Base Metals - A Gold Alternative?

Alf Field
2 Nov, 2006

There is nothing that possesses all the qualities of money in the way that gold does, so there really isn't a competitor to gold as "the ultimate money".

Base metals do share a number of qualities of money with gold. They represent assets which have a value based on usage. They can be stored and will retain or increase in value as the US dollar declines in both purchasing power and on foreign exchange markets. Base metals are not someone's liability and do not rely on a third party's promise for their value. They can provide protection against the certain future demise of all global fiat currencies.

There is a high probability that base metals are at the start of a major bull market, a bull market that may last for many years and propel metal prices to much higher levels. This is not a prevalent point of view. Most media articles over the past six months have been negative on base metals for one or more of the following reasons:

1. The base metals have been in a "bubble" which has burst;
2. The US economy is headed into a recession propelled by a slump in the housing market which will result in China selling fewer goods to the US and thus requiring fewer base metals;
3. The CRB Index has broken down and given a major sell signal;
4. The surge in base metal prices will generate rapid increases in new supplies of metals which will cause the prices to collapse;
5. Hedge Funds and Commodity Funds have been buyers and when they dispose of their holdings, prices will drop.

These reasons are all false, as I will attempt to demonstrate below:

Was it a "Bubble" that has burst?

It is easy to understand why people might think that base metal prices have been in a "bubble" when one looks at the very long term chart of copper below.

This chart condenses over 35 years of price history for copper. Two very important points emerge from a study of this chart.

1. The copper price in 2003 was the same as the copper price that prevailed in 1973! What an incredible bear market.
2. Just over a year ago, during the September 2005 quarter, copper burst upwards out of a base that extended over no less than 30 years!

Once out of the base, the price of copper rocketed upwards, more than doubling in price in the space of little more than six months. Since the peak in May 2006, copper has been consolidating in a sideways movement not reflected on this long term chart.

Is this a "bubble" as many have suggested or is it the initial move in a very much bigger bull market that is in its very early stages? From a technical point of view it is highly unlikely that a massive upside break such as this one from a 30 year-long base will exhaust itself in just 6 months. It is more likely to be just the first upside run in a new bull market.

If copper had been in a "bubble" one would expect to find many of the symptoms of a "bubble" present, e.g.

1. Vast public participation and enthusiasm for the item concerned;
2. Very bullish and continuous media coverage of the item;
3. Stocks involved in the item selling for ridiculously high and unsupportable valuations (think technology stocks in the bubble of the late 1990's).

None of these factors are present in base metals or base metal share prices at present. There is virtually no public participation or enthusiasm for base metals; the media coverage tends to be almost universally negative and base metal stocks are selling at mouth-watering valuations that can only be justified by factoring in an expectation of much lower metal prices.

I would like to give a couple of examples of these enticing valuations for two companies that I have in my portfolio of base metal stocks. One is a zinc company and the other a nickel producer. Zinc and nickel are the two metals that I am particularly bullish about.

The first company is Zinifex (ZFX on the Australian Stock Exchange). ZFX is the largest zinc producer in Australia, producing 6% of the world's demand for zinc. In addition, ZFX supplies 4% of the global demand for lead, a metal also making new highs at this time. Here are a few brief facts about ZFX:

Trades more than 5m shares per day; market capitalisation exceeds US$5 billion.
Current ZFX share price (30 October 2006) approximately A$15.00.
Earnings for year to June 2006 - A$2.20 per share and dividend 80c per share.
Historic PE ratio 6.8; historic dividend yield 5.3%.
Average zinc price received in the 2006 year was 96cUS.
Current zinc price has just made a new all time high above US$1.90c.
If current zinc and lead prices are maintained, 2007 earnings will be at least double 2006 earnings - perhaps A$4.00 per share or more, and the 2007 dividend say A$1.60.
Thus ZFX is trading at a forward PE of 3.8 and a dividend yield of 10.6%.
If zinc goes to $2.50, which is what I expect in the near future as a result of the continuing decline in LME zinc stocks, ZFX earnings and dividends will obviously be even higher.

The point I am making is that ZFX is not trading at wildly optimistic, unsupportable "bubble" valuations. ZFX is trading at the sort of valuation one expects at the start of bull markets. As Richard Russell is wont to say, "Bull markets climb a Wall of Worry". This is what we have in base metals. The overwhelming emotion is fear whereas in bubbles the prevailing emotion is greed. ZFX share price can be justified on historic earnings and dividends. The current ZFX market price takes no account of the bullish numbers emerging in zinc and lead prices.

Turning to nickel, there is a similar situation of a decline in LME stocks leading to a sharp increase in the nickel price - as depicted in the 5 year charts of LME nickel prices and stocks:

There is a current shortage of refined nickel of about 100,000t tons per annum. Despite new production expected over the next few years from Ravensthorpe, Voisey's Bay, Goro and a variety of brownfield expansions, Steve Barrett, the President of the Nickel Institute, in a recent presentation at the Nickel Conference in Perth, indicated that the production shortfall would not only continue, but actually increase, through 2010. The main drivers on the demand side being increased stainless steel capacity installed in China and Korea.

