Copper, iron ore and coal to lead commodities

by Commodity Online

Copper, iron ore and coal is expected to create a bullish undertone for commodities thanks to insatiable appetite for commodities from developing nations such as India and China.

The rising demand and the supply demand mismatch turn copper into a top contender for leading the commodities pack up in the coming years. The red metal already faces a market deficit and it is expected to widen further when economies emerge out of their protective cocoons as recovery gathers momentum.

Iron ore also has claimed a position among the favourites following the rising demand for steel and the new pricing structure the market has now adopted. The benefit to the energy sector is obvious enough to be over looked, and coal is a major source of it. Countries like China, which relies on coal for more than 70 percent of its energy needs, are sure to bolster prices of coal in the coming days.

Standard Chartered Plc predicts gold, copper, coal and iron ore to be in the forefront of the commodities price rally in the few years to come.

Goldman Sachs also sees raw materials price to climb in the coming days, along with Deutsche Bank and Barclay’s capital, all of which advocate the strength in commodities to stick.

However, rising commodities prices punt up global food prices adding to the inflationary situation, which lead countries such as China, Brazil and India etc to hike interest rates.

The Standard & Poor’s GSCI 24 commodities index beat stocks, bonds and currencies in the last five months, which is the longest winning streak in last 14 years, reports showed. But the index has been on the downside of the late due to the subsequent fall back of commodities market.

The development expectations from India and China are sure to dominate the future path for commodities. India is expected raise the demand for metals by 80 percent in the coming years to complement her investments in infrastructure. Coal demand, on the other hand, is seen at 2 billion tonnes in the coming years, reports showed.

Nevertheless, more immediate concerns dog the commodities markets currently. Slowing growth in the US, debt troubles in the European Union and rising inflation and the apparent real estate bubble in China, all of which present the market with enough and more hurdles.

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Fortify your portfolio with some iron ore

by Eric Lam 

Anybody who still has any lingering doubts that Canada is the next big player in iron ore should have taken a walk down down the aisles of the 2011 Prospectors & Developers Association of Canada mining convention in Toronto this week.

Frank Condon, director of Quebec operations with Adriana Resources Inc., said there were easily three times as many people stopping by the iron exploration company’s booth this year compared with last.

“It’s the most interest we’ve ever seen,” he said. “When the mom and pop investors stop by and they see 4 billion tonnes indicated, there’s a lot of people saying ‘Gee whiz, that’s a lot.’ It certainly is an eyecatcher.”

Investors may also want to bulk out their portfolio with a little iron ore, one of the primary components of steel.

Mr. Condon, who has more than 40 years experience working in the resource industry, was referring to Adriana’s Lac Otelnuk project in the Labrador Trough in northern Quebec. The company secured a $120-million deal with China’s Wuhan Iron and Steel Co. Ltd. in January to co-develop the massive deposit, which would have been much too expensive for the junior miner to do on its own.

And on Monday, New Millenium Capital Corp. worked out a financing deal with India’s Tata Steel to develop its own project in the region.

Iron ore has hit historically high prices of US$200 a tonne on intense construction demand from China, India and other developing countries.

All the attention the world is now paying to Canada’s previously dormant iron sector has created an excellent buying opportunity for speculative investors, John Stephenson, portfolio manager with First Asset Funds, said in an interview.

“The huge development wave in China is going to continue for at least the next three or four years. Both price and demand will remain high,” he said. “I’d say we’re on the cusp of another buying wave. It’s a sector that China wants to consolidate, it’s a hot sector that’s going to get hotter and you’ll see more IPO and M&A action.”

However, none of these upstarts are close to production and remain risky buys on the TSX Venture Exchange.

Arnold Zwaig, senior wealth manager with ScotiaMcLeod, said investors are better off sticking with the big three producers — BHP Billiton PLC, Vale SA and Rio Tinto.

