By Anthony Zalesky
The commodities sector has been on a momentous run-up in the past year. Now that it is not rising as quickly, some have begun to think that the sector could be topping out. I am of the opinion that commodity stocks have not hit a ceiling; rather, I believe they are just taking a breather.
Commodities are cyclical in nature, and are currently in their boom cycle. The boom is a result of the commodity price busts in the late ‘80s and early ‘90s. This caused years of under-investment in productive capacity. Now that China and India are on a rampage to amass as many raw materials as they can to feed their infrastructure demand, commodity prices have skyrocketed.
The out performance of this sector has only been a recent event. It has only been since January 2006 that the industry has started to take off. It took the commodities industry 11 years (1995-2006) to return to its 1995 levels, when looking at the S&P 500 Diversified Metals and Mining Index. From May 2003 to May 2006, the price of base-metals on the London Metal Exchange more than doubled, with copper and zinc rising six-fold. From May 2006 to November 2007, prices have been virtually flat with the exception of lead and nickel who have continued to surge higher in price. Metal markets will go higher if the growth in global demand for materials offsets the declining growth in demand for materials in the U.S. The world economy has never grown in the last 150 years when the U.S. economy was slowing; so we are entering uncharted territory. If the global markets are not as “decoupled” as much as we have been led to believe, global growth might slow, along with demand for metals. If the market does indeed start to slow down, it is likely that something else that will sustain and prolong the growth in metals stocks: consolidation.
Growth in commodity stocks is certainly due to higher commodity prices, but that hasn’t been the only reason for the boom. How can mining companies keep or expand their profit margins when faced with the rising costs of production and the huge capital costs of finding new resources? By consolidation. The commodities industry has undergone a wave of consolidation in response to high capital costs of operation. The always-increasing costs are due to developing new sources of supply to meet the insatiable demand. You used to be able to measure how the metals prices were doing by comparing them to the performance of the company for that particular metal. For example, you could compare copper to Phelps Dodge or nickel to Inco. But within the last year, Freeport-McMoRan (NYSE: FCX) swallowed up Phelps Dodge and Companhia Vale do Rio Doce (NYSE: RIO) swallowed up Inco. The global metals and mining business is being concentrated in a few behemoths around the world such as Rio Tinto (NYSE: RTP), BHP Billiton (NYSE: BHP), and RIO.
Now there are rumors of further consolidation even amongst the giants. Rio Tinto, an Australian mining company, received an unsolicited offer from BHP Billiton, another Australian mining company. BHP’s offer was for $130 billion in an all-share takeover, but was spurned by RTP. BHP unveiled a plan that would save the two companies approximately $3.7 billion combined over the next seven years as well as offering a $30 billion post-deal share buyback. This doesn’t sit well with China, who is the largest customer of the two companies and buys 50% of the world’s iron ore production. China Development Bank, China’s state-owned investment agency, has apparently been building up a secretive stake in Rio Tinto in an attempt to block any merger deal, according to Britain’s Daily Telegraph. The report said the bank has taken a small, but symbolic (currently less than 1%), stake in RTP. China Development Bank issued a denial of the story. All of this in conjunction with China expressing concerns of the greater pricing power the combined company would have in the iron ore market. This would effectively create a duopoly with RIO. The offer consists of 3 shares of BHP for 1 share of RTP, giving RTP shareholders 41% of the combined company on a pro forma basis. The combined company would also control 40% of the world’s iron ore sales, which would surpass the world leader, Companhia Vale do Rio Doce (RIO) of Brazil.
China’s biggest steelmaker, Baosteel Group, has also publicly announced it is debating on whether it should make an offer for RTP. Separately, a consortium of Chinese steelmakers may also make an offer for RTP. China Investment Bank has repeatedly rejected reports that say it will join the consortium although the steelmakers were supposed to be meeting with the National Development and Reform Commission, China’s main planning agency. The would-be Chinese offer is reported to be near $200 billion.
Even in this time of a tight credit crunch, private equity still might be lurking to score a deal. The Blackstone Group (NYSE: BX) is rumored to be trying to gather a team to make a rival bid of its own for Rio Tinto. A Chinese sovereign wealth fund, China Investment Corp., is said to be amongst the group. Blackstone’s plan is a little different than any of the other bidders. They want to break up RTP, including undoing the merger with Alcan and selling off its prized iron-ore assets. Blackstone has denied the report saying it is not involved in buying or investing in the mining business.
It is likely that global demand growth should at least offset a decline in domestic growth if not be higher and will sustain the rise in basic materials stocks. If you don’t buy in to that argument, there are plenty of M&A rumors out there that something will probably get done. I would be cautiously optimistic entering this sector now, but I believe there is no reason to get out now if you are currently in these stocks.
In the interest of full disclosure, the author of this article owns shares of Companhia Vale do Rio Doce (RIO). The author does not own shares in any of the other companies mentioned.
