Hand-Offs or Hands Off?

It is a market maxim that both, or either, the top and bottom of market can be seen in a wave of M & A activity. At the bottom of a market assets are cheap and bigger fish gobble up smaller ones. At the top of a market enthusiasm takes hold even in those who should know better, and they overpay for assets with their own high priced paper.

We have been seeing historically high metals prices, and last year by far the largest take-over deals in the sector’s history. Hubris marking the end of the cycle? We think not. Another review of history is in order.

Looking back to 1997, the one thing we did not do enough of was move out of the sector when it got overheated. That year mining was in collective “Finally, profits!” mode induced by huge gains to Asia’s economy. Being missed was the precarious state of the region’s currencies. Several years earlier China had devalued its trade currency in order to stimulate external trade. It did this, but the flood of cheap goods it created sapped growth in the rest of the continent. Most Asian currencies broke under the weight of high debt and declining exports due to China’s move.

The collapse of demand this created was very hard on the resource sector, sending some metal prices below average extraction costs for years. Should you think “they should have seen it coming”, you are being a bit hard on “them”. What many thought they were seeing was a long overdue catch-up. The resource sector had seen no real profits since the oil shocks of the 1970s catching the maturing Baby Boom pushed the price of everything up several fold.

The ‘70s price booms pumped money into the resource sector in an attempt to locate new deposits for a seemingly insatiable growth of demand. This race to outline new mineral resources was highly successful. Unfortunately a combination of Cold War and post European colonization politics limited industrialized growth to about 1/5 of the globe’s population.

We have been chewing through an in-situ oversupply since then. And much of the new output created was in capital intensive bulk tonnage mines that have to push out metal almost regardless of price in order to pay down large debt loads. The tail end of that problem was seen in the late entry of zinc to the current price boom, which, as we laid out several years ago, was caused by banks forcing product out of failing operations to cover interest payments.

The real theme of this cycle has been an executive level shift emblemized by nickel’s early and current price surges. Bleeding red ink, Inco put out the message that it had to stop mining nickel for $3 per pound that it was selling for $2. In other words, its high cost operations would no longer ship product at a loss. The other firms at the top of the nickel sector took that as a signal and followed suit. Sustained demand then pushed nickel prices higher.

Simply put, this shift was away from maintaining market share and towards strengthened bottom lines. Demand gains from Asia have done the rest. So much so that equity markets have had little chance to keep up with rising profits for base metal producers. So good, so far.

So this means the big risks are in a slowing China, right? That is a risk, and one that is difficult to quantify due to weak accounting. The bulk assessment from China’s large net savings rate is that its accelerated growth will continue for some years to come. A change to this would show up early in figures like foreign reserves. The refrain that China is wholly dependant on US trade ignores the potential for China to use its excess savings in-country.

We would never assume a continued Asian boom is without risk, but we do consider that a manageable and, at a gross level measurable, factor. Tougher to measure are market risks, both real and perceived. That was evident from earlier rumors about a hedge fund being offside on metal trades. That chilled long holders who exited copper and zinc holdings due to the uncertainty. Zinc’s decline was hastened by news that China resumed its net exporter position for the metal last year. China is a major zinc producer, and the affect of its poor accounting is being felt again here. But the LME warehouse stocks of zinc continue to decline, and we don’t expect a large decline in zinc’s price below current levels.

A fund blowing up is a temporary event, but could create some gut wrenching price moves before the dust settles. Underlying this is a market getting more interested in metals, not less. That can be seen in recent price gains for stories like Virginia (see update), and for Quaterra Minerals Ltd. that is run by the Tom Patton headed group that sold Western Silver to Glamis Gold. (Tom received the much deserved Cambridge House award for Corporate Development on behalf of Western Silver in January). This is evidence of funds moving into the sector and buying exploration stories to round out portfolios. Virginia and Quaterra are both run by winners, so get early “bet the jockey” based buying. Add to that stories like Minefinders Minera Andes and Atna trading below asset valuation, or like First Quantum that is an obvious choice for private equity funds who know Africa, and the “how Funds can make a late entrance and still gain in resources” primer is reasonably complete.