“How much of the M&A premium is already priced into those upstarts?” he said. “It will take so many years for these projects to give China what it needs, it will still need to go to the big producers.”

While there’s no specific ETF focused on iron as the mineral is sold on contract and by the tonne, there are natural resources ETFs that hold either the big three or even coal producers such as Teck Resources Ltd. (coking coal is a key part of the steel smelting process).

One option is the Market Vectors Steel ETF from Van Eck Global, which counts Vale and Rio Tinto as its top two holdings along with major U.S. iron producer Cliffs Natural Resources Inc. in its top 10. The ETF, started in 2006 on the New York Stock Exchange, holds assets under management of about US$242-million and an expense ratio of 0.56%.

Another is the Invesco PowerShares Global Steel Portfolio ETF, which is traded on the Nasdaq and carries a market value of US$11.7-million. The MER is 0.75% and top holdings include Vale and steel producer ArcelorMittal as well as several international iron producers.

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Commodities Bubble: Why I'd Avoid Iron Ore at Current Levels

by Muditha Weeratunga

The collapse of the US housing market bubble gave birth to another bubble in the commodity markets. As with any other bubble, this commodity bubble has some form of a logical fundamental arguments attached to it. A key argument to support the commodity bubble is growing demand coming from the emerging Asian market. In my view, the massive money supply that is being created by the developed world central banks has now fueled this bubble further.

Beware of the supply side developments

If you speak to most of the brokers these days they will provide you with pages and pages of research highlighting the growing demand created by the emerging world. But only few bother to study the developments in the supply side of the industry. In this article I attempt to look at the demand and supply side dynamics for commodities (specifically for Iron Ore) and highlight some of the inherent risks in the commodity market.

Downside risks to demand assumptions

1. Rising inflation will force China to slow down

True, there is a vast amount of people who live in poverty in developing countries and there is massive demand to build infrastructure to support them. But at the same time, with the current high inflation levels in the emerging economies, the developing world central banks are trying to slow down the growth rate in these economies. With these actions, there is a high possibility that some of the growth assumptions turn out to be too optimistic.

2. Unlike energy, commodity demand is a one off thing

Energy demand is an accumulating thing

The beauty of the energy industry is that, the consumer continuously uses the energy. (They may change the source of energy from oil to renewable energy, but still will consume energy) The demand may fluctuate depending on the economic cycle, but once you use energy you need energy again on the next day. Just because you pump petrol into your car today doesn’t mean you will stop buying petrol. You will need petrol next week / month. And with more people joining the middle class there is going to be continued demand for energy. Just because more people in China need fuel for their cars doesn’t mean the developed world consumers stop buying fuel. So the demand for energy is an accumulating thing. More energy efficient processes will reduce the per capita consumption, but the total demand for energy should continue to grow.

Commodity demand is a one off thing

Unlike energy, when you buy iron ore (steel) to build a road / bridge, it is a one off thing. Once you build, you will not go to the market to buy iron / steel again for years.

Hence, though, it is true that China and other developing world countries need a lot of iron ore for their construction projects. Once they finish their projects, the demand will come down steadily.

3. Developed world Money Supply will slow down after June 2011

It seems the US economy has finally started to stabilize. If this trend continues, there is a good chance that Fed will not extend its QE2 program after June 2011. In my view, the massive money supply that is being created by QE1 and QE2 is partly to blame for the commodity bubble. So I believe, with QE2 coming to an end, this aspect of the bubble will end after June 2011.

Increasing supply of commodities creates an over supply scenario

1. Increasing Capex volumes

The chart below highlights the total capex expenditure by the 10 largest global Iron Ore and Diversified miners.

Chart 1: Rapid growth in capex by top 10 companies

It is important to note that these are only the top 10 listed companies. There are a large number of companies based in China whose data is not publicly available.

In the table below I have summarized the total capex expenditure by the top 50 listed companies since 2005. The top 50 listed companies have increased their cumulative capex levels at a compounded growth rate of 74% over the last 4 years by the end of the 2009 financial year.

