Editor’s Note: This article was first published as the In Focus feature in the October issue of Australian Edge. AE focuses on high total return opportunities in Australia. — RC

In the background of almost everything that goes on in Australia these days lurks China. On most of the US-centric world maps we see in the Northern Hemisphere the Middle Kingdom literally looms over the Land Down Under.

It’s undeniably true that China’s economic growth has had a direct, beneficial impact on Australia’s fortunes in the 21st century. It’s probably the greatest single reason Australia avoided a recession while the rest of the world sank from 2007 to 2009. Much like Canada, its resource-rich Commonwealth Cousin, stable institutions over the long term, coupled with generally responsible recent political management have positioned Australia for further expansion because of China’s still-growing demand for commodities.

Even more than the Great White North, for which the US is and will remain the biggest bilateral trade partner, Australia depends on this still-emerging economic giant. But like Canada, too, which is and must continue to become more of a multi-trick pony, Australia does business with other important economies.

Canada’s trade minister last week visited Beijing to continue laying the foundation for a broad agreement between the two countries that will facilitate investment, another step that will help further reduce overreliance on the US. “Diversification” is a byword at the level of geopolitics and investing as well.

Assessing China’s impact on the supply-demand equation of countless goods, services and commodities will certainly help us understand Australia’s place in a rapidly changing global economy. We know that China–and India, for that matter, and other emerging Asian economies as well–will have increasing need for power as its population urbanizes and further develops middle-class appetites. This is one of the most well-known trends known to man: demand for electricity is rising.

What gets overlooked too often is that there are existing demand trends in place as well. Japan, for instance, the world’s third-biggest economy, consumes more electricity than any other country except China and the US.

Take a closer look at Australia’s coal exports. In 2010 it exported 300.6 metric tons, up from 274 metric tons in 2009 and 233.5 in 2008. These substantial increases at a time of weak global economic growth reflect yet again the importance of fundamental supply and demand issues that are often more important to the detail of the dry-bulk market than the overarching macro view.

It might also be noted that the 70 metric tons of increased exports China was not responsible for any of the net increase. Exports of coal from Australia to China fell by 9.4 metric tons 36.3, though exports of iron ore did increase by 7.9 metric tons to 274.5.

Combined there was a net reduction of 1.5 metric tons.

The 70 metric ton increase came from Japan, which saw its requirements from Australia rise by 17 metric tons for coal and by 16.6 metric tons for iron ore, accounting for almost half of the increase. South Korea accounted for 15 metric tons, and other emerging Asian economies accounted for the balance, albeit with a significant increase in coking coal exports to Europe.

Japanese imports of coal were forecast to increase in 2011 even before the full impact of the Mar. 11 earthquake and subsequent tsunami that rocked the Fukushima-Daiichi nuclear power plant. But Japan’s imports of liquefied natural gas (LNG) and thermal coal rose to a record in August because of low utilization rates at still-functioning nukes; LNG imports climbed 18.2 percent from a year earlier to 7.55 million metric tons, while thermal coal imports increased 7.1 percent to 10 million tons.

The operating rate for nuclear power plants fell to 26.4 percent in August, the lowest since Japan’s Federation of Electric Power Companies started compiling data in April 1977. Power generation at thermal plants rose 8.2 percent, while total electricity output by utilities dropped 12.1 percent on lower temperatures and efforts to conserve energy.

Coal is an increasing part of the power solution in China and in developed Japan, and it will remain a crucial part of the global equation as well at least as far out as 2035. Closer to the ground, in March 2010 the Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) forecast growth in Australia’s exports from 274 metric tons 2009 to over 390 metric tons in 2015, driven by the increasing coal demand from the emerging economies, particularly China and India. ABARES forecast a 22 percent growth in metallurgical coal, used in steelmaking, and 42 percent growth in thermal coal, burned to produce electricity, in that period.

Based on actual numbers it looks like 390 may come earlier. But this growth in demand explains why New Hope Corp Ltd (ASX: NHC, OTC: NHPEF), which produces thermal coal exclusively and also owns a key export facility, recently put itself up for what amounts to an auction after receiving “numerous” of unsolicited inquiries about its availability for sale. A more formal process is unlikely to draw the sort of announced premium (72 percent) that China Petroleum & Chemical Corp Ltd–better known as Sinopec (NYSE: SNP)–is paying for Canada-based oil and gas producer Daylight Energy Ltd (TSX: DAY, OTC: DAYYF). And at the end of any transaction–and this is the most important point you’ll read in this space today–you want to own stock in a business that you’d own whether a takeover offer emerges or not. Our primary interest is in building wealth over the long term.

