Fundamental View On Metal Markets
Larry W. Reaugh
December 9, 2008
The resource industry and market review I have
prepared are the result of several queries from
investors and associates in the past few months about
my feelings and beliefs regarding the current debacle
and what the future holds. Unfortunately, most of us
will be affected on one level or another.
It is my belief that the world always or ultimately
operates on the fundamentals of supply and demand.
To reinforce this, my understanding of the demand
from the BRIC (Brazil, Russia, India and China) countries
has always remained positive. These countries
will continue their modernization regardless of the
recession we are experiencing in the West.
That leaves the supply side - the question is: What
has been happening to disrupt the supply of metals?
Taking a cross-section and focusing on mine shutdowns
and cut-backs in production, I had two huge
surprises. First, I was astounded by the proliferation
of new producers in the past 1 – 3 years. Second, I
am shocked by the rapid response to the downturn
reflected in the number of recent production shutdowns.
Over the past few weeks, while conducting
research for this piece, the number of shutdowns has
accelerated considerably.
Also, major small and mid size producers are cutting
back their production in all metals. The immensity of
that combined extinguished supply demonstrates that
a tilt in the supply/demand equilibrium is just
around the corner and a spike up in commodity
prices is not far behind.
In 2003, I conducted a supply-and-demand analysis
for molybdenum. As a result I moved to create a pure
molybdenum company and to achieve the advantage
of a head start towards production.
I have been involved in the stock market and the
mining industry for the past 45 years. In that time, I
have never experienced such a terrible meltdown in
the markets. Even the stagflation of the 1970’s would
be welcome at this point in time. The value of my
mining stocks during the mid to late 70’s neither
went up nor down but remained at pretty much the
same prices, as compared to today where my portfolio
is down by 80% to 90%. Although most markets
have lost 60% to 80%, resource stocks particularly,
have been hit hard. My entire working life has been
in the resource sector, so that will be the focus of
this editorial.
The majority of the forecasters on commodities today
are predicting a several-year bear market in
the prices of metal commodities across the board.
My fundamentalist point of view, resulting from
hands on research, is the exact opposite of the
popular consensus for several reasons:
- The world-wide recession is well into its second
year. I believe a financial meltdown scenario has
been averted for the interim and once the new U.S.
government is installed (or its direction is made
known) markets will establish or have already hit a
bottom from which to build.
- The U.S. and European economies are being
vigorously re-inflated.
- Commodity prices have fallen too far too fast.
- The shut down of several coal-fired power generating
plants in China during the Olympics contributed
to the metal price collapse. The shutdowns sidelined
demand and led to the stockpiling of metals,
(This put China in the driver’s seat on negotiating
long-term metal contracts, especially in iron and
coal) for a five month period, a lot of primary industry
in China was cut to 50% capacity. The commodity
demand was weakening and I believe the final blow
was the planned slow down in China which helped
accelerate the downturn, certainly a one time event.
Definitely a huge long-term benefit for China.
- Forced liquidation of commodities by commodity
traders again compromised the stability of the
supply/demand factor of metal commodities. LME
traded commodities, especially copper, will take
longer to rally due to the heavy manipulation by
funds, whereby much larger stockpiles existed than
were apparent.
- More producers are currently operating at or
below their cash cost. Those companies with large
debt are being forced to shut down their marginal
operations. The reaction to this sudden market
downturn by producers has been to shut down, curtail
and reduce production of copper, aluminum,
iron, nickel, zinc, lead, manganese, uranium, molybdenum,
cobalt, tantalum, etc. Even the market for
raw diamonds has shown a significant drop in price.
This has been immediate and I believe it will result in
a faster recovery of the prices for these commodities.
- Literally hundreds of small to medium producers
worldwide, in all categories, have been forced to
shut down production of metals. Some of these producers
will not re-open.
- China will be stimulating its economy with a
package amounting to $600 billion U.S. over the next
three years. I believe the first beneficiary will be the
steel industry which will lead the way out of the recession
in base metals. The first steel related metals
to recover will be molybdenum, cobalt, manganese,
tungsten, niobium and chrome.
- Dozens of mining projects slated to begin construction
have been postponed indefinitely.
- Infrastructure replacement and expansion to
be implemented in Western countries, particularly in
the United States.
- Yunnan province in China has announced a one
million tonne purchase of commodities for stockpiling
namely, copper, aluminum, lead, zinc and tin a $3
billion dollar investment. The central government is
also looking to stockpile all metals as a result of low
prices. This would be a wise move to convert U.S.
dollars into tangible assets. (Beginning to see a trend
here?)
I have been steadfast in my belief that all commodities
are strictly governed by supply and demand with
the exception of LME-traded metals which are heavily
influenced by speculators, funds and large investor
trading. My theory about a bounce-back in metals
was reinforced when researching a large cross-section
of current and near-term producers, in conjunction
with a list of several operators now on care and
maintenance which currently influence or could influence
the supply of all categories of metal. For those
of you interested, I have compiled a list of companies
which currently have some of their mining operation
on care and maintenance that may be obtained from:
www.reacompanies.com/list. This list is only
the tip of the iceberg of what is happening in our industry
and focuses only on North American listed
stocks where the situation here at home is only a reflection
of what is happening worldwide. The total
analysis involved over 100 companies but I have only
listed those companies which have actually shut
down or those that have put some of their mining
operations on care and maintenance. Remember, this
is only a glimpse what is happening out there.
Due to safety regulations, China alone will be shutting
down 6,000 of its 16,000 coal mines over the
next 2 years. Forty-five out of seventy-five copper/
cobalt producers have shut down in the Democratic
Republic of Congo (DRC). Shut downs are also widespread
in Australia, South Africa, South America and
India, etc.