Table -1: Growing capex levels

Cum. capex (US$ Mn)	2005	2006	2007	2008	2009	4 yr CAGR
Top 10	13,399	30,283	54,815	90,126	121,568	74%
Top 50	1,414	3,248	6,647	11,702	15,135	81%
Total	14,813	33,531	61,462	101,828	136,703	74%

To get a feel for how big these capex projects are; I have compared the cumulative capex expenditure with the Apollo program and the Iraq war.

• The Apollo program cost US$ 24bn over almost 8 years and these top 50 listed companies has spent more than 5 times that in just over 4 years.

• According to the Congressional Research Service, it is estimated that the Iraq war cost US$2bn a week. These capex projects could have run the Iraq war for over 15 months.

2. Increasing Net Cash positions will fund more future capex projects

The Chart below highlights the growth in the net cash position of these top 50 listed Iron Ore and diversified mining companies. By the end of the financial year 2009 they had enough cash to fund 2 Apollo projects and occupy Iraq for over 3 months.

This is only the net cash level. Given how willing the capital markets are to fund current commodity projects at the moment, there is a lot more potential for these companies to expand their capacities significantly.

Chart 2: Increasing net cash positions

3. Companies are moving into short term contracts, this can lead to an increasing volatility in earnings

 

To benefit from the short term price rises, mining companies are moving into a more short term pricing mechanism for commodity contracts. This will make their earnings highly correlated to the commodity prices. (Currently most of the contracts are long term and hence earnings tend to be less volatile than the commodity prices). At the moment this move is working in favor for the miners, as we are in a price rising environment. However, the moment the commodity bubble crashes the earnings are going to come down sharply. This increasing volatility in earning is not an ideal scenario for an equity investor. As the volatility of earnings increases, the risk of the investment increases and the market will pay these companies lower PE multiples.

4. Most of the iron ore Reserves are sourced from the developing world

The table given below highlights the top 10 iron ore reserves by the country. Of this list, only three countries are among the developed world and they account for only 20% of the global reserves.

If there is a scenario of oversupply of iron ore in the global markets and if prices come down drastically, the developing world countries will be willing to sell their iron ore at even lower prices to support their local economy. This will support a prolonged period of lower iron ore prices in the market with mining companies trying to cover their marginal cost.

Table -1: Global IronOre reserve levels

Rank		Reserves (Mt)	as a % of total reserves
1	Russia	34,728	26%
2	Brazil	28,679	22%
3	Australia	17,252	13%
4	India	5,426	4%
5	Canada	4,151	3%
6	China	3,464	3%
7	South Africa	2,123	2%
8	US	1,834	1%
9	Sweden	1,592	1%
10	Argentina	402	0%
	Total World	133,338

5. Increasing iron ore prices makes more projects viable

Based on a simple data search, currently there are 418,276Mt of iron ore resources in the world, but only 133,338Mt reserves are available. (i.e. There are almost 3 times more iron ore available but not economically viable to extract). These numbers don’t even include the resources available from Africa. With increasing iron ore prices, more unprofitable projects become profitable and more players will enter the market. This is another aspect of the over capacity problem I discussed earlier .

Chart 3: global iron ore resources and reserves levels

Conclusion: Don’t bet your retirement money on the commodity (Iron ore) market 

I believe there is an increasing risk of commodity bubble crashing in the next few years, as a result of investors realizing how optimistic the demand assumptions are, developed world QE programs coming to an end, and over capacity that is being built on by the mining companies.

The equity market is a forward looking indicator, and hence, if we assume there is going to be an over capacity scenario in commodity / iron ore markets in two years time, we will see equity markets reflecting this at least 1 year in advance. Once crashed, it will take a prolonged period for the commodity / iron ore market to recover. Therefore, I think it is advisable to stay away from commodity / Iron ore exposure at current levels. [..]

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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