The biggest risk for resource stocks is a sharp correction in oil and other commodity prices. That would create another opportunity to pick up materials-related stocks at decent prices, but the selloff would be excruciatingly painful in the near term.  

Our most recent recommendation in the basic materials sector was to take profits. Given that consumption usually slows during the summer, we still think that now is the time book profits and hold rather than buy. That cautionary advice comes on the heels of bit of a run-up in commodities as investors have flocked to the space; commodity funds have enjoyed huge inflows this year–roughly USD2.2 billion through mid June–surpassing similar periods two to three years ago.

The reasons for this are twofold. First, last year’s selloff was of epic proportions, making the value proposition easy to spot. Second, the talking heads have traditionally had little difficulty persuading investors to buy oil and commodity-related stocks; these “stories” are relatively easy to tell and understand.
That said, resource stocks have performed extremely well this year, with the leveraged ones achieving returns close to 250 percent. Recent market weakness notwithstanding, base metals (nickel, aluminum, zinc, copper, iron ore) have rallied strongly since March–an impressive feat given analysts’ extremely negative sentiment earlier in the year. 

Developments in China have played a big role in reviving demand for commodities. The Chinese economy is on track to grow by 8 percent this year, mainly because of rising domestic demand and investment. Once investors realized that China would deliver solid growth, many scooped up resource stocks at attractive valuations. At the same time, the Chinese took the opportunity to stockpile natural resources (including oil) and invest in commodities-related companies around the world. After this flurry of import activity, it remains to be seen whether the Chinese will keep up this pace in the second half of the year.

Although emerging economies remain the driving force behind the long-term bull market for commodties, the current weakness in developed economies will likely counteract that trend in the near term.

The Iron Ore Factor

The three biggest iron ore suppliers–Vale (NYSE: VALE), BHP Billiton (NYSE: BHP) and Rio Tinto (NYSE: RTP)–recently negotiated price reductions of around 28 to 33 percent with their Japanese and Korean customers, but forging agreements with Europe and China, Vale’s two biggest markets, hasn’t progressed as swimmingly. 

Chinese steelmakers rejected the price cuts proposed by the troika of miners, seeking a 40 to 45 percent reduction in price.  BHP subsequently upped the ante by threatening to sell its iron ore on the spot market.

The global iron ore market has traditionally been a contract market; the majority of the metal is sold at a set price that’s determined through negotiations. Companies in Japan, Korea, Taiwan and Europe have purchased iron ore in this manner for years, benefiting from the relative price stability.

But that tradition is under fire. China’s growing demand for steel, a decline in domestic iron ore production and suppliers’ efforts to increase the purview of the spot market are gradually changing the complexion of the market. This year China is expected to purchase rougly 50 percent of its iron ore imoprts on the spot market–that’s a big jump from a year ago, when China bought just 39 percent of its supplies on the spot market.
 
BHP Billiton has been one of the biggest proponents of spot sales for two reasons. For one, spot pricing is ostensibly a more transparent pricing mechanism for all market participants, an argument used when BHP pioneered the development of spot prices for thermal coal ten years ago.

Second, even during bull times the contracts negotiated with the likes of China, although much higher than previous cycles, weren’t close to the spot prevailing price at the time. Furthermore, during down times many customers either failed to fulfill their contract obligations or delayed payments.

Rio Tinto and Vale have traditionally been more comfortable with the status quo: a mix of annual contracts and spot pricing.

Because contract negotiations are so thorny, many market observers expect the spot market to become an important part of the iron ore business.

The Joint Venture

BHP Billiton and Rio Tinto recently announced a joint venture regarding the two companies’ iron ore operations in Western Australia.

The Rio-BHP joint venture was proposed as the alternative to the Rio-Chinalco deal worth USD19, which involved the sale to Chinalco of minority interests in Rio assets–a move designed to sort out Rio’s debt issues. The deal with BHP covers all iron ore assets owned by the two companies in western Australia’s Pilbara. As part of the transaction, BHP will pay a USD5.8 billion “equalization” payment to Rio Tinto.

If the joint venture gains approval, the Chinese company will be cut off from direct access to raw materials–another instance of resources serving as a poltical/economic weapon.

According to the announcement, each party will market and sell iron ore independently, though both companies have agreed to co-market certain volumes. Industry experts anticipate that roughly 10 to 15 percent of combined production would be sold jointly on the spot market. It remains to be seen whether the two companies will be able to balance their different production strategies.

Both companies should benefit from the synergies that would accrue from increasing volume and lower capex costs, especially for new developments.

Capital costs in the Pilbara have more than tripled over the past five years, making the region less appealing in that regard; if the joint venture is able to optimize mine, port, and rail operations, about USD90/t can be allocated brownfield development, which would make additional brownfield expansion very profitable. Greenfield capex costs are estimated at USD120/t.

