After swooning more than 15 percent in the last two months, copper appears to be trying to find a bottom. Having plunged in the month of May, the price decline has certainly slowed over the first two weeks of June. We have a ways to go to call a bottom, but in the short term, the price action over the last few days is starting to look interesting.
Meanwhile, there are fundamental reasons to believe that copper may be ripe for a move higher. First, copper inventories at the LME recently hit a 4 year low, having dropped almost 50 percent since August of last year. The decline of excess inventories indicates that excess supply is no longer burdening the market. On the contrary, with inventories at 4-year lows, any positive demand shock would send dealers scrambling for metal. Second, with the global economic outlook darkening, the news out of China indicates that the policy of monetary and fiscal tightening is in full retreat. China has recently begun fast tracking infrastructure projects again to shore up growth, a clear positive for copper. Additional monetary stimulus, including a 25 basis point cut in interest rates last week, should provide further support for the world's largest copper consumer.
Still, with Europe falling apart, any play on copper is going to require a stomach for volatility. Until we see signs of stabilization in Asia, copper is going to continue to feel pressure. Any signs of further weakness out of China would likely send the metal to retest its recent lows.
With that in mind, it pays to find copper producers with a hedge in the current environment. After poring through numerous mining stocks, two in particular have the sort of hedge to make them compelling long term growth copper plays. The first stock, Revett Minerals (RVM), derives only half of its revenues from copper, with the other half coming from silver. The second company, Nevsun Resources (NSU), has a primary resource of copper buried underneath a significant amount of gold. As their mine is still in the early phase of its life, Nevsun has not yet begun to produce copper, but its gold is throwing off significant cash flows right now.
Let's take a deeper look at Revett. At the moment, the company actually has two hedges for a falling copper price. First, it has put on a tactical hedge by selling forward 25 percent of 2012 copper production at $4 per pound. Next, Revett's long term hedge is that revenues are split about 50/50 between copper and silver. This gives the company a bit of safety in its revenues as silver is less sensitive to the economic outlook than copper and has the potential to mimic gold as a "currency" asset.
Although earnings are likely to decline from the first quarter due to weakening commodity prices, this is already a very inexpensive stock. Revett sports a market cap of $113M as of this writing, and has a clean balance sheet with no debt and over $28M in cash on the books. Meanwhile, the company generated $7.5M in cash from operations in Q1 and net income of $3.7M. Even accounting for the decline in commodity prices, Revett looks poised to generate at least $25M in cash from operations in 2012 and earn in excess of $12M. That gives the company a P/E of less than 10 while it adds significant amounts of cash to its books each quarter. With almost $30 million in cash and no debt on the balance sheet, the financials would be enough to get any savvy investor interested.
However, what is truly interesting about this play is that Revett has 100 percent ownership of the largest copper/silver project in North America. Its Rock Creek project, which is essentially assigned no value in the current share price, boasts over 200 million ounces of silver and over 2 billion pounds of copper resources. The mine is still in the process of obtaining environmental approvals, but if approved, is projected to yield 6 million ounces of silver and 52 million pounds of copper annually, which amounts to more than 5 times Revett's current production.
Simply put, Rock Creek is a game changer for Revett. The project remains at the environmental review stage at present, and while the mine faces opposition from several environmental groups, the courts and the U.S. Forest Service have repeatedly sided with Revett in past lawsuits. While the environmental and legal hurdles at Rock Creek are certainly risk factors going forward, Revett's current valuation suggests that downside may be limited even if Revett suffers another legal setback in developing its prime asset. For those looking to buy into a small cap copper play, Revett provides low risk and the potential for big rewards.
Meanwhile, Nevsun Resources is a slightly more risky play on copper, but also sports a bargain valuation and hedge against a decline in copper prices. Nevsun's main asset is the Bisha Mine in Eritrea. The deposit, an open pit copper mine topped with a layer of high-grade gold, is in its second year of production. Due to the geological structure of Nevsun's resources, the company is producing gold almost exclusively until their mine reaches the deeper depths of the copper deposit. As a result, Nevsun expects to produce 240K to 260K ounces of gold in 2012. In the first quarter of 2012, the company produced 82K ounces of gold at a cash cost of $277 per ounce, generating $27 million in cash from operating activities. Nevsun also has a strong balance sheet, with almost $280 million in cash and no debt against a $770 million market cap. Additionally, Nevsun has a large land position in Eritrea and significant opportunity to expand its resources by further exploration around the Bisha Mine. Indeed, its two main exploration prospects have already returned promising drill results, and are close enough to Bisha to use existing infrastructure.
The two big risks with Nevsun are political risk and acquisition risk. On the political side, there are positives and negatives. While Nevsun does not face the permitting hassle of Revett or any U.S. based miner, Eritrea is a one party state and thus property rights are relatively weak. The Eritrean government currently owns 30 percent of the Bisha project, but based on trends around the world, it would not be surprising if the government were to attempt to gain more control of the asset if prices move higher or resources grow with exploration. Second, on the acquisition risk front, Nevsun has said that its stated goal is to stockpile cash to be used for an acquisition to diversify the company geographically. The strategy is obviously sound, but it remains to be seen whether Nevsun can find another attractive asset and add value through acquisition. As the management has not done a major acquisition before, the risk that they overpay or choose a risky asset will likely hold down Nevsun's valuation until the deal gets done.
Overall, Revett and Nevsun are small cap stocks dependent on one asset for the time being. This makes them inherently risky, but both already appear to be priced to reflect that risk. With healthy balance sheets, solid cash flow, and big upside from further exploration and development, the risk/reward profile at both Revett and Nevsun looks favorable for investors. For those looking for small cap copper plays with a hedge against falling copper prices, they are certainly worth a look.
Disclosure: I am long RVM.