Investing In Commodities: A Mini-Guide (vol 2)

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[This story continues from last week, Weekly Insights, 5th November 2012]

By Rudi Filapek-Vandyck, Editor FNArena

Last week I wrote that most investors tend to focus on the demand side when assessing potential opportunities among commodities, but history shows they ignore what is happening on the supply side at their own peril.

I also suggested commodities are best viewed through the prism of "feast" and "famine", in continuous revolving phases.

Probably the best example of this has been provided by uranium. For years both sector analysts and leading producers have been warning that the market is facing a supply squeeze as prices are not high enough to stimulate new mines, but instead of a new bull market the sector continues to muddle through an extended period of famine.

Recently, the spot price sunk as low as US$40.75/lb and share prices for producers have not been this "cheap" for a very long time.

The answer as to why lies with leading producer Kazakhstan whose annual production output has been ramped up to 54m pounds U3O8 from only 5m pounds less than ten years ago. The emergence of Kazakhstan has taken most investors and analysts by surprise, in particular because the increase in production has been nothing short of spectacular.

Add the serious disruption on the demand side post Fukushima as reactors in Japan are still on hold, not to mention the political impasse in countries such as China, Germany and Belgium, and it is not difficult to see as to why things have remained extremely tough for producers such as Paladin Energy ((PDN)) and Canada's Cameco.

Traditionally, such a period of serious famine ultimately forces the sector into structural deficit which should translate into a new bull market at some point. Certainly this is the prospect that has the full attention of ever so bullish market analysts the world around, in particular with steady supply from Russian nuke conversion about to evaporate from 2014 onwards. But certainly not everyone is equally convinced that 2014 will bring the long awaited turnaround for the sector.

BMO analyst Edward Sterck, for example, remains convinced that Kazakhstan will continue to spoil the party for anyone who dares to turn bullish too soon. On Sterck's estimates, Kazakhstan will further increase annual production to 71m pounds U3O8 in the next few years which seems sufficient to compensate for any shortfall due to the expiration of the Russian cold war nukes conversion agreement with the US.

Sterck agrees, ultimately, from the present period of famine will rise the next strong bull market. On his current projections the big turnaround is likely to announce itself by 2018. Unless the price for uranium rises to at least US$70/lb, but preferably to US$80/lb, by year-end 2013 (which would stimulate new mines being developed), the industry globally won't be able to match the projected shortfall by 2018 – all else being equal. This is, alas, still five long years away. One can only imagine Sterck will not receive too many Christmas cards from BMO clients and uranium enthusiasts this year (even though he is merely the messenger).

Analysts at JP Morgan recently pushed out their timeline to 2015, which is not as far out as Sterck, but still more than two years away.

Most commodity markets are in a similar position with one or two major suppliers holding the key to what is going to happen in the years ahead. In coal markets Indonesia (thermal and metallurgical) and Mongolia (predominantly thermal) have successfully developed into leading market producers, but it appears US producers are aggressively chasing demand for thermal coal overseas and this is keeping downward pressure on the price. Those US producers are facing increasing competition from the emerging shale gas revolution on home soil and they are clearly refusing to go down without a fight.

Indonesia is, through blending, able to supply China with high grade thermal coal and annual production is estimated to more than double between now and 2025. Mongolia is equally doing its best to ramp up volumes. The result is for what is often euphemistically labeled a well-supplied market. In metallurgical coal, Indonesia's output is declining but the likes of BHP/Mitsubishi are ready to fill the gap.

Regardless, the overriding view among coal market analysts is that prices for both thermal and metallurgical coal have fallen too far and a price rebound should be on the cards, but when? As is often the case with commodities, these price jumps from unsustainable levels can be quite pronounced. The general expectation is that met coal prices will recover back above US$200/tonne at some point in 2013. This compares with cargoes sold for as low as US$150/t in 2012. Equally, thermal coal prices are presently priced below cost levels for high-cost marginal producers, suggesting a jump of the same magnitude is possible next year.

A similar pattern seems to be unfolding in the market for diamonds where prices for rough diamonds seem equally in the process of trying to find a bottom and 2013 might thus bring better rewards for producers.

In iron ore it is new Australian supply that is going to push high cost producers out of the market and, eventually, the price sustainably below US$100/tonne. The Big Three -Rio Tinto ((RIO)), BHP Billiton ((BHP)) and Fortescue Metals ((FMG))- are all bringing sizeable new supplies into the market from next year onwards, this on top of extra supply from smaller players such as Atlas Iron ((AGO)).

Thus far, a disappointing performance from Vale in Brazil as well as sudden supply disruption in India, the number three producer in the global iron ore market, have ensured support under prices, apart from temporary weakness in September. But now that Chinese steel is adjusting to lower growth for the years ahead, risks have increased for sub-US$100/t prices much sooner.

Some experts, such as Andrew Shaw at Credit Suisse, believe the risks are real for a sharp retreat in iron ore prices to as low as US$55/tonne. At that price, neither Fortescue or any of the other emerging producers in Australia, would have a viable business. Most other experts, however, believe the dynamic is still there to keep the price above US$100/tonne for maybe up to three more years.

The accuracy of all these pricing scenarios may well be decided by how quickly India can return as an important exporter, if that is still the country's ambition. Were India to permanently remove itself as an exporter, this should at least delay the anticipated return to sub-US$100/t prices (and make disaster scenarios as put forward by experts such as Andrew Shaw less likely in the short to near term).

