The Mineral Sands Boom

This story features ILUKA RESOURCES LIMITED, and other companies. For more info SHARE ANALYSIS: ILU

By Greg Peel

When one speaks of mineral sands one is referring specifically to zircon, rutile and, to a lesser extent, ilmenite.

Zircon is mostly used to make ceramic glazes for, for example, kitchen and bathroom tiles, but given its highly refractive properties it is also used in high-tech industrial and chemical applications where its high temperature tolerance and abrasion resistance are coveted.

Rutile, synthetic rutile and ilmenite are all feedstocks for titanium oxide, which is the pigment that puts the “white” in “whitegoods”. Titanium oxide is also used as car paint and sunscreens, among other things, and titanium metal is used in aerospace and desalination plant construction.

It is no stretch of the imagination to appreciate that China has become a major consumer of zircon and titanium oxide as its population shifts into the twentieth century with first purchases of cars, fridges and so forth to stock new, Western-style homes that boast modern kitchens and bathrooms. China is not a major mineral sands producer itself (unlike, for example, rare earth metals) and thus has become a significant importer.

The price of zircon has kept rough pace with other rising commodity prices over the past decade and analysts have long assumed demand-side pressure emanating out of China and other emerging markets. However, the world's large zircon mines have mostly passed maturity and zircon has not sufficiently been on the radar such that greenfield projects have been actively sought. Zircon has suffered, like all commodities, from previous decade doldrums and lack of investment in projects.

Suddenly, the world is facing a zircon shortage. Some small supply-side disruptions have added to the problem and Goldman Sachs now believes the market has moved into “notional” deficit two years earlier than the analysts had previously forecast. Producers are rationing supply, and Chinese buyers are reported to be able to only purchase one in every three tonnes sought at present.

Such a situation clearly means higher prices, and zircon prices have indeed been on the rise. But as Goldman implies, this might just be the beginning.

The deficit is considered only “notional” for a few reasons. Firstly, like many other industrial commodities zircon can be subject to “thrifting”and substitution. Thrifting means using less zircon in glazes for example, in this case, while chromite is one material that can be substituted for zircon if the price is too high. Furthermore, there are zircon mines in the world currently lying idle which can be fired up again.

However as Goldman notes, manufacturers have already “thrifted” down to minimum limits and limited substitution is expected in refractory applications. Moreover, in your standard glazed tile the price of zircon only represents about 1% of the price of the tile, so there's plenty of price inelasticity. Furthermore, while there is a fashion shift away from glazed tiles and toward ceramic tiles, ceramic tiles actually require a higher zircon intensity. And lastly, to reopen idle zircon mines it is anticipated higher zircon prices will first be needed.

There is not a lot here to suggest the zircon price can go anywhere but up in the medium term.

Mineral sands producers in Australia and South Africa have long suffered from the adverse effect of rising currencies on export receipts, and the current situation is clearly one in which the impact is severe. However, the boot is currently on the producer's foot, so Goldman suggests producers can push for higher USD prices to compensate for AUD and ZAR exchange rate losses. The same is true for titanium oxide.

The titanium oxide market is in a similar position to the zircon market, but there is an added factor. Traditionally, TiO2 has traded globally on a long-date contract basis (think uranium, iron ore until recently) with a cap-and-floor pricing system in place. A CAF system is one agreed upon by producers and consumers to reduce price volatility, such that producers provide price relief when supplies are low and consumers offset with price bonuses when supplies are abundant. Because of this system, TiO2 prices have been stagnant for the past decade despite major price hikes in just about everything else.

But as Goldman notes, the last of those contracts is due to roll off in about 18 months and thereafter it is likely CAF will be abandoned for a more spot-based pricing mechanism. So while the zircon price is looking at some significant upside, the upside for TiO2 is significantly magnified.

I noted yesterday that Citi had been one of the first brokers to acknowledge the QE2 impact by upgrading commodity price forecasts (Here Come The QE2 Commodity Price Upgrades). Citi's upgrades for mineral sands prices were substantial given the specific demand-supply equation, and these price upgrades led the broker to upgrade forecast earnings for Iluka Resources ((ILU)) by 50% in 2012 after netting for a new AUD assumption.

Iluka is Australia's only pure-play mineral sands miner currently in production. Rio Tinto ((RIO)) has a mineral sands division but it pales against iron ore, aluminium etc. Other pure-plays include Mineral Deposits ((MDL)) which is hoping to initiate mineral sands production in 2013, and Base Resources ((BSE)) likewise.

Goldman Sachs has a Conviction Buy on Iluka, a Buy on Mineral Deposits and doesn't cover Base Resources. The Goldman analysts have been spurred into action on mineral sands having just returned from a very upbeat industry conference in Hong Kong where they were able to improve their understanding of industry fundamentals. Consequently, Goldman has increased its 2010 forecast earnings for Iluka by 224% (off a low base) and 2011 by 70%.

Yesterday, Citi (Buy) increased its price target for Iluka from $4.75 to $8.30. Goldmans had a target of $7.50 but is yet to publish a new one. BA-Merrill Lynch (Buy) has nevertheless joined the chorus, increasing its target from $7.20 to $8.60. One assumes there will shortly be some moves from other brokers.

Merrills sums up the past decade of the mineral sands industry as one of “depleting resources, rising costs, capped prices, ill-disciplined supply and no pricing power” which led to a period of “near profitless prosperity”. But the analysts agree with others that the situation is now changing, and dramatically so.

Merrills has increased its Iluka forecast profit by 53% in 2010 and 87% in 2012 having lifted its mineral sands price forecasts by around 20%. The analysts note decades of disappointment for Iluka shareholders have meant a market wrought with “cynicism and scepticism” over the stock. That may be about to change.

Two other points to note from Merrills are that the company will likely put dividends back on the agenda and that Iluka has no major corporate shareholder as such.

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