What is the nickel price outlook in these circumstances? Barring a world depression, it seems that nickel will continue to rise in price, possibly for a decade. I have a target price of US$25 per lb during the next year or two, compared with the current price of around $15 per lb.

This forecast price (or even the current price) will do wonders for the earnings of a number of small Australian nickel producers. One of these is Mincor (MCR on the ASX), which is the stock that I have chosen to highlight. Here are a few salient facts about Mincor:

Mincor details.
Issued capital - 195m shares.
Share price (30 Oct 2006) was A$1.80, hence a market capitalisation of A$350m
No debt. Cash on hand at 30 Sept 2006 was A$69m.
Enterprise value thus A$350m-A$69m cash = A$271m.
Mine life is expected to be 7 years but new discoveries seem certain to extend this.
Strong geological exploration team. Many new exploration prospects.
Some hedging (approx 30%) in place to December 2007, but minimal thereafter.
Target production is 15,000 tons nickel in concentrate per annum, (30m lbs).
Payable nickel is 65% of nickel in concentrate, i.e. about 9,750 tons (19.5m lbs).
By-product revenue (copper and cobalt) is running at about A$18m per annum.

The following analysis shows the gearing related to higher nickel prices. Profit estimates are done at nickel prices of US$15 lb (current price); US$10 lb (a 33% reduction) and US$25 lb, which is my expectation for the nickel price in the next year or so:

NB: These figures include corporate overheads but exclude exploration expenses and amortization/depreciation charges.

The point of this exercise is to show that these shares are discounting a return to a nickel price of US$10 per lb. There is no public enthusiasm in the MCR share price, all the blue sky is still available. MCR is not trading at a "bubble" valuation and there is spectacular upside in the stock if my US$25 lb forecast for the nickel price eventuates. In fact, MCR could earn the entire current Enterprise Value of the company in one year with nickel at US$25 per lb.

These two examples, ZFX and MCR, are not companies operating in the wilds of Africa, South America or outer Siberia. They operate in mining-friendly, political risk-free Australia.

There are many other examples of base metal companies trading at very low valuations. Even the major base metal companies such as BHP and RIO are trading on forward PE's of about 9 according to most analysts, and even lower PE's if metal prices continue to rise.

I conclude from this discussion that there is no evidence of a "bubble" in base metal prices. On the contrary, there is evidence that base metals have commenced a major new bull market.

China Factor and a Possible US recession?

One cannot understand what is happening to base metals without a deeper appreciation of the China factor. This is something I have come to appreciate after visiting China recently. I simply didn't have a sufficient understanding of the history of China.

For centuries, indeed millennia, China has been a hugely productive, entrepreneurial nation. Historically it has been largely self-sufficient, providing the rest of the world with much wanted goods. The modern history of China from the 1930's when Japan invaded the country, has been different. The Japanese were not evicted until after the second World War. Thereafter there was an internal civil war between the Communists and the Nationalists. The Communists won, the Nationalists went to Taiwan and Mao Zedong took draconian control of the country, imposing Stalinist type Communism.

The essentially free enterprise Chinese people were deprived of their land and other assets. The State told everyone what to do and how much they would get paid. It was a disaster economically. When the nation was facing starvation in 1978 a bunch of farmers took matters into their own hands and formed what was effectively a co-operative society. They ignored instructions and did what they knew would be most productive. Food production soared and the farmers became wealthy. Soon others copied them and the movement spread.

It was the start of a free market underground rebellion. People were prepared to break laws in order to progress and eventually the State accepted what was happening and went along with the new movements, finally officially encouraging the "new" system.

What is essential to understand is that for nearly 50 years the Chinese economy was brutally suppressed. From 1978 onwards this massive 1.3 billion productive Chinese population has been released economically and they are making up for lost time. Some analysts claim that the population figure is higher, probably 1.5 billion, a claim derived from food consumption statistics. In any event, the growth in China over the last 20 years has been staggering with annual growth rates of around 10%.

The Chinese now want what other developed nations take for granted. The top 3 items desired by Chinese at the moment are condominiums, automobiles and education. The number of automobiles in the country is tiny relative to the population, some suggest as few as 40 million motor cars. No wonder automobile sales are running at a rate of 6.5m per annum and growing rapidly. The building boom in China has been awesome and it continues unabated.

The infrastructure of the country is being revived after over 50 years of neglect. One should not forget the Beijing Olympics scheduled for September 2008. This is a major driver in many projects and it seems that there will not be a slow down in China's growth rate until after the Olympics in 2008. This is why China has an insatiable demand for raw materials, especially base metals.

