Resources Sector Bull Market Gathers Pace

Key Points

The messages from the market for much better times ahead for resources are getting stronger by the week as rallies in important commodities and the bounces in the A$ and C$ gather momentum.  The market indications from the last Dawes Points seem to have come together well with gains for us everywhere.

I have been talking for most of the past year about a global economic boom unfolding as millions of people in Asia, Africa and Sth America join the rising middle classes seeking higher standards of living.

Without doubt, the GFC of 2007/09 undermined the confidence of many of the investors in the West and caused a run to cash and bonds and produced a commentariat vying to see who could be most bearish.  I think US investment banks out of Wall Street have grabbed the honours here but the internet bloggers and the End-of-the-Worlders have been very close behind.

It has been a China bashing, commodity thumping and gold shorting mantra in front of a `come and buy my 30 year 2.5% risk free pieces of US Govt junk paper because you won’t get any income anywhere else!’ program.

Dawes Points has disputed this all along because it just never made sense against the true actions in the market place.

First of all just refer to the performance of the equity markets around the world.  New all time highs everywhere (and now even Nasdaq after a 15 year wait) or at least new 6-7 years highs for the laggards.

Rising equity markets do what they have always done:- attract new capital for investment.  More capital, more investment, more employment and more demand for inputs.

In today’s environment of too much cash in bank deposits and mostly undergeared corporate balance sheets you might ask what is there to invest in.  Good question, but the answer is always initially M&A of competitors but this time there is a massive global requirement for infrastructure expansions and upgrades(Even in the US’s US$0.5Tn deficit economy, infrastructure replacement is important.). The rest just follows.  The longer it takes the longer will the equity bull market run.

For infrastructure examples, isn’t it amazing that Singapore with a population of under 6m, rough dimensions of 40x23km with area of 720km2 can have five busy metro rail lines and three more under construction.  Imagine this in dozens of cities in China.

The householder in Australia with its A$1,700bn bank deposits will be coming out soon as will its counterpart in China with RMB100trillion (US15tn!) to spend. Similar numbers crop up around the world.   Too much cash and too much fear.

The ASX Gold Index made a new rally high in April that marked at 68% gain from the November lows and even the majors BHP, RIO and FMG have jumped.

The global bond markets obviously last month decided enough was enough and carnage was wrought upon the buyers of sovereign junk at sub 1% yields.  If there ever was a mania where people lost control of their senses it is the recent actions in the bond market.

The comments on bonds in the last Dawes Points seem to have been on target.

So now that game of miniscule and negative cash/bond yields is over, where will the money go?

Could it be that after all the efforts of central bankers to increase inflation they may actually have succeeded?

Let’s think about that for a few moments.  We will come back soon.

Let’s think about China now.

China Steel and Iron Ore

Remember the China is slowing/adjusting/collapsing story we have been fed over the last few years? And last month too.  Do you believe it?

We all know China has debt.  And enormous reserves.  Most of the State Owned Enterprises (SOEs) have excessive debt as do the provincial governments.  The Central Government is OK and households have around RMB100trillion in bank deposits.

A rising Shanghai stock market will attract an equity for debt swap where everyone benefits.  Gigantic savings to meet huge capital raisings and debt repayment.

But in the meantime demand for raw materials is still strong.  Despite the calls for a decline in demand for raw materials, especially iron ore, the opposite was true.  Iron ore imports were up 13.8% in 2014 and are expected to rise about 12% to over 1,000mt in 2015. How do you get a decline in demand with a 13.8% increase in 2014 and the highest import rates were in the Dec Qtr?

I have noted that even the know-alls in the political gossip sheets now have a view (and advice!) on the declining market for iron ore.   Surely a true sign of a market low.

In the real world it seems the December and March Quarters were for running down inventory.  China port stocks fell 12% (now down below 90mt and almost 20% from the Sept 14 high), steel mill stocks fell, the major iron ore producers cut back production and ran down mine inventories.  But steel production stayed high.

March 2015 had the 6th highest ever monthly annualised production rate for crude steel in China and was only 1% lower than March 2014.  Some massive slowdown here!

The Spring Festival (Chinese New Year) brings seasonal slowdowns and seasonal expansion afterwards.  It should be the same in 2015.

Of course higher steel production means more iron ore needed so steel mill ore stocks may actually be quite low.  Finished product stocks are also well down over the past 18 months.

And there is nothing here that suggests a decline in imports has happened or is likely.

This is a take on China Port Inventories as a % of imports.  89mt of port stocks is only 32 days at 1,000mtpa imports.

See any oversupply here?

Certainly the world has new iron ore capacity coming on stream over the next few years and you might ask yourself why would that be? Could it be that demand will be increasing and finally Chinese domestic production is sharply declining?

