Metals: When Headwinds Become Tailwinds

by: Roger S. Conrad

The Metals and Mining industry is highly cyclical and fiercely competitive, given to periodic overcapacity and sharp fluctuations in prices and demand.

Weakening global economic conditions have provided a major headwind for this sector, but I still think that its long-term prospects are attractive. I expect these headwinds to soon become tailwinds.

Natural resources prices-and by extension sector profits-rise and fall with economic growth. And while prices for many resources remain high, including copper, the fear is slowing growth or even a new recession in 2013 will send the price of everything from gold to iron ore plunging.

The other major headwind affecting commodity stocks this year has been operating costs. Labor and materials shortages have pushed up production costs in countries such as Australia. A wave of strikes, meanwhile, has threatened output and economics in South Africa, long a mainstay of global supply for a wide range of key metals and minerals.

Elsewhere in Africa, resource nationalism has risen sharply, with governments demanding bigger shares of ownership and profits. And the so-called M23 rebels in Congo have seized control of a region that ranks among the world's largest sources of columbite-tantalite, a key mineral known as "coltan" that's used in wireless phones and computers.

Rising costs, hampered production and lower selling prices have already taken a toll on miners' earnings this year. Damage has been worst at smaller companies with limited product and geographic development ranges. But even giants have felt the bite.

BHP Billiton's (NYSE:BHP) long-time CEO Marius Kloppers, for example, is again the target of replacement rumors, after the company's latest job cuts and the failure of recent acquisitions to perform to expectations. This Aussie miner, as well as other mining companies down under, also began paying a new mining "super profits" tax in their home country in October.

Resource nationalism always waxes when metals have been in a bull market. And the more companies ramp up development activity, the higher operating and materials costs rises. Finally, every bull market in commodities eventually comes to an end, as higher prices encourage new production and swell new supplies, even as they spur greater conservation and the use of alternatives.

That's precisely what happened in the 1980s, following the 1970s commodities bull market many at the time considered a new normal. And the result was devastating for metals and mining stocks across the board for years after, including the companies that were able to continue growing output.

The Resource Bull Market: Older But Stronger

The question is, are we at the end of this bull market, or just at a temporary lull on the way to higher prices in coming years?

It's hard to argue we haven't come a long way already. I co-authored the book The Agile Investor (1997) with money manager and newsletter editor Stephen Leeb. In it, we noted what was then a very long bear market in prices for a wide range of resources, from titanium and copper to silver.

The 10 resources we highlighted had dropped an average of 36 percent from their average 1980 price in nominal terms-and were selling for literally pennies on the dollar of their former prices, adjusted for inflation. Since then, however, the price of copper has soared more than six-fold.

Arguably, the bull market of the past 15 years still doesn't get us all the way back to the early 1980s adjusted for inflation. In fact, even at nearly $1,700 an ounce, the price of gold itself is still barely half its 1980 high water market of $3,000 plus an ounce, adjusted for inflation. But it's an impressive move all the same and begs the question, how much higher can prices go?

Much of the appeal natural resources prices, particularly gold, is in the idea that the US is headed for runaway inflation and a dollar collapse-the "inevitable" result of several years of basically zero interest rates to combat deflationary pressures. For more than a few investors, the re-election of President Obama for four more years and the failure of Republicans to take over the US Senate has sealed the US dollar's fate, making it imperative to get money into hard assets.

Gold is undeniably the world's most enduring store of wealth. And to the extent the US dollar loses value in coming years, its price-as well as those of other natural resources-will likely rise, because it represents the antithesis of paper money.

The more convincing argument that the 15-year natural resources bull market still has legs, however, has little to do with monetary policy. Rather, it's the continued growth of developing Asian economies which, while they've come a long way, still have even further to go to approach living standards of the developed world.

China, for example, is on track to become the world's largest economy by gross domestic product (GDP) later this decade. In terms of per capita GDP, however, it's barely in the top 100 nations. India, the world's second most populous nation, ranked nearly 50 places lower in world standings. Neither are Indonesia, the Philippines or Vietnam in the top 100 for per capital GDP, despite torrid growth in recent years.

Getting those populations up to anything approaching world standards for infrastructure will require an enormous additional investment that can only be made in terms of decades. And it will have to be fueled by an unprecedented future call on the world's natural resources.

Demand for copper, iron ore, metallurgical coal, aluminum and other raw materials will wax and wane along the way-and right now we're definitely in a waning phase. But as long as these countries are striving to build a better life for their citizens, their need will provide a floor under demand, and when the global mood improves so will prices and miners' profits.

To be sure, costs will continue to rise as well, as will risks from mining execution to politics. Not every resource company will survive the inevitable setbacks. Others will be forced to combine with larger rivals to go ever-further, ever-deeper and ever-more dangerously to secure needed supplies.

That's why it's absolutely essential to be particular when picking the natural resource companies whose fortunes you choose to ride. Stick to companies with rising production profiles, geographic diversification with a focus on safer lands and strong balance sheets. One producer that has these qualities is Glencore International (OTCPK:GLNCY), which has now won shareholder approval for its proposed takeover of Xstrata Plc (OTC:XSRAY).
The arrangement also passed muster with European Union anti-trust regulators. That leaves only approval of anti-trust authorities in China and South Africa as hurdles to completing the deal to create the world's-fourth largest producer of commodities by market capitalization.

Glencore, which already held roughly 33.7 percent of Xstrata, was forced to win over a range of other large owners, notably the sovereign wealth fund of Qatar. The latter in the end forced Glencore to raise its all-stock offer, even as Xstrata shareholders wound up voting down an arrangement to offer bonuses to Xstrata executives in return for staying on post-merger.

Failure of that measure to pass induced Xstrata Chairman Sir John Bond to resign effective with the merger's close, which is still expected in early 2013. And it could also lead to the departure of other top staff, 70 of who would have received payments to stay.

Even in a worst case, however, the merger offers compelling economics for shareholders of both the acquirer and the acquired. Those include vast geographic and product diversification and unmatched ability to market output, all key advantages to weathering the ups and downs of a natural resources bull market that's already older than its predecessor in the 1970s.

Recent developments include the launch of production at the Koniambo nickel project in New Caledonia in late November. Xstrata also announced its Antapaccay copper mine in southern Peru has begun to produce commercial grades and is rapidly ramping up to a target annual output rate of 160,000 tonnes of copper in concentrate.

As for the balance sheet, credit rater Moody's has affirmed an investment grade rating and stable outlook for the combination. One big reason is opportunities for synergies by combining Glencore's trading operation with Xstrata's production and both companies' pipelines of large mining projects. Another is Glencore's still-to-be-completed purchase of the Australian and Canadian grain handling assets of Viterra Inc., expanding reach into that lucrative market.

Offsetting these strengths is the inherent volatility of the commodity business. But with improved scale and a deeper resource base, the approaching completion of this belated merger is another good reason to stay bullish on this company. For 9 more commodity stock picks, see my free report.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.