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Debt Debacle IIDavid and Eric
Coffin's Snippets from the September 2007 HRA Journal For readers in a hurry: jump to Metals & Markets Illiquidity Events While The US housing indices won't bottom out for another year or two, the bad debt associated with it should get sorted out more quickly. The economy will function, albeit at a lower level, while this happens, but markets will be skittish. Usually a debt crisis is sector focused, so loans to the failed sector are put into a "un-receivables" pile while interest rates rise to make up the loss. Lenders' other clients pay for their stupidity, and the bad debt sold at a discount. This time the bad mortgages are sprinkled around in various bundles of commercial paper that also contain more secure loans. Ratings have been assigned to these bundles for "least" or "average" rather than "greatest" risk. Oops! When sub prime mortgages went
no-bid, asset-backed commercial paper (ABCP), collateralized
Debt Obligations (CDO) and all the other "structured products"
containing them also did. This locked up large chunks of the
short term debt market, and made working capital parked in some
money market funds unavailable. An illiquidity wild fire had
been started. US sub prime mortgages are said to total about $1.5 trillion, or roughly the dollar volume on a typical day of global debt trading before illiquidity set in. Perhaps 20%, or about $300 billion face value, are thought to be truly at risk. Specialists are moving in looking for deep discounts on this paper. Cash accumulated to deal with a mess many could see coming is ready. While there have been some "vulture fund" debt purchases already, these groups are not altruists. We expect most of them to wait until there is blood on the streets and not bid any more than necessary to relieve owners of their paper. The main debt issue is really that some of the bad paper needs to be taken out of "good" bundles and put into the remainders bins. That should largely be done for Q3 reporting, which means largely by November. There will of course still be a US assets issue. The secondary issue is that many of these black box products are turning out to be quite different than advertised. A lot of light will need to be shed on these products while they are disassembled and repackaged and the level of distrust between counterparties will take time to abate. The value of US real estate is falling. When it peaked last year it was fully priced, including carrying charges. To the extent houses can be treated like bonds, their face value was simply falling as interest rates rose. Of course the coupon is clipped by the non-owners, which is an issue that will grow if commercial rates rise further. The US Fed chairman has already signaled he may drop rates to induce liquidity in debt markets. That should help the reverse-bond issue in housing, eventually, but there will be more housing pain in the US and the psychology of this will hurt other areas of consumption. One area in particular that will get worse before it gets better is unsold home inventories. Realtors like to insist that there is little speculation in residential real estate. That fantasy is quickly being put to rest. Simple market psychology leads one to believe that a large percentage of the Alt A or "liar loan" category is home to amateur speculators and recent default statistics bear this out. The percentage of "non owner occupied" (i.e., speculator owned) homes in mortgage default is rising rapidly, focused on the hottest markets earlier this decade. With resets coming, prices falling and loans that involved little if any speculator equity it's safe to assume most of these budding Trumps will walk away. Don't count on prices lifting in these markets any time soon. Worries about US inflation should be offset by weaker demand. Falling US interest rates will weaken the greenback, which should continue to aid its exports, as well as commodity prices. A final point on ABCP is that a significant number of resource companies have some funds in them. The companies can be blamed for listening to their banks on this issue, and since the junior resource sector raises project funds for a 1 to 3 year time horizon it should thinking about how best to park it. These biggest problems will be companies in mid development phase which are big cash consumers and need to pull out a large percentage of these funds. A stretched repayment schedule could force them back to market for interim funding. We don't see this as a large issue for most since mineral goods continue to be priced to medium shortfall in supply. Yes there was a serious pull back in sector prices, but we don't see that as sector related per se. One point worth adding if you have shares in a company with significant ABCP exposure is that there are really two markets for this in Canada; bank and non bank. The bank market should survive though it sounds like the repayment schedules could be stretched significantly. The non-bank part of the market includes issues with a lot of exoteric ingredients like default swaps and interest rate straddles. Now that we are in the middle of those "once in 10,000 year" events that seem to surprise Wall St every decade those derivatives are likely to be very deep underwater. A number of analysts familiar with the ABCP market expect losses of up to 50% in the non bank arena. Not pretty. Almost all the ABCP exposure announcement we've seen involve the bank market but if you're worried, check with the company and confirm it. Liquidity Events This phrase has surfaced for the past month to describe a release of good results that produces strong share turnover but little, if any, price gain. This happens in the junior markets either when commodity prices are falling, or as now when risk aversion grips the market. It has also been happening with larger cap companies generating good quarterly results, indicating that simply banking cash was the theme. Some of that cash generation was to cover margins in leveraged accounts. For the most part, juniors were being sold if they offered liquidity, uranium stocks aside (see below), rather then because people necessarily wanted out of a specific company. Resources have been strong enough that many hedge and private equity funds have had a least a taste of the juniors, bur rarely