Or is it that the mining companies and their bankers are stupid and just want to blow shareholders’ funds?

We can accept that Chinese steel consumption growth rate declined in 2014 to just over 1% and the increase was the lowest for many years and that China maintained steel output by exporting about 90mt of steel products.  But there are many aspects to this equation.

Firstly, iron ore imports at record levels displaced Chinese domestic magnetite production then greater Asia shared China’s steel output.  India has complained about dumping of steel but with its own archaic capacity of only 85mtpa and steel demand growing at almost 8%pa then it must be welcoming the opportunity of gaining access to new steel. Per capita steel consumption there is only one tenth that of China.  India’s own forecasts are for 140mtpa by 2017 with imported iron ore to figure prominently.

Secondly, East Asia (including China) and India consume over 1,000mtpa of which ASEAN consumes about 80mtpa whilst producing only about 20mtpa.

India wants 150mtpa domestic steel capacity quickly but I am sure it would take lots of Chinese steel now. Chinese steel anyone? Yes please!

Overall ASEAN with its 700m people has a steel use per capita of about one fifth of China.  It will take a lot of Chinese steel in the immediate term and then build its own furnaces.  More iron ore needed.

The inventory adjustment that has taken place in iron ore into 2015 will probably have added 40-50mt to supply.  We have already seen 20mt rundown from China ports.  Probably 10mt from the steel mills.  Fortescue and other Australian producers have had mine cuts to give another 10mt port reduction.  Now that has gone will it be rebuilt and increase demand?  And overall global demand should soon pick up as well.  But probably not yet for high cost producers.

These inventory shifts could cause a serious short cover rally in iron ore price.  Watch this space.

Keep in mind iron ore is an illiquid market and the shorts in the futures market may have some heart burn trying to pick up a few cargoes if the market goes buyer no seller.

All three Australian iron ore producers BHP, RIO and FMG are strong BUYs and recent operational rationalisations by each has only improved their prospects.

Industrial Metals

Another surprise for the bears who have been talking down metals consumption and oversupply.  You will recall in the last Dawes Points the table of consumption of most major resources and the prospects of supply/demand deficits in 2014/15/16.  Well, have a look at some of these growth rate figures since 2000 (14 years) and from 2010 (4 years).

Some robust figures here.   Who was saying declining demand for resources?

I have included Manganese Alloys (Ferro manganese and Silico manganese) here because they are now the fourth biggest metal group after steel, aluminium and copper.

Do you like these growth rates?  And most people KNOW commodity demand has fallen.

2014

000tpa

14 years % CAGR

4 years

% CAGR

NEW CAPACITY NEEDED FOR 2017 (ktpa)
Steel *(mtpa)

1,689*

5.07

4.65

247*

Aluminium

47,623

3.85

4.33

6,458

Copper

22,886

3.21

4.58

3,291

Manganese Alloys

19,346

6.89

7.70

4,822

Zinc

13,573

3.21

1.77

734

Lead

10,952

3.76

2.80

946

Nickel

1,860

3.70

6.16

365

Tin

361

1.95

0.70

8

Any ideas about where we will find this capacity and the ores to fill them?

And can you see any of the Recession/Depression/economic collapse in the features of this graphic?

And the individual metals.  Don’t manganese alloys look interesting!  Strongest of all the metals!

Looking at LME inventories over the same period against consumption it is clear that the denominator has risen 30-40% for the LME metals.

Nickel metal inventories have surged wildly as stainless steel producers have sought far cheaper nickel pig iron made from nickel iron laterites. Perversely, reductions in availability of such ores from Indonesia will leave nickel in a deficit very soon.  Watch the price of this metal.

Most other inventories have been heading south rapidly over the past two years.  Some inventory levels are now very low.  Against 40% more consumption they are VERY low.

If we leave out the distorting effects of aluminium and nickel, a composite can be established.  This says the average LME availability of these four metals copper, lead, zinc and tin is just over six days (just 1.78%!!!).

This certainly doesn’t say a collapse in demand.

Is there anything in the above that suggests Dawes Points is incorrect in being bullish?

Now just look at copper.

In US$ testing downtrend but in Euros it is already away and will move higher.

Copper in A$ is looking ready for a massive upmove.  After a compound annual growth rate (CAGR) from 2000 of 3.21% and 4.58% pa from 2010 in consumption, copper is moving ahead of supply and has only 1.5% of annual consumption as LME inventory.

I have some favourite stocks here but Cudeco (CDU.ASX) is now finally so close to production.  Inventories (>200kt) of high grade ore and native copper have been built up ( http://www.asx.com.au/asxpdf/20150505/pdf/42ycgd1lzml3y0.pdf ) and are ready for milling or direct shipment.

