By Kris Sayce and Dr. Alex Cowie, Editors, Money Morning
[Publisher’s Note: the following is an interview between Money Morning editors, Kris Sayce and Dr. Alex Cowie. The interview took place six weeks ago, but is still timely for those investors looking to make profits in mining stocks this year.]
Kris Sayce: I think the big issue for resources investors is the big picture view of the economy. Do you think China will continue to have the same influence over commodity prices in the future as it did between 2003 and 2008?
Dr. Alex Cowie: China is now the world’s second largest economy. Only the United States economy is bigger. But China’s growth has been 3-4 times faster than America’s, as it builds infrastructure. That has made China the biggest commodity user. And it has been the biggest price driver of key commodities like coal, copper and iron ore for years.
But China’s engines have started misfiring this year.
China was already slowly coming off the three year sugar-rush after a four trillion Yuan stimulus program. But the government also deliberately stepped in to slow down the runaway property sector. And this looks like it may have worked too well.
The tell-tale signs are falling electricity production growth, bank lending all but ceasing, and very dodgy real estate figures. Each point to a big fall in Chinese growth rates.
The knock-on effect (and why this is important to Aussie investors) is that it could lead to a big drop in demand for some commodities. This would take China out of the driving seat for commodity prices.
Kris Sayce: That doesn’t sound good for commodity prices. Are you saying they could fall further?
Dr. Alex Cowie: Some commodities could get smashed if China’s growth slows down.
China is the biggest buyer of iron ore, coal and copper. So these commodities could fall much further unless the Chinese government steps in with further stimulus – which is always possible.
To make things worse for thermal coal, which is used in power stations, it has another big problem to deal with: the competition from all the cheap shale gas in the United States. Power stations are switching from coal powered to gas powered, sending the global coal price down even further.
Kris Sayce: So, can we put all commodities and all resources stocks in the same bag? Or is there a group of commodities and stocks that could do better than others over the next few years?
Dr. Alex Cowie: The world of resource investing is changing. The industrial commodities that built China have already HAD their bull run. The copper price is up SIX-fold in the last ten years. I’m not saying you won’t make money from iron ore, coal or copper stocks in the future – but it’s getting harder. Most of the easy money has been made already.
But there is good news. There are always opportunities if you know where to look. Not all commodities are used for Chinese construction or manufacturing.
Take gold for example; this monetary metal has risen each year for the past 11 years. Every time central banks print more money, the gold price goes up. Right now it’s holding up relatively well at a time other commodities are getting smashed. This is probably because of the prospect of the US Federal Reserve, and the European Central Bank (ECB) printing more money before the end of the year.
After precious metals, oil is the next commodity still giving investors plenty of profit opportunity in these tricky markets. Even with shale oil adding slowly to supplies, global oil supply just can’t keep up with increased demand. Oil is pumped from some of the most unstable places in the world. So this commodity has a big ‘geopolitical cost risk’ involved in first extracting it from these places, and then transporting it to you.
On top of this, the easy oil has mostly been found and extracted. So now producers have to spend more money getting the ‘harder-to-reach’ oil. Analysts now reckon it costs as much as $80 per barrel to produce oil in Saudi Arabia. With such high production costs, the price of a barrel of oil isn’t likely to fall any time soon.
The opportunities are still there with gold and oil. But they get a lot of attention, and the best opportunities are hard to find. When the market is this crowded, you have to look in less obvious places to find the big money-spinners of tomorrow. And the best place to look right now is with strategic minerals.
Kris Sayce: Sorry, before you go on, for the benefit of our readers, can you explain strategic minerals in more detail?
Dr. Alex Cowie: Sure. Strategic minerals are a varied group of commodities with a few common features.
Strategic minerals are generally integral to the national defence, aerospace or energy industries in some way. They also all face supply restrictions, typically because production is dominated by one country. This is what we saw with the Chinese rare earths supply a few years ago. This list shows the minerals that the Royal Geological Society deems most at risk of supply shocks.
Take graphite for example. You’d never think the main ingredient in pencils could be so critical! But nearly all of the world’s graphite comes from China. It’s also of growing importance as the chief component of modern batteries, which are growing in use in electric vehicles, laptops and mobile phones.
Kris Sayce: I notice tungsten is high on the list. What’s so special about tungsten?
Dr. Alex Cowie: Tungsten is another commodity that I think has a bigger future than anyone expects. Again, China controls production, but it’s needed worldwide. The important thing about tungsten is that it’s essential for military applications such as the production of bullets. Say a war breaks out between Iran and the US, and China backs its ally, Iran – what happens if China decides to stop selling the US the tungsten its military needs?
The tungsten price has doubled in the last few years, and no one has noticed yet. In the next year or two, I think the market will suddenly notice this investment opportunity. And the best time to invest is well before that happens!
Kris Sayce: OK. So if you could only choose one commodity to invest in, which would you choose?
Dr. Alex Cowie: It would have to be gold. It has outperformed anything else in the long run, and is set to keep doing so. Gold is money, so you can buy other commodities with it anyway!
Kris Sayce: That’s interesting. So you wouldn’t go for the big bulk miners. You prefer gold, energy and strategic minerals. But I still read a lot of people in the mainstream press saying they’re backing the big miners like BHP Billiton [ASX: BHP] and Fortescue Mining [ASX: FMG]. Why have you avoided the big mining stocks?
Dr. Alex Cowie: I’d rather eat a bag of gravel than invest in those stocks. They’re so big it’s hard to get significant profits. For example, in the first four months of this year, BHP went up just 4%. FMG did much better, but still gained just 33%. But then take Western Desert Resources [ASX: WDR]. Maybe you’ve never heard of it, but this small-cap iron ore stock gained 115% in the same time. This is the type of leverage the smaller stocks can give investors.