At the same time, as much as understanding Chinese economic growth helps us understand Australian investment opportunities, the New Hope experience helps us understand potential value in the Basic Materials space. It’s a prism through which to view the Basic Materials coverage universe, possibly identifying overlooked assets in the process.

New Hope and Reality

Investment by China–and India–in Australia’s coal mines and supporting infrastructure is a long-term growth driver, an effort to boost export capacity of metallurgical and thermal exports in Queensland and New South Wales. Although much has been made of the big premium Sinopec is paying for Daylight–the Canadian shale-gas play closed at CAD4.59 the Friday before the deal’s Oct. 9 announcement, which happened be the night before Canada’s Thanksgiving holiday, but opened Tuesday, Oct. 11, at CAD9.64–the stock was dirt-cheap after the late summer-early fall selloff and based on natural gas’ long term price swoon. It’s still trading at less than 2 times book value (1.73).

Daylight’s balance sheet also explains, at least in part, why it was cheap, as the company has a credit line of CAD650 million, CAD437 million of which was outstanding as of Jun. 30, 2011, maturing this month.

Sinopec was willing to pay a big price because it wants access to Daylight’s huge inventory of low-risk development locations. Sinopec has been steadily adding to its reserves in Canada, paying CAD4.65 billion last year for a stake in the Syncrude oil sands partnership. The offer for Daylight gives it access to 300,000-plus acres of land and a reserve portfolio that grew 46 percent in 2010, which is on track for comparable growth this year. The Alberta and British Columbia properties include valuable stakes in the Deep Basin (gas) and Pembina Cardium (light oil).

New Hope’s appeal is more discrete, as it produces on thermal coal. But it’s relatively small–not like the sub-CAD1 billion-Daylight pre-announcement, but still digestible at AUD5.4 billion–and it’s cheap, shooting to a 2.31 book-to-value ratio only after the public announcement of the auction. New Hope has no debt and AUD75 million in cash, which means it has access to capital to fund maintenance of existing operations as well as the development of future projects. The dividend is modest, but it hasn’t been cut since management first declared one in March 2004.

New Hope, which can afford to hold out for a suitable premium if it chooses to be acquired, is a buy under USD6.

Below are companies that fit a profile similar to New Hope’s: their operations include production of a key resource; they feature balance-sheet characteristics that might make it attractive or vulnerable, depending on the nature of the issue, i.e., a lot of cash versus too much debt; and they’re priced cheaply relative to underlying value. 

Dr. Copper

Fluctuating copper prices have predictably increased resource nationalism in many countries. The reactions by governments have ranged from de facto expropriation–as in the Democratic Republic of the Congo with First Quantum Minerals’ (TSX: FM, OTC: FQVLF) concessions–to increased royalties/taxes and higher barriers to foreign ownership.

But copper remains an indispensable element for any nation trying to grow its economy. Chinese moves to stock and destock inventories continue to rile global market. But global demand growth has risen roughly 16.4 percent per year over that time. And the International Wrought Copper Council anticipates growth of 8.4 percent for the next few years, as demand in countries such as India continues to rise.

Returning to the “this is not 2008” theme, copper prices fell by more than 50 percent during that nasty year. That’s not the case now. And China’s manufacturing Purchasing Managers Index dove sharply ahead of the global recession back then, and that’s not the case now. The PMI has weakened, and it’s hovering right around the 50 mark, which separates “growth” on the upside from “contraction” on the downside, but, again, nothing like 2008. Stabilization month over month, on the other hand, is supportive of copper prices.

Melbourne-based OZ Minerals Ltd (ASX: OZL, OTC: OZMLF, ADR: OZMLY) produces primarily copper but also gold from its Prominent Hill open-cut mine in South Australia. The company also owns development property in Cambodia. No debt and a cash pile of more than AUD1.3 billion make OZ an attractive target–as does its 1.08 price-to-book value ratio–as well as a potential acquirer.

In fact the company practiced a little of what we’re preaching, apparently expanding its ownership stake in Sandfire Resources NL (ASX: SFR, OTC: SFRRF) on the cheap last month via on-the-market share purchases of 1.8 million shares, or just under 1 percent of the total outstanding. OZ now owns 19.83 percent of Sandfire.

Sandfire is developing the AUD400 million DeGrussa copper-gold project north of Meekatharra, described by many observers as Western Australia’s best copper discovery and one of the country’s most valuable mineral finds in the past decade.

