It’s A New World For Commodities

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

By Rudi Filapek-Vandyck, Editor FNArena

In today's 24 hour media world that is increasingly centred around extreme outcomes and potential possibilities, such as China: hard landing or not?, surely the biggest surprise of the past two years has been the relentless underperformance of mining and energy stocks.

Which makes it a bit odd when strategists, market commentators and economists try to reinstate their credentials by reminding everyone they did predict China would not experience a hard landing, don't you remember?

Well, errmmm, yes, but Rio Tinto ((RIO)) shares are now back in the mid-$50s and they were a lot lower not that long ago. Atlas Iron ((AGO)) shares are significantly below $1 and have been a lot lower too.

It's probably best I don't even mention what the share prices are for the likes of Newcrest Mining ((NCM)), Alacer Gold ((AQG)), Indepence Group ((IGO)), PanAust ((PNA)), OZ Minerals ((OZL)), Western Areas ((WSA)), et cetera. As many among you know from first hand experience, many stocks further up the risk scales have tales of absolute horror to tell.

Another oft repeated prediction amongst those same strategists, commentators and economists has been that commodity prices will "remain at elevated levels". Which is not so much a prediction (even though it has been dressed up as such) but more an observation of today's reality and that is it takes a lot more effort, time, technology and capital to dig up stuff from deep underground and that's why prices for energy and base materials can never go back to where they were during the nineties.

The words are correct, but the implication is dead wrong.

A third "misunderstanding" I'd like to nominate, and de-mystify, is that we're now entering the phase of increased output volumes after years of multi-billion investments the world around. Again, this is strictly taken correct but it is misleading for equity investors and their advisors who think this will translate into strong earnings growth for the companies involved.

It can be, but only if the projected growth is both substantial and achievable. Newcrest, for example, still has substantial growth potential up its sleeve but right now too many disappointments have cost shareholders too much money, so the market's focus has shifted to management's credibility which, by now, must be at an all-time low.

Deutsche Bank analysts recently concluded both BHP Billiton ((BHP)) and Rio Tinto should be able to achieve significant growth numbers in the years ahead as both sector juggernauts enter their "fastest volume growth phase ever". But investors should note the ability to do so hinges on two key components: achieving targeted production increases AND substantially lower operational costs.

Many smaller players in the industry don't necessarily have that second option at their disposal.

Even then, a closer look into the details of Deutsche Bank's projections, all the way up until 2020, shows a remarkable shift in underlying dynamics for these "fastest volume growth phase ever"-companies: gone are the days of 20%, 30%, 40% or higher growth years. Instead, Deutsche Bank's projections show one single high growth number (FY14 for BHP Billiton after two consecutive years of sharply declining EPS growth) but overall the coming decade, so it appears, will be one characterised by low to medium single digit growth years. Deutsche Bank is projecting two years of negative growth for Rio Tinto out of the next seven.

This is what "substantial volume growth" looks like in an environment of weaker prices.

No surprise thus, analysts believe the boards at both companies will increasingly play their dividend cards. Both BHP Billiton and Rio Tinto are projected to have billions in free cash flow between 2015 and 2020, BHP in particular, so there should be enough room to combine financing further expansions with pleasing shareholders through extra dividends and other forms of capital management.

On Deutsche Bank's projections, Rio Tinto's annual dividends will steadily increase by 50% between 2012-2020. BHP's projected increase is smaller, but that's because it is the better dividend payer of the two right now.

Maybe this is as good as any other time to reflect upon the fact (not opinion, but fact) that neither BHP Billiton nor Rio Tinto have generated any sustainable returns for their loyal shareholders since 2006 other than the dividends paid. Surely many of those shareholders will be crossing their fingers today the next seven years will add something on top of the dividends. If not, at least the dividends are expected to keep on rising in the years ahead.

As I wrote last week, see "The Times They Really Are A-Changing", it is not that unusual for dividends to make up an important part of shareholder rewards at BHP Billiton and Rio Tinto. Throughout the nineties dividends were responsible for 50% of total returns for the ten years leading up to the new millennium. Since 2006, dividends have made up close to 100% of total return.

Yes, I know, nobody ever buys resources companies for their dividends…

Analysts at Goldman Sachs recently lined up the key characteristics for the sector during the era that has now been relegated to history, plus they nominated what they believe are likely to become the new characteristics for the era that lies ahead.

In their terminology, such were the ten key characteristics of the past ten years:

– The BRICs phenomenon
– Short aluminium and long iron ore
– UK the new home of mining finance
– The A$200k truck driver – cost inflation
– Emergence of the commodities ETF
– Spot pricing for the bulks
– Focus on capex, not dividends
– Contracting P/Es
– Super Cycle = Super M&A Cycle
– Bye bye hedging

And these will be important issues for the years ahead:

– Growing environmental awareness
– Mining in a carbon constrained world
– Potash
– Resource nationalism
– Recycling and the threat of alternate supply
– Mining's technology revolution
– The need to mine in more 'exotic' locations
– The rise of the mega project
– The return of high interest rates
– Can N11 become the new China?

The cycle is not over, the analysts assure confidently, it's just evolving.

That may well be the case, but it surely looks like the years ahead will be very different from the years in the past. Seven out the ten items lined up for the years ahead imply either upward cost pressures, elevated risks or downward pressures on product prices. This equates to seven more reason as to why large cap miners look better equipped to deal with the sector's challenges as industry dynamics change, and Goldman Sachs analysts agree wholeheartedly.

While the BRICs have been solely responsible for starting this Super Cycle, Goldman analysts note the past decade also saw very, very loose monetary policies. This may well change in the years ahead. Equally important is that the BRICs will now pass on the baton to N11, which stands for Next 11, comprising of countries Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, Philippines, Turkey, South Korea and Vietnam. It is Goldman's view these 11 will keep demand for commodities high, but they will not trigger a repeat of the impact Chinese demand has had since 2003.

The analysts are tipping that potash might become the new iron ore. (Note also: shale oil and gas didn't even make the list).

(This story was written on Monday, 06 May 2013. It was published on that day in the form of an email to paying subscribers).

DO YOU HAVE YOUR COPY YET?

At the very least, my latest e-Booklet "Making Risk Your Friend. Finding All-Weather Performers", which was published in January this year, managed to accurately capture the Zeitgeist.

All three categories of stocks mentioned in the booklet are responsible for the index gains post 2009 and this remains the case throughout 2013.

This e-Booklet (58 pages) is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com

(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. All views are mine and not by association FNArena's – see disclaimer on the website)

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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

– I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm

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