enough to think twice about losing them if they needed cash. As long as we are seeing these "liquidity events" it will be evidence that markets have not yet finished wringing out from the debt scare. We expect them to continue until there is better clarity on how illiquidity in the debt market will get loosened up. However, that does not mean that a given stock will be constantly subject to them as it delivers results. Value will win out if consistently superior results continue to arrive. Ankle Deep A number of references to having entered the "second leg" of the resource market have been made here this year. That would be the middle of three stages a typical resource bull market goes through. Even though we don't consider this cycle typical, we still expect to see those three legs. The first leg starts after excess warehouse stock of metal runs down. The sector takes a steep run from the bottom as metal supply tightens. Producers fix their bottom lines and focus on merging with, and taking over, each other. Exploration companies get cashed up and gain on discoveries recognised mainly by people who know the sector. Market pros take a greater interest in the sector, and things get a little overheated until stocking levels come into balance. That was early 2002 and into mid 2006, in a general sense. Two points distinguish this secular bull from a typical cyclical resource bull, beyond its first leg lasting three times the usual 18 months. One is that while M & A activity has been higher then usual, the cycle killer of developing large new deposits has been almost non-existent. The second is that with the sector running full out and experiencing long waits for essentially all specialised parts and labour, metal supply is just managing to keep up with demand rather then going into excess. That is still the case a year into the second leg of this secular bull market, and there has been very few large new mines announced much less started. Growth in Asian demand for materials has simply been too large, and the past focus by miners on market share simply too limited, for an excess to build. During the second leg of this market expect a greater focus on take-out of asset rich juniors, those with defined deposits. The large players in the sector will be looking for deposits that are in the upper reaches of available grade-scale, and/or that offer significant geological or geopolitical strategic advantages. This will still leave plenty of opportunity for smaller growth oriented producers to develop deposits that are accretive to their bottom lines, and to merge with each other into mid tier companies. Strong exploration stories will continue to have audiences, but others may have to go through another period of confidence building. While that confidence is being rebuilt there will be more time to pick up on discoveries after they are announced. Pruning a speculative portfolio to be ready for that makes sense right now. As more rags-to riches stories come forward, a larger audience for the sector will be built and in due course begin again to lift all boats. This eventually creates the third crescendo leg, about which we will say more in (we hope) about five years. In the mean time some focus on the sub-sectors that make up metal markets is in order. Metals & Markets We said coming into this summer's market that we were more sanguine about metal pricing then we had been early in 2006. The turmoil in lending markets has not changed that basic view. There have been some strong corrections in metal prices, but markets had not, for the most part, been pricing equities for metals prices above current levels. Spreads between spot and long term contract pricing on the London Metal Exchange (LME) have narrowed considerably. This indicates metal users are cautious about medium term supply, or at least content with the current trading range for most metals. Evidence the US economy was moving to recession would cause some further softening of prices, but it would take a significant decline in Asian growth to pull prices much lower then current levels. The uranium sub-sector is the poster boy for the shift to a fear based market. It was being badly beaten up before the debt squeeze started. Even before the "unofficial spot price" peaked in June, the reality that there were too many uranium stocks with too much valuation had hit home. The grinding decline this caused moved into overdrive when debt market problems began to surface. The rather obvious reason for this was that too many had margin in uranium stocks. Much of this has been wrung out, but further decline by weak players can be expected with tax loss selling season. Uranium has no actual spot market. The Trade Tech (http://www.uranium.info/) site reports off-contract pricing for one-off sales. Very useful information, but quite different from a spot price based on the last trade of a regular, active market. The meager supply of non contracted uranium output did undergo a squeeze, but when this got overdone the utilities that use the stuff looked to each other for short term supply, not a spot market. A mantra like repetition that the cost of uranium has a minimal impact the operations of nuclear reactors also got out of hand. At $10 per pound this has some truth, but at $100+ it is nonsense. Uranium's market is small, and its mine supply costly. Both miners and users need long term contracts to justify their high capital needs, and these are not going to be based on "crisis pricing". The uranium supply constraint is real, and there is room for several new high-quality uranium producing districts to take shape because of it. Strateco (RSC-V) is our pick to be in the running for this status, and that potential has been reflected in the relative support its market has seen. Our other picks have been technically oriented groups in established North American districts that can either have partners move projects through development, or sell discoveries to new or planned operations. We expect all of them to resume orderly markets in due course. Tungsten also lacks a true spot market, but in its case that has meant a lack of attention. After moving up later then most metals, its recent contract pricing has held in the $250 per MTU (about $11 per pound) area. China's tungsten miners, who dominate the market, are looking for higher prices. We continue