To me, the conclusion is obvious - those companies
which have recently commenced production or have
advanced projects on stream to go into production are
being severely punished by the market with some market
caps decreasing as much as 90% to 99%. There is
no avenue for them to raise money to streamline operations
in order to turn the corner on new production.
At the present market stage bridge loans are a particularly
difficult scenario with which to deal and any
company having to repay those bridges is at severe
risk of failure. It is a ‘damned if you do and damned
if you don’t’ scenario. My sympathies go out to those
companies as I understand the hard work and focus
required to bring on new production today. The old
adage of having production to see you through the
lean times has not held up this time around for a vast
number of companies and appears to be a liability
rather than an asset for most of them. The above list
reflects only 20 companies which have shut down
production – to think of the total number boggles the
mind.
The entire resource sector has been ravaged with the
share prices of junior explorers down 95% to 99%,
intermediate producers down 60% - 90% and some
majors down close to 85%, especially in the steel industry.
The total resource sector has had approximately
$1.5 trillion knocked off of its market cap,
with household names like U.S. Steel losing 85% of its
market cap in the past 6 months.
In my opinion, the way all categories of mining stocks
are now viewed by the investment bankers and the
investment community will change radically as follows:
- Geopolitical risk will become a major factor
whereas a year ago it was not heavily considered
in the investment strategy.
- Bridge loans are now considered toxic by the
investment community and no one is stepping
up to re-finance even good projects especially
those exposed to bridge loans.
- Bond issues and debt financing are impossible
and probably should not be pursued at this
time.
- Obviously, most of the advanced-stage projects
have been rendered unfeasible at current commodity
prices.
- Overwhelming reluctance to do equity financings
at this point in the market.
- Feasibility Studies by new producers will have
to be economical at close to current commodity
prices.
- Close attention will be focused on strip ratios,
continuity of deposits, bulk testing, proven
metallurgy and road access.
- Mergers and acquisitions will only occur between
strong companies. In this market weak
companies will tend to bring down the strong
company. The take-over candidate must be
able to generate the price of the acquisition.
- Balance sheets will be scrutinized and, companies
having large debt loads will be evaluated
on their ability to continue servicing that debt.
Companies cannot service debt when they are
losing money.
- Companies with large commitments will face
tougher evaluations.
- Financings will get back into a selective positive
mode once commodity prices move up significantly
from today’s lows.
The following is a snapshot comparison of some of
the commodity price losses in the past 6 months:
Through previous observation and current research
I have identified certain trends which indicate that
prices will again head north in the next 6 – 18
months and eventually break most historic highs.
This commodity Bull will break all previous cycles as
the BRIC countries continue to modernize their.
The massive amount of metal supply that
has been extinguished in the last 6 months will very
quickly have a positive effect on metal commodity
prices once again.
Some of the benefits derived from the financial meltdown
are as follows:
- Cheaper cost of production as fuel, replacement
machinery, power, transportation, floatation
additives and consumables go down in price.
- Drilling and exploration infrastructure costs
will go down. Drilling companies are now readily
available.
- Availability of geologists, mining engineers and
engineering firms is now prolific.
- Availability of large mining and milling equipment
is readily accessible. Lead-time is dramatically
reduced.
- Experienced mining and milling personnel are
now available as tens of thousands are being laid-off.
I have pretty much focused on base and minor metals in
my review and it goes without saying that precious metals
have a similar driving force and are experiencing
closures as well. With gold being the exception, silver,
platinum and palladium have a solid industrial base and
will follow the direction of the base metals. Conversely,
gold is the ultimate currency and will lead all metals out
of this current recession. The disconnect between gold
and other precious metals will become more evident
going forward. My observation is that gold will play a
much more important role as we become awash in all
the world’s currencies and seek value that cannot be
destroyed by banks or governments.
I believe the deck is stacked in favor of all commodities,
surviving mining companies and explorers over
the next three years. We will look back on the last
two months of 2008 as the greatest buying opportunity
of the century.
My exercise in the synopsis outlined above was to
source a course of action to direct my companies
over the next 2 – 5 years. I am more enthused now
about the prospects for our industry than I have been
in the last 18 months. Caution is the direction I
choose for the interim and as the market signals, I
plan to become more aggressive in the future.
I believe the shareholders deserve to know how their
management and directors intend to move forward
during these tumultuous times so I will be posting my
observations on our website: www.reacompanies.com
In conclusion, I personally have been investing and
continue to invest at these dramatically lower prices.
Due to the current market my retirement has been
postponed several years and I believe the only way I
will be able to recoup is to take advantage of the
current low share values. This is the tax selling season
which creates further discounts from current low
prices, definitely an advantage to the contrarian
buyer. Look for companies that will survive the current
market as these companies will be the strongest
emerging from this recession. It’s a new world out
there but the emerging economies need our products.
Daily, more and more casualties are appearing
in our industry and this will continue until well after
commodity prices once again head north.
Mines can not operate at losses so supply will diminish
much faster in this cycle, once more creating runaway
prices in the next leg of the commodity Bull
market.
I encourage everyone to do their own due diligence
as there are great opportunities in the market today
with excellent projects, low-cost production and
don’t forget the junior companies that are trading at
less than cash value.
From time to time, I’ll be updating this article, and if
you’d like to receive those updates, please send an
email to: lwreaugh@rdminerals.ca
Larry W. Reaugh is not an investment advisor and any reference
to specific securities in the list referred to in the article
does not constitute a recommendation thereof. The opinions
expressed herein are the express personal opinions of Larry W.
Reaugh. Nothing in this article should be construed as a solicitation
to buy or sell any securities referred to in the list or in the
article. The author bears no liability for losses and/or damages
arising from the use of this article.
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