Contributing editor Tom Slee is with us this week. After scoring a big profit for IWB readers with Inmet Mining, he has been keeping a close watch on metals markets looking for more opportunities. Here he is to tell us about why he thinks copper is the place to invest and to offer two new stock suggestions. Tom Slee writes:
These are extraordinary times in the once lacklustre copper market. The red metal traded as high as $4.60 a pound earlier this year, rocketing up from a low of $2.85 last June (figures in U.S. currency). Like all the metals, it dropped last week, finishing in New York on Friday at $3.96 (May contract). But that's still 39% higher than last June and I think it's a temporary retreat. The fundamentals are in copper's favour and it is the metal of choice in more ways than one.
Copper theft has become a $1 billion problem in North America. It's more profitable than robbing banks, so much so that people equipped with wire cutters have been arrested climbing hydro poles. Little League baseball stadiums are dark because thieves keep stealing the light fixtures. As a matter of fact, the FBI now regards copper theft as a national threat in the U.S.
For many of the producers, the soaring demand is creating problems as well as prosperity. Rising copper prices are obviously a big plus but ramping up production is difficult. It's not like running a factory where you turn on a switch and add capacity. This is an inefficient industry, now operating at about 79% of estimated capacity. Bringing new or previously abandoned mines on stream is proving expensive and time-consuming. Skilled technicians are reluctant to rejoin a traditionally boom and bust business. Above all, there are the political uncertainties. A lot of our energy and metal producers have their operations in the world's trouble spots. That makes financing difficult. Bankers, needless to say, are looking for geopolitical calm as well as earnings potential.
What does it all mean for Canadian investors? Well, I think that we should seize the moment. Take full advantage of the pull-back in the copper market and add to your positions in these stocks. The fundamentals are very encouraging. Discount all the reports about production glitches. Well-managed companies always manage to solve problems on the supply side. One caveat: if for any reason demand falls away the entire sector could sell off quickly and last week's price drop was a reflection of such fears. These are volatile stocks without much downside protection.
What is the risk? Some analysts believe that we have a price bubble largely created by traders and speculators. They think $4.30 a pound copper, where we were during much of April, is unsustainable. They also believe that Chinese consumption is going to slow. Perhaps they're right. My feeling, however, is that the risk is acceptable, especially now that we have seen a pull-back. Sure, there are speculators in the metals markets but the real supply and demand figures look good. Keep in mind too that naysayers have been underestimating China's economic growth potential for 10 years now. The fundamentals point to fluctuating copper prices trending higher over the next year or so.
Nevertheless, you can understand the skepticism. Copper prices took off and that sort of rapid rise always concerns people, which is why so many were quick to sell last week. But there is no evidence of a bubble. What we have is a sort of two-tier history of copper prices. During the period from 1998 to 2003, copper traded within a narrow range at an unexciting average price of $0.83 a pound. It was a dismal industry. Many mining companies collapsed. Then, in 2003, we saw the first impact of new Indian and Chinese demand and copper soared to about $3.50. It dipped during the worldwide recession but a new base line had been formed. At the same time, copper prices became more volatile.
Given that background, $4 is hardly a bubble. Much more important is the fact that demand is outstripping supply. According to Wood Mackenzie, a respected international metals consulting firm in Scotland, there is going to be a 570,000 ton shortfall this year. The massive Rio Tinto Group expects copper shortages until 2015, mainly because China's current five-year expansion plan calls for a 7% annual growth rate. China, which now accounts for at least 33% of global demand (some estimates put the figure higher), will build 36 million affordable homes during the period (a typical house unit requires about 440 pounds of copper). Chinese car sales are expected to exceed 20 million vehicles in 2011 and keep growing. There are approximately 50 pounds of copper in a modern motor vehicle.
On the other side of the equation, Chile, currently supplying almost 36% of the world's copper production, is unable to keep pace. Lower grades, transportation constraints, and rising costs are taking their toll. The country's February output was down 6.6% year-over-year. BHP Billiton has indicated that output at its giant Escondida mine in northern Chile is declining at a rate of 5% to 10% per annum. Elsewhere, major new mines in Australia are years away from production. It all adds up to shortages.
