Resources: In Need Of A Catalyst

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By Rudi Filapek-Vandyck, Editor FNArena

It is a truth not universally acknowledged by both investors and market commentators that resources stocks are best bought when ultra-cheap. Certainly history seems to make this case.

These are very confusing times, to say the least. According to many a market commentator, we are in the early stages of a multi-year bull market for equities, yet those equities closely correlated with risk and risk appetite are languishing in the background, abandoned and ignored by most of the funds flowing into equities this year.

Meanwhile, the safest options available in the share market together with solid dividend payers remain at the centre of share market action. Who wants to own a high risk, small cap miner when Telstra ((TLS)) still offers more than 6% in fully franked dividends plus the prospects of capital management in the years ahead, seems to be the general, dominant view.

As shown on the chart below, which compares share price action of Westpac ((WBC)) and BHP Billiton ((BHP)), the divergence between banks and resources stocks started to get traction in September 2011 (21 months ago) and the gap has today widened to some 50% between the two.
 

Not only does the gap appear incredibly wide, it also ignores the fact that BHP still has performed much better than many others in the resources sector. Which is why the chart below is equally interesting as it compares the All Ordinaries against Small Industrials, the Small Ords and Small Resources index -in that order- and guess what? The performance gap between the All Ordinaries and Small Industrials hardly registers, but the Small Resources index has by now underperformed the broader index by 50%!

There we have that dreadful number again: minus 50%. It's tough to be a resources bull in the post-2007 era, bull market or not.
 

Maybe investors can draw solace from the fact that last year when the relative performance of the Small Resources index widened as much as it has today, a relative catch up rally emerged from the battlefield, twice (!) throughout the year.

Firstly, let me draw everyone's attention to the wide disparity that has opened up in the sector since late 2010. Since then, stocks like OZ Minerals ((OZL)), Paladin Energy ((PDN)) and Western Areas ((WSA)) have gradually deflated to share price levels as low as we've seen them post 2007, while others added a few months, or even longer, of solid performances in line with the share market in general. Take a look at a share price chart for Oil Search ((OSH)), or BC Iron ((BCI)), or Sirius Resources ((SIR)) and the first observation is: gap? What gap?
 

Maybe the most logical conclusion to draw from all this is there's no longer a general trend for resources stocks as a group. Iron ore stocks still performed well until September last year (though BC Iron has kept on performing since). Energy stocks have now consistently outperformed miners. Large cap miners have significantly outperformed the vast majority of their smaller cap nephews.

Most of the above still suggests a catch-up rally, at some point, for the beaten down metals and minerals sector seems but logical. We had two such rallies in 2012, why would 2013 be any different?

Longer term, however, the outlook remains murky at best. Analysts from UBS and from Macquarie recently returned from visits to China and their observations essentially confirmed just that. The Chinese steel industry has been too enthusiastic in ramping up production since late last year and is now confronted with too much steel left as inventory. Worse, steel manufacturers in the country have signalled they want to see lower prices for iron ore and intend to keep inventories of iron ore at lower than usual levels. Traders in China are worried about what might happen in the second half of the year when additional supply will start hitting the market.

The biggest reversal, however, is happening in the copper sector as more analysts are increasingly turning less bullish on the metal. Copper's main problem, so to speak, is the same one as for iron ore: increasing supply. On Monday, analysts at Deutsche Bank printed a sentence that would have surprised most market watchers: "copper is starting to look more similar to aluminium than many would have ever thought possible". Copper is today still trading at a 30% premium to the marginal cost of production. Deutsche Bank analysts are concerned that as the market for copper will see more supplies becoming available, that premium will be gradually eroded.

If Deutsche Bank's prediction proves correct, the current premium can halve in years ahead (to 10-15% level); this implies a copper price of US$6,300/tonne versus circa US$7700/tonne today. This will not go unnoticed.

Yet analysts at JP Morgan had been going through all kinds of variations in price scenarios last week and they always ended up with Net Present Values above today's share prices for both BHP Billiton and for Rio Tinto ((RIO)). One major difference with smaller, single commodity producers is, of course, that the major diversifieds can cut more costs from longer life, larger mining operations. Regardless, this assessment still leaves unanswered whether investors now think these majors should trade at lower multiples or not, since prospects for runaway earnings growth seem to have dissipated and propping up earnings growth via cost cutting remains a low quality exercise, even though potentially effective in the short term?

Most experts and analysts will also ensure us the overall risks to China's growth and its appetite for commodities is quite low in the years ahead. However, analysts at the highly regarded BCA Emerging Market Strategy recently reported credit expansion in China has in their view reached unsustainable levels with non-public debt to GDP expanding from 120% to 190% over the past four years. According to the BCA report, most of these transactions take place behind several layers in order to hide the true levels of credit expansion and banks are accomplices to these schemes. The research states some major Chinese companies are operating under unsustainable leverage levels and will likely crumble at some point. Of course, it will be up to the central government to bail out both local governments and corporations, and they do have the necessary means to do so, but can anyone imagine the shock waves such an outcome would trigger around the world?

Always good to remember: do not put all your eggs into the resources basket (that seemed okay pre-2007, but it'll never again be okay since)

Bottom line 1: it's much better to buy BHP shares closer to $30 and Rio Tinto closer to $50; just look at the price action over the past six years

Bottom line 2: only pursue with the correct risk assessment

Bottom line 3: we need a much better environment to make any bounce more than a temporary phenomenon. Where's that global, synchronised re-stocking? It's still on its way, maintains UBS strategist Julian Garran – see story from four weeks ago: "Commodities Due For An Upside Surprise"

Bottom line 4: yesterday's downturn by definition creates a more fertile environment for a pick-up tomorrow. That's how supply and demand balances interact for commodities. If we extrapolate this principle into the future then the outlook for nickel, zinc and lead will prove better than for iron ore, crude oil and copper. Note there's still no sign of life for uranium and thermal coal continues to look abysmal. There are promising signs for mineral sands products.

Bottom line 5: at times like these investors end up being heavily short the sector (not just for gold) and we all know what that means: any rally can be of considerable strength.

Now, where is the catalyst?

(Answer: no doubt, it's in China, somewhere, but where? And when?)
 

(This story was written on Monday, 18th March 2013. It was published on that day in the form of an email to paying subscribers at FNArena)

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Rudi On Tour in 2013

– I will present and contribute during the 2013 National Conference of the Australian Technical Analysts Association (ATAA) at the Novotel in Sydney's Brighton Beach, June 21-23

Interview on Radio

– I will be interviewed about my recent eBooklet "Make Risk Your Friend. Finding All-Weather Performers" this Sunday, March 24, between 10-11am. The program is called Ringside, on Radio Northern Beaches, 87.7fm & 90.3fm / www.rnb.org.au/stream

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