Try these numbers:-

Copper price/ tonne     US$6400 (A$8200)

3mtpa @ 3% Cu = 90,000tpa = A$738m revenue

Op costs @ A$40/t (CDU says <A$30/t) = A$120m

Operating surplus  =  A$620m.

Market cap ~A$350m on 278m shares.

And very long mine life beyond just the high grade zones.

Could this be cheap?   The NPV must be 10x the current market cap.

Look at other industrial metals.

Aluminium is looking reasonable after a compound annual growth rate (CAGR) from 2000 of 3.85% and of 4 year rate of 4.33% and has also had a reduction in inventories of 1.6mt ( from 12% of consumption to now just 7.9%).  It does need a strong move up soon to suggest higher prices in 2015.

Lead has had a good move up in the past two months and a 14 year CAGR of 3.76% and four years of 2.80% but there is less than a week’s supply on LME.   Should be much higher in 12 months.

Nickel  has a roller coaster ride with a long term growth of 3.70%pa since 2000 but 6.16%pa since 2010.  The appearance of nickel rich iron laterites being turned into nickel pig iron has left demand for metallic nickel high and dry and hence the big build up of LME inventory.  The export bans by Indonesia on unprocessed ores have now changed the market balance so we should see a draw down on LME inventories, and if this takes place, nickel prices could surge.

Tin has the lowest long term growth of all the LME metals but the real story here is the requirement for new supply.  Nothing much coming, no inventory (down 25% in past 3 months!) and the interesting characteristic of being the only LME metal other than copper that made a post GFC high in 2010/11.  Should be one of the better performing metals for the next few years.

Zinc has had a slower consumption growth rate but has moved up strongly as inventories have declined sharply with a decline in supply that will only get worse in 2016.  A much bigger price coming here.

These don’t suggest recession is upon us.

And as you can see, no LME inventory buffer is available for these metals.

Oil Price

It has been a fair observation that previous collapses in oil prices have been followed by several months of consolidation then a rally back to previous levels.  A postulation would be that demand increases as the price falls and all storage options are taken up to grab rare cheap oil.

This time is unlikely to be very different. Certainly excess supply in the US is chasing ever diminishing storage availability but market price action is saying something else.

It has previously been noted that the most recent new low in localised US domestic WTI was not confirmed by the global Brent price and oil expressed in Euros simply does not suggest that new lows are coming.

In Australia this means anything in LNG export or the Cooper Basin or newly developing unconventional is now very cheap.

Ask me about my favourites.

Gold Stocks

The last Dawes Points highlighted the discount of gold stocks against A$ gold price.

This is finally turning up and it would suggest that over the next two years this means ASX Gold Index should almost double against A$ gold from 1.6x to 3.0x.

Are you bullish on US$ gold?  I am bullish on US$ gold but also the A$ so if both rise then ASX Gold stocks will be really flying.

Dawes Points has picked some real winners here from the lows in November and December 2014.

As noted previously, the issues for individual stocks are complex of course but we are talking about stocks still down 70% and in the very early days of a new bull market in gold.

Risk is still low, reward is still high!

Price Target Potential Price Left to gain

2-Dec

end 2016 gain

11-May

Gain end 2016
XGD

2010

5100

154%

2584

29%

125%

BDR

20

125

525%

22.0

10%

515%

DRM

29

100

245%

44.5

53%

191%

EVN

54

200

270%

118.0

119%

152%

KCN

70

400

471%

75.5

8%

464%

MML

65

250

285%

101.0

55%

229%

NCM

1037

2400

131%

1384.0

33%

98%

NST

117

500

327%

202.5

73%

254%

OGC

230

600

161%

262.0

14%

147%

RRL

144

250

74%

121.0

-16%

90%

RSG

27

125

363%

36.5

35%

328%

SAR

24

90

275%

48.5

102%

173%

SLR

25

85

240%

18.5

-26%

266%

TBR

265

1000

277%

345.0

30%

247%

TRY

50

450

800%

40.5

-19%

819%

GOR

22

220

900%

36.5

66%

834%

CGN

12

50

317%

9.2

-23%

340%

ABU

25

90

260%

25.0

0%

260%

MLX

70

300

329%

151.0

116%

213%

So back to that inflation comment earlier here.

Most of the investing public has no idea of inflation and seems to think deflation is still the way forward.

Indications are now coming through.

Let us count the ways:-

Let us just watch this but keep in mind the flow of funds out of bonds now that a peak has been achieved.

Global competitive pressures have been good against rising costs for some time now but with demand bottoming for labour and again pressing against limited supply and under investment for many resources commodities then we might see some unexpected CPI numbers ahead soon

I consider this Resources Bull Market has a very long way to go!

Barry Dawes

11 May 2015

I own DRM, MML NCM, NST, TBR, GOR, ABU, MLX, CDU, FMG, BHP

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