Risk Revisions

Our message that the world was moving to decouple the resource market from the US economy has had one overhanging concern. It was not that growth in Asia would eventually accomplish this. The concern was that a major downturn would happen in the US before the shift in psychology needed for eastern leadership in metals had taken place. Now that a mantra of Asian self determination is rising in the aftermath of the first major debt related swoon in the US market we are comfortable that concern is behind us.

That does not yet mean we have suddenly entered a risk free market. We expect to see further growth in appetite near term for the sector. But understanding the shifting risk factor is important not only to being within your comfort zone; risk has its own upside.

What might still derail the resource train are surges in metals supply, a significant down shift in Asia, or simple investor fatigue. We have been saying for four years that there is simply no large scale resource base ready to move into production, and that has not yet changed.

It is worth bearing that in mind, especially where smaller metal markets are concerned. They might begin to see supply gains from small operators who push ahead in jurisdictions with weak rules or who simply ignore whatever rules are in place. In the medium term, it will be worth keeping lessons from the last time resource shortage looked set to slow an emerging market, in Japan during the late 70s. Japanese firms went out and sought long term contracts for iron and metallurgical coal plus some smaller market metals, to the point where development of them went into oversupply. China is beginning to make similar moves. It will be years before these moves are likely to bear fruit. But the bear will be watching for them.

On the issue of gauging growth in Asia, it is still only possible to do this in a rough sense. We do not however see any major concern with this. We think the market is moving increasingly to our contention that even if there is some curtailment of exports due to weakness in the US or elsewhere, the broader growth in Asia will continue.

The move by China in January to restock copper only after having let its price swoon is also worth bearing in mind. Shanghai traders have been on a steep learning curve since being caught in a short squeeze in the zinc market in 1997. They are well aware that their moves are being watched for direction in the more traditional metals trading pits. If they sense local stock piles or long term contracts in high priced metals like nickel allow them to withdraw open market orders for a while, they will try to play this to their advantage. As mining’s consolidation continues, larger producers will be working with them, if only because they have to establish themselves in what will be the most important growth markets for the balance of current managers careers. Again, this is a caution rather then an immediate concern.

So this leaves market fatigue as the big potential concern for the immediate future. This includes debt problems in the US; not just the housing mess but also government debt and a trade deficient that is essentially in the debt category.

There have been mixed signals where housing is concerned, with a recent up tick in existing home sales cheering the market some. We repeat that while we are not expecting a “crash”, the housing market troubles are far from over. The specialty lenders have been falling apart as the sub-par borrowers they specialized in housing simply stop making payments that they don’t have the income to afford.

Many sub prime lenders will go bust, and their mortgage portfolios will pass on to stronger hands. The buyers of this distressed debt will then start unloading houses and create the next phase of this asset downshift. It is also fair to assume that some prime borrowers have overdone it with investment buying and pull some higher end houses into the mix (and some second homes in places like Vancouver).

How large this mess is can not be easily gauged, but given advertising geared to using housing as a credit card have been around the US market for four years or so, it could get large. Not so much so it will kill off the US economy, but enough to provide a drag for several more years. If the US dollar takes a serious swoon because foreign capital decides it does not want be in US debt any longer, Americans will be pulling in their own investment horns for a while. Capital flows into US securities for safe haven is already losing appeal, which does tend to be self fulfilling.

Though this is a very real concern, it is not one likely to play out much further in the first half of this year. The other type of fatigue, something more akin to boredom, is more difficult to gauge. There have been many calls to “rotate” out of resources and into other sectors, but none has lately been able to supply the kind of gains a rejuvenating minerals sector has.

The reality is that while Canadian mining investment shows have been seeing record numbers, as have a few in places like Germany, there has so far been a fairly limited participation in the mining sector by US retail investors. That, we think, is because the US market has been riding a general equities recovery on top of huge gains in the “safe” housing sector. With housing in decline it is now a matter of convincing Americans that another economic centre is driving resources to bring on greater interest in mining deals. We expect to see the cause aided by an increasing pace of takeovers within the sector.

The just announced take over bid by Lundin Mining for Rio Narcea (see updates) gives RNG a gain of over 80% in the past three months, but what is actually more impressive to those who don’t know the sector is that has also garnered Lundin a 25% gain from recent lows and a 16% gain on the day of the announcement. While mergers that are accretive to both sides are not confined to the mining sector they are generally rare in a sector that has been on bull run for almost five years. This is a message that something more then a top-of-the-curve feeding frenzy is underway.

A large number of companies are in fact hitting new highs. First Quantum has just made our most recent intermediate target of $80, another gain of about 20% from recent bottoms and in spite of having been written off recently by some analysts due to some (in our view) relatively minor issues. Were we not keeping track of supply trends within the sector, we might be worried that this is over exuberance. Instead, we expect the pace of take overs and mergers to accelerate as cash rich producers look for ways to enhance their value without having to wade through a 3-5 year mine development process. At this point there is little reason to expect this to end until the new developments are used up.

We think instead of downgrading resource companies due to a long bull run, we are entering a period when a whole new upgrading of risk is at hand. That means in essence that strong deposits in “troubling” locales, such as Aurelian’s Condor project in Ecuador, are increasingly being pushed into a must have category since there is simply little else around to compete with them.

That is not to say a blind rush will be made into difficult areas (not that we actually consider Ecuador all that difficult). But risk assessment by public mining companies must now include the risk that non-market companies, both private capital and government assisted, are also on the hunt for resource deals. Large mining companies of any ilk are quite used to the idea that they have to negotiate with local governments and social organizations, and so in a period of unprecedented cash flow they will be willing to risk large dollars to gain access to strong deposits. As deals are struck in areas considered higher risk, the value of lesser deposits in safer environs will rise and the interest of those who have so far eschewed the sector as too risky will be tweaked.

We have moved into the second leg of this secular bull market for metals, and that will mean a reassessment of deals that have been pushed beyond reasonable valuations. But so long as the shortage of new supply persists while growth continues in Asia, reassessments will also include giving greater weight to deposits with scale versus vagaries of governments in areas that need capital imports to prosper. More of the operating net may go to taxes and royalties, but that is an inevitability a booming sector must face at any rate.

David Coffin and Eric Coffin are the editors of the Hard Rock Analyst (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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