Another reason why I am bullish on copper is the scrap metal situation. As a rule, high copper prices are eventually undermined by an influx of recycled metals. This time around, though, the junkyards are bare. The Asian economic expansion is essentially "Greenfield". It's breaking new ground so there is relatively little demolition and small amounts of resulting scrap. Moreover, India and China have been siphoning off used North American metal for years. So severe are the shortages that junk dealers have been competing for access to old municipal dumps.
I also think that we should not lose sight of the U.S. housing industry. Right now it's a horror show but there are a few first signs of life. Any pick-up in starts would sharply increase the demand for copper. It would also attract the speculators and drive prices higher.
On balance, therefore, I think that copper prices will resume their trend higher although there are bound to be almost daily adjustments. There is no consensus amongst the many forecasters but Goldman Sachs' projection of $5 a pound over the next 18 months seems reasonable.
How do we participate? Well, I still like Quadra FNX Mining (TSX: QUX, OTC: QADMF) which is trading at $13.75 and is on our Buy List with a target of $20. My update follows. Before we get to that, here are two new picks.
HudBay Minerals (TSX, NYSE: HBM)
HudBay Minerals is a company with upside potential. This fully integrated metals producer gained a new lease on life when CEO David Garafalo took the helm late last year and the company has a lot going for it. It has a solid balance sheet, a strong experienced technical team, and its mines are located in Canada, the United States, and relatively trouble-free Guatemala. Expansion plans include a C$43 million exploration program in 2011 and on-going arrangements to seed small companies that own promising properties. The company is well diversified and expects to produce 70 to 90 kt of zinc, about 50 kt of copper, and between 95 and 120 koz of gold in 2011. (Note: kt is the abbreviation for 1,000 tons while koz is 1,000 ounces.)
In short, HudBay is a relatively defensive play that provides exposure to the most exciting metals: gold and copper. My only reservation is that zinc prices are likely to move sideways for a while. According to the Royal Bank forecasters, global production is outstripping demand as a result of rising mine capacity. As a result, the zinc market is going to be in a balanced to surplus position until 2013. As a matter of fact, zinc was recently trading at $1.08 an ounce, above the long-term forecasted price of $0.95. That means HBM's expected cash flow of C$1.60 a share in 2011 could slip to about C$1.40 next year. On the plus side, the gold production appears to be undervalued.
Action now: HudBay Minerals is a Buy at C$14.92, US$15.45 with a target of C$21, US$22. I will revisit the stock if it dips to $13.
Southern Copper (NYSE: SCCO)
For those who would prefer a pure copper play, Southern Copper is your stock. This company has the largest corporate copper reserves in the world. Founded in 1952 as the Southern Peru Copper Corporation, SCCO was renamed Southern Copper in 2005 and now has operations in Mexico and Chile as well as Peru. More than 80% owned by Arizona-based Grupo Mexico, the company produces around one billion pounds of copper annually and owns approximately 70 billion pounds of copper and molybdenum reserves. The relatively minor output of silver and zinc is essentially a by-product of the copper mining.
This is a major international company with a market capitalization of $36 billion (all dollar amounts are in U.S. currency) and an investment grade rating from Standard & Poor's and Moody's. All of its mines and smelters are located in stable jurisdictions although there has been some violence recently at SCCO's Tia Maria deposit in Peru. Residents there fear that this major project will contaminate local water supplies. With an election due on June 5 and the politicians posturing, analysts were not surprised when the Peruvian government rejected Southern's environmental plans and closed operations pending further study. It should be pointed out, though, that the actual loss is limited because most of SCCO's equipment was offsite and the setback is now built into SCCO's stock price.
SCCO should generate cash flow of about $3.50 a share this year with an increase to $3.80 or more in 2012. There is talk of a merger with Asarco, another Grupo Mexico subsidiary, and this would create significant synergies. Another plus is that investors are not totally exposed to copper prices. Southern has now hedged 59% of 2011 production through swap contracts.
I think that SCCO provides a good opportunity to participate in the copper market for investors who can assume some risk.
