Essay

THE BUZZ FROM BELOW

Asia's boom ís driving up the value of commodities—and mining stocks

DONALD COXE March 21 2005
Essay

THE BUZZ FROM BELOW

Asia's boom ís driving up the value of commodities—and mining stocks

DONALD COXE March 21 2005

THE BUZZ FROM BELOW

Asia's boom ís driving up the value of commodities—and mining stocks

Essay

DONALD COXE

INVESTORS WITH AN EAR to the ground have been hearing the buzz from below: the miners are back. It has been nearly a half-century since the mining industry experienced what economists call a “real” boom. That’s when prices of metals soar because of sustained consumption growth outstripping the industry’s productive capacity, instead of from speculative hoarding fuelled by fears of inflation. In recent decades, mining has been the

boom-bust bane of the stock market—companies borrowing too much during booms to open too many new mines which came on stream at times of falling demand, producing price collapses for both the metals and their shares.

The mining industry experienced what I call a Triple Waterfall collapse from the early 1980s to 2002. The inflation mania of the 1970s, driven by fashionable intellectuals’ claims that the world was running out of almost everything except fast-depreciating paper money, led to massive overinvest-

ment in mines and smelters and plunging metals prices.

The extent of this tripartite plunge was exacerbated by the fall of the Berlin Wall. That signalled, to the shock of fashionable intellectuals, that Ronald Reagan and Margaret Thatcher had won the Cold War, and Soviet communism would collapse. The end of the Cold War meant a plunge in military spending, thereby removing the only non-cyclical source of demand for metals—military hardware

procurement. Worse, it meant that the great Soviet gulag mines that had lived off the Red Army would be dumping their vast output on world markets.

Finally came 9/11, a new war and a big military buildup in the U.S. (Not, of course, in Canada, where the Department of Inoffence continued to rely on antiquated hardware that was a threat, if at all, only to the brave Canadians who flew or sailed in it.) China emerged as the world’s fastest-growing metals buyer, and India entered the big leagues with the cheeky claim that it intended to have a larger economy than China by 2040 or so.

Flash forward to the annual BMO Nesbitt Bums Global Resources Conference in Florida this month, one of the world’s

biggest gatherings for miners and institutional investors. (Disclosure: I serve as the global portfolio strategist for BMO and was a speaker.) Among the first presenters was Russia’s MMC Norilsk Nickel, for decades the world’s largest producer of nickel, and a heavyweight producer of copper. Norilsk used to be one of the most notorious hellholes of the gulag, where hundreds of thousands of victims of Joseph Stalin were sent to Siberia to labour and die amid hideous pollution. Now it’s capitalist, a good employer and trying to be enviroffiendly, Nasdaq-listed, and it has one of the smartest management teams in the industry.

Mining is a global business. Companies from around the world came to the conference to talk to investors from around the world. In most cases, where a company has its headquarters gave only scant indication of where its mines and refineries are located. The industry told about its thrill and amazement at the soaring demand. Even some of those who had told us in former years about China’s powerful growth spoke in awe about the implications for the industry for the rest of this decade. Inco’s CEO, Scott Hand, in an uncharacteristically ebullient mood, said China’s fourth-quarter demand for nickel was up 36 per cent over the previous year, and he predicted that total nickel demand this year will be beyond the world’s available supplies—inventories, scrap and new-mined production. As he spoke, the price of nickel in London was hovering around US$7.25 per pound. (Inco cautiously calculates its future profitability based on a long-term average nickel price of just US$3 a pound. Other big producers, scarred by two decades of disappointment, show similar caution: Phelps Dodge, the world’s second-largest copper producer, spoke of US$0.85-a-pound copper, which traded that day at US$1.45.)

This is the year Inco brings on Voisey’s Bay, the great new Labrador nickel mine. In 2007, it starts mostly nickel production at Goro in New Caledonia. At current prices, these high-grade mines will be gigantic money-spinners. But investors are choosing to bite the hand that feeds them. This is the most bullish story Inco has offered in decades. At the time of the conference they were valuing Inco at approximately 10 times what it earns from its existing mines, apparently assigning zero value to Goro and Voisey’s. Not that they’re discriminating

against Inco. No sirree, they’re valuing America’s Phelps at around the same rate, even though the price-earnings ratio of U.5. stocks on major indices is between 18 and 20.

One of the slogans I shared with attendees is, “The best investment opportunities come from an asset class where those who know it best, love it least because they’ve been disappointed most.” The mostly cautious people who run the mines and the Street analysts who report on them to investors, are heirs to a generation who believed in booms, but got busts. Most investment strategists disdain the mines as “deep cyclical stocks.” If mines are earning big profits now, then they surely face big losses soon.

That would be the right call, if the recent history in the advanced industrial countries were the only basis for forecasting. The sustained mining boom of the 1950s came from the emergence of the new middle class across the industrial world. As tens of millions of people acquired middle-class living standards—indoor plumbing, electricity, basic appliances and cars—metal demand just kept growing. Since then, scrap has been a big factor in metal supplies, and total net new demand for dwellings and cars no longer rises at rapid rates, except in brief boom periods. Result: a few good years for miners, then the return of weakness and bleakness.

But right now millions of people in China and India are on the move to the middle class. Their demand for metals in the next two decades will make the 1950s’ boom look like a blip. Indeed, the most important constraint on the progress of those people to the lifestyle they crave is the world’s shortage of commodities—particularly oil and metals.

Mining companies must somehow find the will, the capital and the ore bodies to give the people of Asia the chance to live in the fashion we have long taken for granted. Unless mining stock prices start trading at multiples approaching those of the market averages, there is almost no chance these companies will raise the equity capital to deliver the metals needed.

If you’re one of those investors who believes this is Asia’s century, you would have been salivating at the base metal presentations made at this annual conference. I can hardly wait ’til next year. Iffl

Chicago-based Donald Coxe is Global Portfolio Strategist, BMO Financial Group. dcoxe@macleans.ca