But this is a long-term project, and iron ore prices will likely decrease in the near term because China’s ports have built up inventory this summer.

Source: Bloomberg

If this proves to be the short-term outcome, then iron ore prices may reach higher levels than the price negotiated between suppliers and consumers. And Chinese production is expected weaken by 20 percent this year because of more-stringent environmental and safety regulations; in six months, current the prices that iron ore currently fetches could appear quite low.

Australia to Africa

The joint venture between Rio and BHP makes Western Australia the focus of the two companies’ iron ore operations. As a result, projects in other parts of the world may be placed on the back burner, particularly expensive projects  in relatively higher-risk.

One such project is the Simandou, a large, high-grade iron ore deposit located in Guinea, west Africa. According to industry sources, the deposit has potential mineralization between 8 to 11 billion tons with a grade of around 65 percent iron, making it by far the largest high-grade undeveloped ore resource in the world.

Though Simandou shows promise, it would be a capital-intensive development. The project is located over 700 km by rail from the nearest Guinean port and around 400 km from the Liberia’s Port of Buchanan. Rio Tinto has talked about developing a Trans-Guinean Railway as well as developing a rail link through the Liberian port. Both options would require significant capital; to generate adequate returns, the development of Simandou would need to be substantial.

Rio had initially scheduled production for 2013, but given the economic crisis–not to mention its own debt burden–the project has been delayed.

According to the most recent assessment, Simandou could require an investment of USD26 billion to fully exploit its 170 tonne capacity. But such outflows are beyond the financial means of Rio Tinto, and investing that much money in the relatively challenging economic climate of Guinea adds further complexity.

Overall, Simandou has the potential to alter sunstantially the long-term supply-demand balance of the global iron ore industry, but the economic and political costs may prompt Rio Tinto to sell. Both Rio and BHP know the importance of the project and would likely avoid selling it to a Chinese company.

On the other hand, the Guinea government has had a love/hate relationship with Rio; it would surprise no one if the government turned the project over to the Chinese should such interest emerge. There’s a distinct possibility that Guinea might feel neglected with more of Rio’s attention focused on the joint venture in western Australia.

The Chinese are involved in a number of projects in Africa and have become fairly comfortable interacting with governments on the continent. Furthermore, China has the capital and the need to produce massive quantities ofiron ore, especially now that the Rio-BHP joint venture is in place.

New World Stocks

BHP Billiton is the world’s largest mining company by market cap, with operations in Australia, Africa, the Americas, Europe and central/southeast Asia. It is the world’s largest producer of export thermal abd coking coal and mined lead; the second-largest producer of nickel; the third-largest producer of iron ore and mined copper; a top-five producer of alumina and aluminium a top-ten producer of uranium, diamonds and refined copper. It is also a significant oil and gas producer.

We continue to recommend BHP because its diversified portfolio limits earnings volatility compared to more-leveraged pure plays.

BHP’s assets are lower cost and longer life “franchise” assets; the company has less sensitivity to prices than many of its peers. Investors tend to view the company as a relatively ungeared proxy for the mining sector and the outlook for global industrial production.

This year BHP has been divesting non-essential projects. Most recently it announced plans to sell its Yabulu nickel refinery to a company controlled by professor Clive Palmer, Australia’s fifth richest man.
The Yabulu refinery processes laterite nickel ore from the Philippines, New Caledonia, and Indonesia. The main issue for the Yabulu refinery is the relatively low level of thermal efficiency and fuel cost inputs.

The refinery uses naphtha to heat the nickel bearing ore to 730 degrees centigrade, which, after passing through the roaster, is cooled to 200 degrees centigrade without recapturing the heat for use elsewhere in the process. BHP had intended to convert the refinery to gas, but never achieve this objective because of limited gas supply. 

Based on its diverse-but-targeted portfolio, BHP remains a buy.

Brazil-based iron ore producer VALE is the other resource recommendation in the Portfolio.

Brazil’s Ministry of Foreign Trade (MDIC) recently released preliminary export figures for June 2009. Iron ore exports reached 21.4 metric tone in the month–a 17.7 percent decline from a year ago but a 40 percent jump from the preceding month.

Although May’s inclement weather may and the accounting of different pricing arrangements (contract negotiations are still underway) may have distorted results, the Ministry’s data has always been a good indicator of the activity in Brazil’s iron ore industry.

With steel prices on the rise in China (6 percent over the past month), local steel producers have been very active in the iron ore spot market in expectation of demand. Note though that global steel production excluding China was down 36 percent year-over-year during the first five months of 2009.

As developed economies have yet to show signs of a quick recovery, iron ore shipping volumes should not be much bigger than the current ones. Vale remains a buy.