We expect this accumulation to continue, and the simple option is to let it happen and participate to the degree it suits your needs. The risk, such as it is, is that deservedly supported stocks get hurt by a sentiment change along with everything else. What evidence there is of a truly overheated market is balanced by much evidence of being still early in a long term revival of a sector that has been, after all, a mainstay of human development for the better part of 10 millennia.

The Cambridge House Vancouver conference, the largest resource investor conference going, attracted 10,000 people this year. That had a few people wondering if the record breaking crowd was sign of a bubble forming in the sector. It’s true that large crowds can flag an overheated market, but there was scant other evidence of that this time around. In a topping market you also see unbridled enthusiasm for weak companies. The crowd this year was younger then in past years, and decidedly interested in learning the sector rather then just plunging in. Our kind of people. And the kind that sustain a bull market.

As for the booths, these were also in record attendance (and part of that 10K count). But in spite of this the comments we were getting from other analysts and money managers was that there were not simply a lot of good looking companies, but also a lot of good looking new deals. This is again evidence of a maturing exploration and development sector for mining. As has been pointed out in the past, mining’s senior companies are less and less interested in doing their own exploration or developing their own smaller deposits. This has freed up both strong projects for, and strong people to run, junior companies.

That theme is furthered by an increasing number of placements by producers into the junior end of the market. Not a new thought, but one that is becoming a major theme of companies with strong cash and cash flow positions who are having a tough time finding deposits to their liking. Where appropriate these placements will take gains the old fashioned way, but the notion is to be in place for a potential mine while having a gain from an equities position in the same sub sector.

So no, we don’t think its hubris on our part. Just another reminder that mining is a long lived sector, which therefore has supply cycles exceeding the length of human generations. In other words, we are not saying “its different this time”, but rather that a long view is needed. One topic of discussion amongst those who look for mines is the likelihood that we will have largely defined the global resource base within the next decade or two. Hence the “peak oil/metals” discussions that are making the rounds lately. That might seem counterintuitive when metal prices are dipping, but short term trading responses shouldn’t be confused with long term realities.

Our take is that the resource base fell below sustainable pricing for profitable extraction for a long period which severely constrained supply. That is not news, as that has been the case on a regional basis numerous times in the past. New is a more truly global basis for the pricing baselines. The market has for the past five years been establishing new prices for this reason, based on growing demand from Asia. If there is a “new reality”, it’s the growing realization that new, much higher, base prices for metals are a precondition to the industry finding sufficient new supplies and getting them into production. It isn’t going to happen at the average prices that prevailed 10 or 20 years ago. Cost changes, such as cheap energy or revolutions in metallurgy, could lower these base prices, but we see little of this coming for the immediate future. Ω

David Coffin and Eric Coffin are the editors of the HRA Journal, HRA Dispatch and HRA Special Delivery publications focused on metals exploration, development and production stocks. They were among the first to draw attention to the current commodities super cycle and have generated one of the best track records in the business thanks to decades of experience and contacts throughout the industry that help them get the story to their readers first. Please visit their website at www.hraadvisory.com for more information.

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The HRA – Journal, HRA-Dispatch and HRA- Special Delivery are independent publications produced and distributed by Stockwork Consulting Ltd, which is committed to providing timely and factual analysis of junior mining, resource, and other venture capital companies. Companies are chosen on the basis of a speculative potential for significant upside gains resulting from asset-base expansion. These are generally high-risk securities, and opinions contained herein are time and market sensitive. No statement or expression of opinion, or any other matter herein, directly or indirectly, is an offer, solicitation or recommendation to buy or sell any securities mentioned. While we believe all sources of information to be factual and reliable we in no way represent or guarantee the accuracy thereof, nor of the statements made herein. We do not receive or request compensation in any form in order to feature companies in these publications. We may, or may not, own securities and/or options to acquire securities of the companies mentioned herein. This document is protected by the copyright laws of Canada and the U.S. and may not be reproduced in any form for other than for personal use without the prior written consent of the publisher. This document may be quoted, in context, provided proper credit is given.


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