Action now: Southern Copper is a Buy at $35.49 with a target of $50. I will revisit the stock if it dips to $32.
These are extraordinary times in the once lacklustre copper market. The red metal traded as high as $4.60 a pound earlier this year, rocketing up from a low of $2.85 last June (figures in U.S. currency). Like all the metals, it dropped last week, finishing in New York on Friday at $3.96 (May contract). But that's still 39% higher than last June and I think it's a temporary retreat. The fundamentals are in copper's favour and it is the metal of choice in more ways than one.
Copper theft has become a $1 billion problem in North America. It's more profitable than robbing banks, so much so that people equipped with wire cutters have been arrested climbing hydro poles. Little League baseball stadiums are dark because thieves keep stealing the light fixtures. As a matter of fact, the FBI now regards copper theft as a national threat in the U.S.
For many of the producers, the soaring demand is creating problems as well as prosperity. Rising copper prices are obviously a big plus but ramping up production is difficult. It's not like running a factory where you turn on a switch and add capacity. This is an inefficient industry, now operating at about 79% of estimated capacity. Bringing new or previously abandoned mines on stream is proving expensive and time-consuming. Skilled technicians are reluctant to rejoin a traditionally boom and bust business. Above all, there are the political uncertainties. A lot of our energy and metal producers have their operations in the world's trouble spots. That makes financing difficult. Bankers, needless to say, are looking for geopolitical calm as well as earnings potential.
What does it all mean for Canadian investors? Well, I think that we should seize the moment. Take full advantage of the pull-back in the copper market and add to your positions in these stocks. The fundamentals are very encouraging. Discount all the reports about production glitches. Well-managed companies always manage to solve problems on the supply side. One caveat: if for any reason demand falls away the entire sector could sell off quickly and last week's price drop was a reflection of such fears. These are volatile stocks without much downside protection.
What is the risk? Some analysts believe that we have a price bubble largely created by traders and speculators. They think $4.30 a pound copper, where we were during much of April, is unsustainable. They also believe that Chinese consumption is going to slow. Perhaps they're right. My feeling, however, is that the risk is acceptable, especially now that we have seen a pull-back. Sure, there are speculators in the metals markets but the real supply and demand figures look good. Keep in mind too that naysayers have been underestimating China's economic growth potential for 10 years now. The fundamentals point to fluctuating copper prices trending higher over the next year or so.
Nevertheless, you can understand the skepticism. Copper prices took off and that sort of rapid rise always concerns people, which is why so many were quick to sell last week. But there is no evidence of a bubble. What we have is a sort of two-tier history of copper prices. During the period from 1998 to 2003, copper traded within a narrow range at an unexciting average price of $0.83 a pound. It was a dismal industry. Many mining companies collapsed. Then, in 2003, we saw the first impact of new Indian and Chinese demand and copper soared to about $3.50. It dipped during the worldwide recession but a new base line had been formed. At the same time, copper prices became more volatile.
Given that background, $4 is hardly a bubble. Much more important is the fact that demand is outstripping supply. According to Wood Mackenzie, a respected international metals consulting firm in Scotland, there is going to be a 570,000 ton shortfall this year. The massive Rio Tinto Group expects copper shortages until 2015, mainly because China's current five-year expansion plan calls for a 7% annual growth rate. China, which now accounts for at least 33% of global demand (some estimates put the figure higher), will build 36 million affordable homes during the period (a typical house unit requires about 440 pounds of copper). Chinese car sales are expected to exceed 20 million vehicles in 2011 and keep growing. There are approximately 50 pounds of copper in a modern motor vehicle.
On the other side of the equation, Chile, currently supplying almost 36% of the world's copper production, is unable to keep pace. Lower grades, transportation constraints, and rising costs are taking their toll. The country's February output was down 6.6% year-over-year. BHP Billiton has indicated that output at its giant Escondida mine in northern Chile is declining at a rate of 5% to 10% per annum. Elsewhere, major new mines in Australia are years away from production. It all adds up to shortages.