to expect them to win out. With Primary Metals (PMI-V) being taken over, North American Tungsten (NTC-V) will be the only primary tungsten miner in public hands. This leaves considerable room for deposits with near term production potential to gain. Nickel has been suffering a near term over supply of direct shipping material. This was a consequence of a hedge fund love affair that caused Ni to run hard, which in turn caused a glut and then a 50% pull back. The spot to 27 month contract spread for nickel on the LME is a very narrow 3%. Recent pricing at $13/pound ($28,700/tonne) is needed to garner development of large new supplies, while still leaving ample room for new small cap producers to gain on direct shipping or low cost concentration operations. Accumulating these now makes sense. Steady demand gains for nickel, which tends to shine in the middle car-building stages of emerging economies, is on the table. A relatively small market means nickel's price will likely be the most volatile of the major metals. This volatility should be viewed opportunistically. Zinc price gains have so far generated frustratingly limited enthusiasm for its asset based juniors. The reasons for this, rooted in an extended oversupply in the early part of this metals bull, we have touched on in the past. The more cautious market we have entered is likely to take greater note that the "relatively meager" 400% gains to zinc's base pricing are none not yet built into most of its smaller players. Warehouse stocks of zinc continue to slowly decline, and the spot to 27 month spread has been in a fairly narrow 11-14% range on the LME. In spite of this a recent price at the $1.32 ($3000/tonne) level is below the recent $1.40/pound price base. This may have traders cautious about going long the metal, even though the steadiness of zinc's market may now appeal to hedge players who had been in nickel as a market hedge. Patience with zinc deals should be rewarded. One of the anomalies of the past month has been the price of lead moving to new highs, and above those of its cousin zinc. Lead prices have rarely exceeded zinc's since the latter began to create a market a century ago. Eighty percent of lead's demand is for auto batteries, and this lead price won't affect the demand for autos. No one is offering lead 27 months out, but its safe to assume the higher lead portions of existing zinc and silver mines are being assessed for near term output. It is worth keeping lead in mind when looking at existing and near term production for these metals. The copper market has tested the $3.20 per pound level we laid out last month, and so far confirmed it as a base for the red metal. Copper still has the largest spread between spot and long term contracts, but that has been declining slightly. This may simply be traders taking note of the $3.20 base on the charts. Copper's market is focused by construction demand, so we are still cautious about it with regards to the psychological impact of the continued waning of the US housing market. For that reason watching its price is a good gauge of broader sentiment on the metals sector while the distress in US markets plays out. Beyond that, our thoughts laid out last month for copper's longer term prospects have not changed. Accumulating copper based assets on weakness in the metal's price makes sense to us. The gold market has continued to trade inversely to moves in the US$, and silver has continued to look like a more volatile shadow to gold against this theme. That has given the precious metals a range bound look, which rephrased means they have been stable in a choppy market. That is gold's job. Many gold producers fared less well than their product until recent sessions. The small gain in gold's price relative to base metals has made it harder for gold producers to play catch up on costs. Traditionally gold companies have had a heavier weighting on "in-ground" metal then base metal companies get. The strength in base metals and energy has simply made all resource watchers much more bottom-line focused. De-hedging is a theme in the gold sector right now since the metal has moved into mine supply deficit. The weakness of the US economy augers weakness for the greenback. Both of these underpin a move towards gold as an assets class. That and the fact that gold is usually a late cycle metal. Its sales go up when people are feeling wealthy. Large demand gains are being recorded in the BRIC as well as in the oil rich middle east. We do think it is time to be gold and silver. Perhaps the brightest spot in the metals universe right now is the increasing attention being focused on the sector by conservative managers of money. Money managers are either value seekers or trend watchers. Taking standard multi-year time frames in the ups and downs of economies would have made either group cautious about the rapid and often record breaking gains to metal prices. A multi-decade analysis of the sector is now taking root. Five years into this secular bull market is time enough for the "long-term" (usually 3-5 year) trend lines used for analyzing companies to have caught up to the new reality. A fundamental evaluation of growth in China and other large emerging economies is pointing to sustained demand growth for materials. These two together will bring new blood into the sector. Sector nay-sayers focus on the US as driver of global demand. We don't disregard this, we simply think emerging economies are developing to the point where exchange of goods with the US is increasingly less important to their growth. The health of the US economy is still a very important component of global economic analysis, and will be through the balance of our working lives. But it is no longer of singular importance. Caution is in order until there is more clarity about the US debt problems. But as that cloud lifts, we expect to see a renewed focus on the sector. Getting ready for that is our current focus. [FYI: Debt Debacle part I is here] David Coffin
& Eric Coffin David Coffin and Eric Coffin are the editors of the 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. If you would like to be added to the HRA FREE mailing list to get notifications about articles like this and other free analyses and reports just add yourself to our list here.
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