Three months ago, the World Bank said that it expected plummeting commodity prices to continue with the losing streak through the end of year. This came in the wake of weaker-than-expected global economic growth estimates in the emerging markets and major economies. China’s economic growth in particular is expected to average about 6.9% in 2015, the slowest recorded pace over the past two decades.
China’s annual GDP growth history (Source: World Bank)
Decelerating economic activity in China coupled with declining demand for imports has certainly brought a lot of speculation to the commodities market and has contributed greatly to driving prices close to historic lows. Since we are already well into the last half of 2015, it clearly seems that the situation will need more time to improve.
Luckily, even with the slowdown, China’s consumption of metals and energy has increased, making it the biggest iron ore consumer and the second-largest energy consumer. As such, it would definitely make sense if investors looked to China in order to figure out the direction of commodity prices.
Going forward, The World Bank has pointed out that most metal prices will continue to decline marginally considering that most are already in surplus. As a matter of fact, its most recent projections expect metal prices to average 16% lower than 2014 levels by the end of the year. This turn of events could essentially spell the end of a couple of mining and exploration firms considering the fact that iron ore prices are already at one-third of peak prices witnessed in 2011.
(Source: Bloomberg)
While some may believe that now is the time to stay away from commodities with the exception of oil, I believe that investors with a much longer-term view for their investment can benefit immensely from commodity stocks with exposure to exploration and mining of metals.
The outlook on metals is brightening
The effects of China’s slowdown have already played out, and it’s now time to consider taking a position in various commodities. Why? Because the bearish sentiments that have been echoed throughout the media have resulted in some of the biggest diversified miners such as BHP Billiton (NYSE:BBL) and Rio Tinto (NYSE:RIO) trading at hugely undervalued prices.
(Source: Yahoo! Finance)
Although, it would make sense if you got a bit skeptical based on the fact that the SPDR S&P Metals and Mining ETF (XME) fund has shed 40.5% this year, investors need to realize that a recovery is already in progress. Over the past month, the XME has risen by 2%; although this upside may seem miniscule to some, this is an extremely positive sign.
BHP Billiton and Rio Tinto, for their parts, have shown their unshakeable confidence in the future outlook of metals, if their recent sentiments are anything to go by. Rio Tinto, the world’s second-largest iron ore producer, reported 12% annual rise in third-quarter iron ore shipments proving that there is still demand unlike what the World Bank report previously suggested.
In fact, the Anglo-Australian miner revealed that its last quarter production of 86.1 million tons was outstripped by demand as it shipped 91.3 million tons during the period. Kieron Hodgson, commodity and mining analyst at Panmure Gordon, also believes that commodities are set for a turnaround as he told CNBC: "The Chinese demand picture has actually improved over the quarter, where they sold more iron ore raw product then they actually produced, which is actually quite a positive indicator.”
Both BHP Billiton and Vale (NYSE:VALE) have also ramped up production of iron ore with the latter reporting a record production of 88.2 million tons, a 2.9% uptick compared to a year ago. On the other hand, some may argue that exposure to copper puts these three companies in a tricky spot as China once again comes into play.
Let’s consider this. Copper makes up about 13% and 20.5% of Rio Tinto and BHP Billiton top line, but the weak outlook, based on oversupply concerns, has weakened the case for the two firms in the eyes of investors. This won’t be the case for long as prices are set to recover in the near term, especially with other large-scale producers such as Glencore, which doubles as a trading firm, announcing plans to scale back on copper production.
What’s more is that, according to Rio Tinto’s third quarter earnings release, production in two of its mines, Kennecott in Utah and Escondida, has declined by 64% and 25%. More large-scale miners are also set to follow suit in terms of scaling back on copper production which points to a bright future for copper as the supply pressure will start to ease.
It has become apparent that the general outlook on copper prices was widely misread in an earlier International Copper Study Group forecast that estimated a production surplus of 360,000 metric tons. The ICSG now believes that the copper market is balanced for the rest of the year which, when coupled with the fact that larger producers aren’t too keen on increasing their output, has created a great opportunity for other discerning miners.
Plenty of ways to weather low prices
Overall the junior producers in the metals sector have been under the ultimate stress test. The downward pressure on metal prices such as iron as mentioned earlier has made it increasingly difficult for such producers to remain competitive. Consequently both the mega producers and smaller producers have had to tweak their business structures in order to weather the commodity price storm.
For example, CD International Enterprises (CDII), whose extensive holdings of core commodities include copper, iron and gold, has been rapidly expanding into business consulting. By leveraging its unique distribution network and expertise in China, CD International has been able to survive the commodity price shakeup rather well with its offerings of a host of consulting services to companies doing business in the region.
To other firms such as Glencore, adapting to the volatile commodity prices has meant implementing a three-point strategy. The strategy basically boils down to suspending dividends, issuing new shares and the sale of assets to trim down debt as it seeks to drive down its operating costs. In contrast, shares of Freeport-McMoRan (NYSE:FCX) have gained 12% so far in the current month on news of seeking out possible alternatives to its oil and gas business and slimming down the number of its board members from 16 to just nine.
(Source: Morningstar.com)
Interestingly enough, though, all these firms share one thing in common – which is the unprecedented need to keep driving their operating costs lower if they are to provide investors with any sort of value in the long term. CD International has been successful in doing so mainly because of its strategic partnerships that expose it to only the distribution part of the commodities operations highlighting that there is more than one way of tapping into the commodities market with a margin of safety.
In essence, its small size gives it the advantage of having complete control on the range commodities it takes up a stake in giving it significant room to maneuver price headwinds. For more established heavyweights such as Freeport-McMoRan which deals with the whole value chain, this is of course out of the question. But I believe the overestimation of the fall in commodity prices has been reflected in the company’s share price albeit unnecessarily.
At current levels of $12, the price paints the picture of a true bargain considering that, once Freeport-McMoRan spins off it oil and gas business, it will significantly increase cash flows and shareholder value along with it. Rio Tinto, whose business is centered on the production of iron ore, also looks attractive when all is said and done. Even with a weaker guidance with regards to its top line over the next couple of quarters, its balance sheet remains strong with adequate cash flow to sustain dividends and capital expenditures making it a pretty safe bet for the long term.
Knowing that this isn’t the first time that BHP Billiton has hit the low $30s range in the past decade should give investors a sense of relief. After all, the market has been wrong about its prospects before and it has always managed to prove the pundits wrong.
Conclusion
Weakening commodity prices have produced two results that most investors will have likely overlooked. First, early stage mining companies caught off guard with the free-falling prices have led to a number of them closing up shop, forcing them to make the shift to other businesses. Second, the more established players have had to significantly bring down their operational costs while still experiencing the fallout from investor selloff.
In my opinion, investors remain with leaner and meaner firms to choose from with the downside risk severely limited. This ultimately means that commodity firms that ultimately manage to survive until probably the last half of 2016 will have a greater chance of rewarding shareholders massively. Most of these mining companies are undervalued in relation to their book values and present investors with unique entry points backed by the fact that, if worse comes to worst, commodity prices have reached their all-time lows, and it will be hard for them to fall lower.