There was a time when America sneezed the rest of the world caught a cold. That probably no longer applies and it is doubtful whether a recession in America now would cause any significant dent in the Chinese growth rate.

The CRB Index has broken down and given a major SELL signal?

It is correct that the CRB index has broken down sharply and given a sell signal - but it gives a false impression of what is transpiring. The components of the CRB index were radically changed during 2005 and the CRB index is now heavily weighted towards oil and energy. The CRB is no longer a reliable index of base metal prices. This is clear from the fact that zinc, nickel and lead have made new all-time highs recently despite this so-called sell signal in the CRB Index. The sell signal in the CRB index was triggered by the decline in oil and natural gas prices, not base metals.

We can safely ignore the CRB Index as an indicator of whether one should or should not get involved in base metals.

Will new metal supplies generated by current higher prices swamp demand leading to lower metal prices?

This is the classic argument put forward by economists and has been the reason for cyclical declines in metal prices in the past. No doubt it will work again, but not for many years, maybe even a decade or more. New supplies cannot be easily garnered for quite some time.

During the protracted 30 year base metals bear market, mining companies laid off geological and exploration staff. There was no need for companies to look for new deposits and projects. The result is that there are very few new deposits being brought to production and those that are about to commence are barely replacing production lost from older mines that are coming to the end of their days. This is evident in the nickel statistics mentioned earlier, but it also applies to other metals. How many new large copper mines about to come into production can you name?

There are other contributing factors flowing from the 30 year bear market. The University enrolment of geologists and mining engineers slumped during that period, understandably so. Consequently there is a major skill shortage in the mining industry that is delaying exploration and development of new projects. One hears stories of shortages of drilling rigs and also drilling crews. Drill rigs require two or three crews to operate effectively around the clock and to give crews time off. Many rigs now have limited crews. When they eventually get the cores to the assay labs for analysis, there are long delays in the labs before results are available for study and co-ordination.

New projects now require much more detailed feasibility studies before Boards of Directors will approve projects. Then the permitting and financing process starts. Finally the mine has to be constructed and brought to production. The average pipeline delay for a new project is between 7 and 10 years - and that is the earliest timeframe that one can visualise for a ramp up of major new supplies. Given current and expected inflation rates, what metal prices will be required to encourage that new production and to ensure profitability in 10 years time? I suggest that it will require metal prices very much higher than at present.

Finally, a related comment about a different staffing problem. During the protracted metals bear market, investment houses and stockbrokers laid off their mining and resource analysts and hired analysts capable of following high technology and industrial companies. The result is that there is now an acute shortage of good mining and resource analysts in the investment industry. That is why there are so many mouth watering investment opportunities around for those who care to look for them. This is another indication of how early we are in this metals bull market and further evidence that this is no "bubble".

Will Metal Prices drop when Funds sell their holdings?

Before funds can sell, they must first buy. Unless they go short, of course.

The chart below shows the weekly copper price and what are known as the COTs - the Commitment of Traders statistics.

The green line below the copper graph shows the positions taken by the large funds.
The red line represents small speculators, and
The blue line shows the position of the "Commercials" - those major players in the industry who may wish to protect their situation from time to time.

These lines provide some very interesting information.

The green line (the net position of the large funds) shows that they were at their maximum long position in March 2005, just before the copper price started to go vertical. Since then the green line has trended steadily downwards as the large funds firstly disposed of their long positions and then went into a net short position. That is where the large funds sit at the moment, short of copper

The blue line (the commercials) has been climbing steadily over this period as the commercials have bought into copper. They now have a large net long position. Historically the commercials have been right in their market calls.

So there is no need to be scared of the large funds off loading their positions. They don't hold any copper and indeed are short of the metal. Their buying will actually help push copper higher when they eventually close their short positions.

One final comment relating to those people in the base metals industry who know most about their industry, i.e. the people who run the major base metal companies. What have they been doing? Trying to buy up their major rivals is what they have been doing.

Why would they want to do that? The answer is that they can smell a bull market coming and the quickest way to increase their reserves and resources in the ground is to buy rival companies while they are still cheap and before the metal prices rise sharply. It is much easier than trying to go the long route of finding new deposits.

Conclusions

In my opinion there is no evidence of a "Bubble" in the base metals markets.

There is technical evidence of a major upside break from a 30 year bear market in the base metals, a base from which very much higher metal prices can be anticipated and which should be a new bull market that spans at least 10 years.

Many of the base metal shares are extremely cheap relative to current metal prices and look to be absolute bargains relative to the much higher metal prices that may be anticipated as the bull market unfolds.

Base metals are not a strict alternative to gold, but they do allow for portfolio diversification and should provide protection to the inevitable currency upheaval that lies ahead, especially relating to the US Dollar.

1 Nov, 2006
Alf Field

321gold Inc