The outlook for copper remains closely linked to production from Chile and Peru on the supply side and collateral financing in China on the demand side. The two Latin American countries account for circa 40% of global supply. In recent years, copper has continuously ignored expectations for market surpluses as labour disputes and falling grades caused supply disruptions and shortfalls but it would appear 2013 might finally be the year when supply catches up with slowing demand growth.

Nobody really knows how much collateral goes into Chinese alternative financing deals, or for how long these practices can and will continue as Chinese authorities are clamping down on it, but a projected 8% jump in copper supply next year seems simply too much for the market to prevent a surplus building up in 2013. (There are still question marks about real output from the Democratic Republic of Congo, so nothing's set in stone just yet).

The prospect of a market surplus should keep a lid on the price of copper, temporary volatility notwithstanding.

Now that most commodities are trading well below all-time peak prices, investors should not automatically assume that the only way is down from here onwards. In fact, copper is one example of a metal that may well revisit those lofty price levels from the past in a few years' time when demand is again expected to outstrip supply.

The Chindia factor may not have fundamentally altered the inner-nature of commodity markets whereby the push-pull dynamic between demand and supply determines the cycles and price outlook, but Chindia does provide longer term support on the demand side and this allows a commodity such as copper -all else being equal- to add cycle upon cycle because supply really has a tough task to live up to potential and to expectations.

A similar outlook seems to have emerged for nickel with the key difference that whenever the price for nickel rises from subdued levels, producers of nickel pig iron (a cheaper substitute) re-emerge in China and elsewhere and this should keep a lid on potential price upside in the years ahead. Note that Indonesia is intent on fully banning all exports of nickel and nickel pig iron from 2014 onwards. While accurate data are impossible to obtain, it is estimated Chinese production of nickel pig iron now represents some 17% of the global nickel market.

The Indonesian government wants to block all exports of raw, unprocessed basic materials from 2014 and analysts estimate markets most heavily impacted on the supply side will be thermal coal, bauxite, alumina and tin.

As for zinc, analysts have long been anticipating the closure of Northwest Queensland's Century mine (once upon a time owned by Zinifex, then OZ Minerals and now by Minmetals). The closure of Century would take out some 500,000 tonnes in annual supply of high quality zinc concentrate and instantly create a significant squeeze but thus far it would appear mine life at Century continues to beat expectations. The latest indication is for Century to continue producing until 2016.

It would appear lead is the only remaining industrial metal with a clear positive outlook for the years ahead, in addition to tin – for as long as nothing nasty happens to the global economy.

In the sector of softs and agricultural commodities, the weather remains the all-important dominant swing factor and if climate change does announce itself in more prominent terms in the years ahead, this sector will show lots of volatility and price action changes. Right now, it would appear that wheat is looking towards higher prices ahead while cocoa should be moving in the opposite direction.

These are only momentarily observations as things can change dramatically and quickly on the basis of one more drought or tornado.

What about the most important commodity of them all: crude oil? Never an easy task to pin down the exact future of oil prices given the sizeable premium that geopolitical stress can inject into the market. Were Israel to bomb nuclear facilities in Iran, the price of oil could potentially spike as high as US$200/bbl, experts say. This would push the world economy in yet another oil price-spike induced recession. It would instantly change everything you just read about the other commodities.

Excluding such a disastrous event, it would appear that global oil supply is catching up with sluggish demand growth and it therefore cannot be excluded that Brent/Louisiana Light (the "real" oil prices) will remain close to present price levels for a while. Crude oil has the advantage of OPEC managing market expectations and global supply so there should be some downside protection, as well as to the upside (but never 100% watertight, of course).

Of course, the world of commodities goes much beyond the examples I briefly discussed above. There's natural gas, mineral sands and rare earth elements, tungsten, molybdenum, silver and palladium, stretching to pork bellies, lumber, paper, orange juice and soybeans. Ultimately, these all go through similar cycles and feast-famine rotations. They all have in common that demand is heavily supported by today's unprecedented changes in the world's demographic growth, composition and urbanisation.

For investors in equities, the golden rule is to seek out producers (and would be producers) that are positioned in the bottom half of the cost curve, because longer term, that's where markets tend to settle in terms of prices and thus producers in the top half of the cost curve risk being squeezed out. One key problem when executing such a strategy is investors cannot rely on information provided by the producers.

As industry experts put it: there are lies, damn lies and reported miners' costs. CRU's Allan Trench regularly uses the example of an ASX-listed gold miner whose published cash cost for production is less than half the gold spot price, yet the company never manages to achieve a profit.

To put it in another way: 75% of all miners always claims to be in the bottom half of the cost curve in their sector, while the remaining 25% promises to be there in about a years' time.

The commodities boom over? If you are a high cost producer the answer is more than likely yes. For the lower cost producers it will be tough maneuvering between investing in extra volumes and creating more value for shareholders. Unless Jim Rogers' scenario of rampant central bank created asset inflation has yet another bubble-leg attached into the future.

Talking about central banks, according to US Global Investors' Chief Investment Officer, Frank Holmes, historically there's a US Presidential Cycle for gold whereby the year of the election delivers a disappointing performance. Thus far, gold has failed to live up to investors' expectations this year. If Holmes is correct, 2013 should prove a more rewarding year for owners of the metal (or should that be "currency"?).

This may be especially the case now that Barack Obama has been re-elected for a second US Presidential term.

(This story follows on from last week's Weekly Insights which was inspired by my recent attendance at the inaugural Asian Mining Indaba in Singapore. It was published in the form of an email to paying subscribers on Monday, 12th November 2012).

Good news for FNArena subscribers: colleague Greg Peel has just finished an in-depth market update on rare earths elements (REE) which has been published in e-booklet format, for FNArena subscribers only.

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)

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