before the commodity run even started a few years ago. Many zinc mines have scaled back production or shutdown altogether as a result of the price decline.

Strategic Resources Corp ((TSX:SRZ)) announced last week it would shut down one of its mines and cancelled two other zinc mines scheduled to go into production.

In an interview with AP, Strategic Resources VP of IR said,

It's a difficult time. We did everything in our power to avoid the scenario of care and maintenance, but when the credit markets dried up we couldn't get the funding.

The expected announcement put the cap on Strategic Resources’ fall from more than $5 per share to less than two cents per share yesterday.

Lundin Mining’s (NYSE:LMC) announced its zinc mine in Ireland will enter a three-year phased shutdown. Hudbay Minerals (HBMFF.PK) announced it will be shutting one of its zinc mines in upstate New York down in August. Mining giant Teck Cominco (NYSE:TCK) said it will be closing down one its zinc mines in Australia.

That’s just a few of the bigger ones. Five more mining companies have either shut down their zinc mines, scaled back production, or canceled plans to go into production. It’s getting ugly out there and the commodity contraction has had a significant impact on the zinc industry.

The problems which have hit the zinc mining sector have come from a 75% decrease in prices. If copper and other base metals prices continue to falter, major diversified mining companies like Rio Tinto (NYSE:RTP) and Freeport McMoRan (NYSE:FCX) will be forced to do the same thing.

They will be able to fight through a soft recession, but they can’t and won’t keep their mines open if they’re not profitable.

Already, mining deals for new mines are getting shelved. Not too many investors and financiers are willing to get behind a new project if current producers are getting shut down.

It’s history all over again. If commodity prices continue to fall, we’ll be right back in the same position we were five years ago. The mining industry will be underfunded and underdeveloped and the supply side of the equation will be in catch-up mode once again.

Right now, it’s still too early to tell. The economy is on the ropes and there’s just too much uncertainty out there. That uncertainty will help keep any rally in the mining sector tame.

For now, I’d recommend being as safe as possible when buying mining stocks. A better time to buy is probably on the way. And if you wait patiently, you’ll probably be able to pick up mining stocks at even better prices. After all, if you miss the first 15% to 20% of the re-boom, you’ll still have gotten in on what should be a huge run without taking on too much risk.

There’s still a lot of uncertainty out there and any further declines in unemployment, consumer spending, will drag commodity prices even lower. Once more mines start getting shut down; it’ll be time to start moving into the mining sector in a big way. The long-term fundamentals are strong and with each mine that gets shut down, they get even stronger.

Disclosure: I have no position in any of the listed shares mentioned.

Comments

[Hefaistos:]

Good analysis.
Demand broke down, supply is scaled back.
What would the lead time be, for a demand-led turnaround in the metals market? Supposedly, we'd nedd to see some robust gdp growth data before your scenario with a rebound plays out.

2008 Oct 30 02:07 PM