I’ll leave the boring ASX200 stocks to the fund managers, thanks!
Kris Sayce: Speaking of the ASX200, I’ve still got a feeling this market could fall further. But are you saying the stocks you’re looking at are cheap today? If so, what do you look for to determine whether a stock is cheap or expensive?
Dr. Alex Cowie: The truth is that the truly important things can’t be quantified. You could have the best spreadsheet in the world that factors in future cash-flows, tax liabilities and the rest of it. But this approach totally overlooks the real drivers of value like the quality of the management, how safe the country is the company is exploring or producing in, or whether the largest shareholder needs to sell his or her 15% holding to pay for a messy divorce. So although I use spreadsheets and valuations, they are more as a rough guide than anything.
But the most important factor that’s not in most analysts’ spreadsheets is whether the company has access to funding. The market’s purse-strings are tightening up. Junior explorers are finding it hard to raise capital for exploration, and even harder to raise the large amounts needed to actually build a mine. Without funding, you can forget it.
Obviously you want stocks that have beaten-down prices, and there it’s not hard to find that in this market. But it’s important to look at the technical charts as well, to time the best entry point. I frequently ask [our in house technical trading expert, Slipstream Trader] Murray Dawes whether his technical view matches my fundamental view. It often improves the success rate.
Kris Sayce: We both know Murray is bearish on the market, so what impact will a falling market have on Aussie resources stocks? I clearly remember the 2008 bear market. Prices ratcheted down gradually, but then suddenly stock prices collapsed. The big mining stocks fell more than 50%, and some small-cap mining stocks fell more than 80-90%. Can you see that happening again?
Dr. Alex Cowie: This is already happening! Small mining stocks have had a terrible 12 months. The ASX300 Metals and Mining index has already fallen 40%, small gold stocks have halved, some uranium stocks are down 80%.
Stocks could fall further of course. Just when you think they’re cheap, the market will show you what ‘cheap’ really looks like. But pretty soon, we’ll be looking at the point when the smart investor gets the trolley out and starts shopping.
Kris Sayce: Getting back to resources stocks, one of the things I’ve looked at – and I know you have too – is shale gas. This has revolutionised the energy market in the United States where shale gas now accounts for 25% of U.S. gas consumption. And according to energy giant, BP, domestic shale gas production will make the U.S. energy independent by 2030 and soon after a net exporter. I know you saw an interesting presentation by BHP Petroleum at the Australian Petroleum Production Energy Association (APPEA) conference this year. What’s your take on the shale gas story?
Dr. Alex Cowie: It’s going to be huge. It already IS in the States. Shale gas will increase from 25% to 50% of the US gas supply by 2020. In some ways it has been TOO successful – there is so much of the stuff, the price has fallen like a stone. This is great for consumers, industry and the economy. But gas producers are having a tough time covering costs! BHP bought into the industry just last year, and the fall in gas prices could mean they are facing a huge loss.
So I’m probably more excited about shale oil. The oil price should hold up better due to a much tighter global market, and the fact it’s easier to export by ship.
The US shale sector is quite mature now, and a lot of the easy money has already been made. The Aussie shale sector now looks like the US sector did about 5-10 years ago. Thing have only really just started. There is a lot of potential. If Aussie shale formations prove to be viable … then some MASSIVE profits could be made, and this could be a huge win for the Aussie economy.
But be warned. There are far more challenges than investors appreciate. There are many shale ‘basins’ in Australia, but we don’t know much about how commercially viable they are yet. Many of them are stranded without the infrastructure needed to get the oil or gas to a port.
At this stage it’s a big punt still. But many of the international oil majors are already joining forces with small Aussie juniors. For example New Standard Energy [ASX:NSE], which has a market cap of $150 million, has joint ventured with $65 billion stock, Conoco Phillips [NYSE:COP]. Like I say, it’s early days – but if these guys are investing, they must see some potential here.
Kris Sayce: Finally, I know from reading Diggers & Drillers that up to now, a lot of your focus has been on hard rock mining (tin, copper, gold, etc.). So is there any difference between valuing an energy stock compared to a hard rock miner?
Dr. Alex Cowie: You need to look at a lot of the same things: location, management, funding; as well as all the oil exploration or production parameters. For explorers its things like how much acreage (land) do they have, and how many wells. You need to see how much geological potential they have from seismic data, and also what success neighbouring miners have had. Some areas are more ‘gassy’, while some are more ‘liquids rich’. I prefer oil over gas, as I expect the oil price to do better long-term.
Kris Sayce: That’s great Alex, thanks a bunch for your time.
Dr. Alex Cowie: I hope I’ve been helpful.
Kris Sayce and Dr. Alex Cowie
Editors, Money Morning
P.S. You can find out more about which resource stocks Alex believes will perform best in 2012, including the five stocks set to soar thanks to the 500-year Dutch Anomaly…)
From the Archives…
The Credit Market Debt Bubble and the Role of Gold
13-07-2012 – Greg Canavan
How to Survive and Thrive from China’s Bust
12-07-2012 – Kris Sayce
Payday Loans: Why This Lender of Last Resort Isn’t the Bad Guy
11-07-2012 – Kris Sayce
What A Slowing Chinese Economy Means For Pork Chops
10-07-2012 – Dr. Alex Cowie
Late News: Bankers Rig Interest Rates, No-One Fired
09-07-2012 – Dr. Alex Cowie