Pressure from investors to diversify its asset base may lead OZ to swallow up Sandfire, which would increase its portfolio of solid assets. It may also attract interest from a potential acquirer.

Either way, OZ Minerals is a buy under USD12.50 on the Australian Securities Exchange (ASX) using the symbol OZL or on the US over-the-counter (OTC) market using the symbol OZMLF; both represent an ordinary share.

OZ Minerals sponsors an American Depositary Receipt (ADR) that trades on the US OTC market under the symbol OZMLY; OZMLY represents 0.5 share of the ASX-listed ordinary share. OZ provides information about its (ADR) on its home website. OZ Minerals’ ADR–which for all intents and purposes is a US stock–is a buy under USD6.25.

OZ Minerals declared a final fiscal 2011 dividend of AUD0.30 per share on Aug. 16 payable Sept. 16 to shareholders of record as of Aug. 23. It will declare its interim fiscal 2012 dividend–forecast to be AUD0.40 per share–on or about Feb. 9, 2012, for payment in March.

Iron, Man

Underlying Chinese demand for iron ore is still strong, despite evidence of more cautious behavior from some buyers. That’s according to a spokesman for global steel producer ArcelorMittal (NYSE: MT). ArcelorMittal expects activity to restart in the fourth quarter.

And Australia-based global materials giant RioTinto foresees no significant change in China’s demand for iron ore, despite investor concerns about slowing steel demand in the country and weak developed economies.

Index-based spot iron ore prices are probing six-month lows after dropping about 5 percent in September, on these fears of slowing Chinese steel demand and uncertainty about the fate of the global economy. China is the world’s biggest buyer of iron ore — a key steelmaking material. There was a longer period of stockholding in China’s mills this past summer than the last couple of summers, as producers took a wait-and see approach. But iron ore producers are still seeing “very strong” underlying demand.

Grange Resources Ltd (ASX: GRR, OTC: GRRLF), which will join AE How They Rate coverage under Basic Materials as of the November issue, owns and operates Australia’s largest integrated iron ore mining and pellet production business. Its Savage River magnetite iron ore mine is a long-life mining asset set to continue operation to 2023 with current reserves estimated to extend the mine life to 2028.

Grange ships its pellets to major steel producers in Australia and Asia under long term supply contracts. The company is developing a world-class magnetite project at Southdown near Albany in Western Australia. The Southdown development project is forecast to supply nearly three times the amount of ore iron from Savage River. Plans are to ship this concentrate to a dedicated pelletising facility to be built at a suitable location.

The company reported gross profit from mining operations of AUD92.5 million for the six months ended Jun. 30, 2011, a 45 percent year-over-year increase.  Revenues from mining operations of AUD209 million were 8 percent higher and the company achieved an operating margin of AUD95.2 per tonne of iron ore pellets. Management reported a strong cash and trade receivables position of AUD183.7 million and no net debt as of Jun. 30, 2011. Half-year production was 840,018 tonnes of iron ore pellets, and the company  is on track to achieve 2 million tonnes of pellet production in 2011.

Grange, the only commercial producer of magnetite pellets in Australia that combines both mining and pellet production expertise, recently declared its first dividend–AUD0.02 per share payable Oct. 13 to shareholders of record Sept. 27. The stock is trading for 1.07 times book value, and its net cash position and nonexistent debt make it a decent target. Its assets and their ability to sustain and grow a dividend make Grange Resources a buy under USD0.55 on the Australian Stock Exchange (ASX) or using the symbol GRLLF on the US over-the-counter (OTC) market.

Drill, Baby, Drill

Specialist driller Ausdrill Ltd (ASX: ASL, Germany: FWG) is not currently trading with an active US over-the-counter (OTC) symbol. If your broker allows direct access to Australia–or Germany, where it trades under the symbol FWG–it’s worth a speculative look.

Fiscal 2011 results met analyst expectations and exceeded guidance, as revenue surged 32 percent to AUD835 million, EBITDA was up 30 percent to AUD195.4 million and net profit after tax (NPAT) grew 52 percent to AUD73.3 million.

Increased working capital requirements led to an operating cash flow decline to AUD117 million from AUD123 million in fiscal 2010. After capital expenditures of AUD179 million a AUD132 million equity issue, net debt as a percentage of equity at fiscal year’s end was 13 percent.

Contract wins and extensions during the year leave a backlog for contract mining services operations at AUD1.8 billion, up from AUD1.2 billion in July 2010. In fiscal 2012 management expects continued growth and is targeting AUD1 billion in revenue at similar margins.

Trading at just 1.36 times book value, Ausdrill is a buy under USD3.20.