Diversified Resources Turning Into… Banks!?

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By Rudi Filapek-Vandyck, Editor FNArena

On my observations, it is not well appreciated among market commentators, financial journalists and analysts in Australia that the cycle for commodity prices has already turned.

One only has to watch the decline in coal prices over the past two years, not to mention what has happened to prices of nickel, lead, zinc, mineral sands, rare earths, molybdenum, etcetera.

The main reason as to why this indisputable observation seems to have escaped most experts making public statements about commodities and the Commodities Super Cycle is the fact that crude oil, copper and iron ore have manifested themselves as the exceptions thus far; each for specific, non-correlated reasons.

Iron ore in particular, being Australia's most prominent export article, has been responsible for keeping the terms of trade, and the Australian dollar, much higher for longer.

Let's start with what is NOT responsible for as to why these three basic materials are still trading at high price levels today (albeit, in each case, well below peak prices in recent years): China's GDP.

Despite an almost unhealthy focus on China's economic growth numbers in financial commentary in Australia, it should be everyone's easy to make conclusion that if China's GDP is the be all and end all for making predictions about commodities prices, why then is nickel priced at more than 50% off its peak? (And that's just one example out of the lot).

Clearly, commodities prices are all about the balance between supply and demand and China's demand (not to be confused with GDP) is only one factor in this story.

The reason why prices for crude oil, copper and iron ore have held up better than the rest lies on the other side of the coin: on the supply side. Crude oil production over the years past has been dented by interruptions in Iraq, Libya, Iran and the North Sea, to name but a few examples, and while production in key countries such as Libya and Iraq still is not where it should be, according to previous plans, new supply from the US shale revolution is now making up for the difference, plus some.

In the copper market, disappointing grades and expansions among major producers for successive years meant forecast market surpluses never materialised, until last year. Now producers are catching up and they are doing such a good job that even with a major outage at Rio Tinto's mine in Utah, most market participants are still anticipating further surpluses ahead.

Iron ore producers have benefited from the fact that expansion plans in Brazil have suffered delay upon delay and the fact that India, until last year the number three producer in the market, has removed itself from the seaborne market. Now the Big Four in the industry find themselves in a game of musical chairs with only three seats available.

Every one of the four knows that when one pulls back, the other three will have a good time for much longer, but who's going to give the other three a jolly good time while excluding its own stakeholders from the party? Adding no further supply additions would only work if at least two of the Big Four decide not to proceed with scheduled expansions (ideally it would be all four). This is why, when authorities don't pay attention, market collusion can be so effective for the players involved.

But it's a different game altogether that is being played in the iron ore market today. Vale, once the dominant player in the market, years ago took a big punt on nickel and surely that's a big regret today (a la aluminium for Rio Tinto). Management needs the scheduled production expansion for iron ore to at least retain some kind of a growth profile for the years ahead. Even then, Vale's additional supply is not likely to hit the market until 2016.

And why should an entrepreneurial Fortescue Metals ((FMG)) cease all expansion plans and retain a rather uncomfortably high production costs level while leaving market direction 100% to the discretion of the Big Boys?

Anyway, and as correctly pointed out in an in-depth sector update by analysts at CommBank last week, even with all the expansions planned, things still do not have to turn sour for any of the four major players in iron ore. It all depends on at what level of production/market prices marginal producers in China will leave the market.

If one has a positive view, such as amongst the boards of BHP Billiton ((BHP)) and Rio Tinto ((RIO)), then additional volumes will simply replace Chinese production and prices can stay at present levels for much longer. If one has an opposing view, such as that Chinese supply will remain active for much longer even at loss-making price levels, then the surprise is likely going to happen on the downside.

The real outcome will be somewhere in between both scenarios, but nobody knows where exactly.

My argument has been, and still remains as at today, that regardless of the teenie weenie details, those three laggards -crude oil, copper and iron ore- are now going through the same process as nickel and most others have gone through earlier, and that means lower prices.

It is very difficult for any company of any kind to continue growing its profits for shareholders when prices of key products are in decline. As a result, I believe that "growth" will become increasingly difficult to sustain for resources companies, outside the emerging producers or those that have large-scale production increases coming on-line.

While thinking about all this over the weekend, at some point it struck me: the Big Diversifieds in the sector are turning into…. banks!

Consider the similarity in key characteristics:

– growth becomes increasingly challenging
– focus shifts to cost reduction which supports growth for longer
– plenty of cash flows flowing in, so options for shareholder rewards remain available through higher dividends and capital management
– on international comparison, Australian companies stand head-and-shoulders above the rest

The fourth characteristic is also one that is not widely understood among analysts and commentators in Australia. Call it sheer luck or admirable prescience from the boards of BHP Billiton and Rio Tinto, fact remains because of a heavy operational skew towards today's laggards (coal is the main exception) share prices and dividends have outperformed most others in the sector, worldwide. It is easily forgotten, but BHP Billiton has continued to lift its progressive dividends even through the midst of the GFC when today's All-Star Performers in the share market, the banks, were forced to cut.

(Rio Tinto was temporarily vulnerable at the time because of the ill-advised Alcan acquisition).

If investors really want to see what a horror experience looks like against the background of a once-in-a-lifetime Super Cycle, they only need to call up a ten year price chart for Alcoa, long time considered one of the global bellwethers for the industry.

Fact remains, and nobody inside the industry will deny this, both Rio Tinto and BHP Billiton are today in far better shape than any of their peers. This is partially thanks to board policies and decisions, but also in large part because iron ore and copper have been so good to them (plus coal until two years ago), while nickel, diamonds, mineral sands, uranium and whatever else has been dug out of the ground in years past hardly register at the bottom line.

This remarkable difference -on international level- was also highlighted by commodities analysts at Nomura last week. In a series of reports on the Commodities Cycle Turning, Nomura analysts have come to the conclusion most large miners today do not have sufficient cash flows or the balance sheet strength to offer shareholders anything extra on top of a non-performing share price. Whilst that also remains the case today for BHP Billiton and Rio Tinto, as large capex programs mature over the next year or so, the situation in Australia is going to change dramatically further out into the future.

On Nomura's numbers, both BHP and Rio Tinto can lift the gearing of their respective balance sheets today, but even if we assume both boards will continue to play it safe, there will be US$20-30bn available for capital management initiatives such as higher dividends, bonus payments and share buyback programs, potentially as early as 2014.

Here's one of the key conclusions made in the report: "From FY14-15, we estimate BHP could generate ~US$7.9bn of surplus cash flow above base dividends; with RIO in the order of US$7.5bn. While both companies are not expected to totally stop new growth investment, a what if scenario (if surpluses are returned) implies an attractive average FY14-15 dividend yield of ~6% and ~7%, respectively, for BHP and RIO."

Free translation of the above Nomura prediction: the next phase of the Commodities Super Cycle is turning BHP Billiton and Rio Tinto into banks, with matching dividend yields! (Both companies have been piling up franking credits over recent years so dividends will remain fully franked in the years ahead).

The charts below (thanks to Nomura) tell a great story.

This is not necessarily where this story ends. Commodities analysts at UBS have explored the theme of potential capital management amongst small resources companies. It is their conclusion the three standouts in Australia are PanAust ((PNA)), Sandfire Resources ((SFR)) and Regis Resources ((RRL)).

(This story was written on Monday, 13 May 2013. It was published on that day in the form of an email to paying subscribers).

See also:

– It's A New World For Commodities – 6 May

– The Times They Really Are A-Changing – 29 April

– The Sorrow Of Australia (*) – 22 April

– Are Iron Ore Producers Now A Valuation Trap? – 8 April

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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