Another reason why I am bullish on copper is the scrap metal situation. As a rule, high copper prices are eventually undermined by an influx of recycled metals. This time around, though, the junkyards are bare. The Asian economic expansion is essentially "Greenfield". It's breaking new ground so there is relatively little demolition and small amounts of resulting scrap. Moreover, India and China have been siphoning off used North American metal for years. So severe are the shortages that junk dealers have been competing for access to old municipal dumps.
I also think that we should not lose sight of the U.S. housing industry. Right now it's a horror show but there are a few first signs of life. Any pick-up in starts would sharply increase the demand for copper. It would also attract the speculators and drive prices higher.
On balance, therefore, I think that copper prices will resume their trend higher although there are bound to be almost daily adjustments. There is no consensus amongst the many forecasters but Goldman Sachs' projection of $5 a pound over the next 18 months seems reasonable.
How do we participate? Well, I still like Quadra FNX Mining (TSX: QUX, OTC: QADMF) which is trading at $13.75 and is on our Buy List with a target of $20. My update follows. Before we get to that, here are two new picks.
HudBay Minerals (TSX, NYSE: HBM)
HudBay Minerals is a company with upside potential. This fully integrated metals producer gained a new lease on life when CEO David Garafalo took the helm late last year and the company has a lot going for it. It has a solid balance sheet, a strong experienced technical team, and its mines are located in Canada, the United States, and relatively trouble-free Guatemala. Expansion plans include a C$43 million exploration program in 2011 and on-going arrangements to seed small companies that own promising properties. The company is well diversified and expects to produce 70 to 90 kt of zinc, about 50 kt of copper, and between 95 and 120 koz of gold in 2011. (Note: kt is the abbreviation for 1,000 tons while koz is 1,000 ounces.)
In short, HudBay is a relatively defensive play that provides exposure to the most exciting metals: gold and copper. My only reservation is that zinc prices are likely to move sideways for a while. According to the Royal Bank forecasters, global production is outstripping demand as a result of rising mine capacity. As a result, the zinc market is going to be in a balanced to surplus position until 2013. As a matter of fact, zinc was recently trading at $1.08 an ounce, above the long-term forecasted price of $0.95. That means HBM's expected cash flow of C$1.60 a share in 2011 could slip to about C$1.40 next year. On the plus side, the gold production appears to be undervalued.
Action now: HudBay Minerals is a Buy at C$14.92, US$15.45 with a target of C$21, US$22. I will revisit the stock if it dips to $13.
Southern Copper (NYSE: SCCO)
For those who would prefer a pure copper play, Southern Copper is your stock. This company has the largest corporate copper reserves in the world. Founded in 1952 as the Southern Peru Copper Corporation, SCCO was renamed Southern Copper in 2005 and now has operations in Mexico and Chile as well as Peru. More than 80% owned by Arizona-based Grupo Mexico, the company produces around one billion pounds of copper annually and owns approximately 70 billion pounds of copper and molybdenum reserves. The relatively minor output of silver and zinc is essentially a by-product of the copper mining.
This is a major international company with a market capitalization of $36 billion (all dollar amounts are in U.S. currency) and an investment grade rating from Standard & Poor's and Moody's. All of its mines and smelters are located in stable jurisdictions although there has been some violence recently at SCCO's Tia Maria deposit in Peru. Residents there fear that this major project will contaminate local water supplies. With an election due on June 5 and the politicians posturing, analysts were not surprised when the Peruvian government rejected Southern's environmental plans and closed operations pending further study. It should be pointed out, though, that the actual loss is limited because most of SCCO's equipment was offsite and the setback is now built into SCCO's stock price.
SCCO should generate cash flow of about $3.50 a share this year with an increase to $3.80 or more in 2012. There is talk of a merger with Asarco, another Grupo Mexico subsidiary, and this would create significant synergies. Another plus is that investors are not totally exposed to copper prices. Southern has now hedged 59% of 2011 production through swap contracts.
I think that SCCO provides a good opportunity to participate in the copper market for investors who can assume some risk.
Action now: Southern Copper is a Buy at $35.49 with a target of $50. I will revisit the stock if it dips to $32.
