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The global economic crisis. Political unrest in the Middle East. Tightening monetary policy in China. The floods and cyclone here in Australia, and the tsunami, earthquake, and nuclear disaster in Japan.  Not surprisingly, none of these have been good for the Australian economy and sharemarket – yet analysts remain bullish on the lucky country’s economic outlook in the medium- and long-term. Again, not surprisingly, this attitude is driven by the continued, if somewhat subdued, resources boom.

Tom Stevenson, investment director at Fidelity, noted that “growing concern about the strength of global demand recently prompted big falls in the price of many commodities.”

Treasurer Wayne Swan said in a recent report, “These near-term challenges are only part of the story. The outlook for our economy over the years ahead is much more positive, and this brings a different set of challenges.” Swan added that the “unprecedented” pipeline of mining and energy projects being undertaken in Australia now is expected to boost prices and wages, he said.

Swan predicted that first-quarter figures would show the impact of the natural disasters, however. This week, the Australian Bureau of Agricultural & Resource Economics and Sciences (ABARE) released April figures showing that planned investment in Australia’s resources sector has soared to a record $173.5 billion – up 31% from October 2010. Queensland accounts for 28 percent of the projects, largely in LNG, coal, and associated infrastructure.  “The investment boom not only is becoming larger, it is becoming more skewed in favour of the miners,” said Stephen Walters, chief economist at JPMorgan.

Although much of the capital expenditure in resources will be in projects of the mining giants, such as BHP Billiton, Rio Tinto and Fortescue Metals, smaller companies are getting their share of the pie as well. Several asset management companies have created funds that focus on small and mid-sized domestic companies in the resources and commodities space.

LimeStreet Capital

LimeStreet Capital’s Australian Resources Hi-Alpha Fund, launched in June 2008, has been a top performer – although managing director Stephen Bartrop acknowledged in a recent letter to investors that “the Fund slipped from first to second place in 1,341 funds surveyed by Morningstar on a 12 month return basis.” LimeStreet, which invests in Australian resources and related sectors but excludes BHP Billiton and Rio Tinto, was overweight in copper companies including Equinox (prior to the Minmetals bid), PanAust (PNA) and Discovery, coal companies including Whitehaven, and gold companies including Perseus mining. They were also substantially exposed to uranium in Peninsula Minerals and Uranium SA, leading to a significant dip in Fund performance following the Japan disaster, Bartrop said.

“Copper is our preferred base metal exposure in 2011, driven primarily by Chinese demand as well as ETF demand becoming an increasingly important demand source and mine supply constraint.” Merrill Lynch analyst Stephen Gorenstein said of Laos-focused copper-gold miner PanAust.

“Our preferred pick of the sector is PNA, as it is the most leveraged to copper, has limited Australian dollar exposure and also the most growth potential.”

Although Whitehaven recently announced that no suitor had been found during a formal bid process, analysts remained positive on the NSW coal miner.

Citi analyst Craig Sainsbury says Whitehaven has coal-volume growth, a quality large scale asset in Narrabri and potential projects like Bluevale.

“Now that the bid situation surrounding the stock has eased, we can take a look again at Whitehaven and assess the company on a standalone basis,” Sainsbury said. “Given the retracement in the shares, we see value starting to emerge in Whitehaven and believe that the stock is a solid fundamental investment at these levels.”

And junior miner Discovery has reported that its copper operations in Botswana look promising. Australian brokerage house RBS Morgans preports that Discovery is “a strong fundamental story, going enrecognised in a buoyant copper price environment.” And London’s Westhouse Securites reported that “Discovery has plenty of exploration upside with only 5% of the 1 300 km of its Kalahari copper belt licence having been explored.”

Patersons

Even more recently, in August 2010, Patersons Asset Management started an Australian Resources Opportunities Fund. Again, BHP and Rio Tinto are nowhere to be found in their portfolio – but the Fund is heavily invested in Santos (STO), Macarthur Coal (MCC), and Newcrest Mining (NCM). They’ve also taken or increased positions in Golden Rim (GMR), Metals X (MLX), and Platinum Australia (PLA), and exited their Equinox (EQN) holdings.

In their April report, Patersons noted:

•    Gold stocks Golden Rim and Newcrest Mining had a strong month in April, up 5.4% and 4.1% respectively as gold ended the month at US $1,563, 33% higher than one year ago.
•    MLX, Australia’s largest tin producer, provides an exposure to the tin sector which is expected to experience constrained supply over the next couple of years. Demand is also expected to increase further, particularly as global sentiment shifts toward tin-based solder rather than lead based.

Analysts say that PLA has produced a positive prefeasibility study for its Rooderand project, but the company’s immediate future will be determined by what happens at its operating Smokey Hills mine. PLA’s share price dropped more than 50% this year, due to the nonperformance of Smokey Hills.

RBC Capital Markets analyst Leon Esterhuizen said, “Smokey Hills has to deliver to the order of A$20m or more per quarter to cover the cash consumption and create enough to cover the shortfall against liabilities.”

Esterhuizen noted that Smokey Hills is predicting significantly better performance and the debt could be re-financed.

“A failure to deliver positive cash flow from Smokey Hills could lead to a further dramatic sell-off in the shares,” Esterhuizen said. “Against this, though, we believe a positive result will have an equally strong positive impact on the share price as the market gets confirmation that the company will not need to raise more working capital and that Smokey Hills can and will work.”

Meanwhile, energy producer Santos is embarking on a $120 million drilling program in the Moomba gas plant, and has reported an oil discovery at Finucane South of the north-west coast of Australia. Production could begin by the end of 2013, the company said.

Goldman Sachs

While the Goldman Sachs Resources Fund is not open to new investment – and does invest in BHP and Rio Tinto – it’s probably still a good idea to keep an eye on the investment strategies of one of the world’s largest asset management companies. The GSRF is overweight in Bathurst Resources (BTU), Iluka (ILU), Alumina Ltd (AWC) and Santos (STO). They recently purchased shares in Medusa Mining (MML), Fortescue Metals (FMG) and Sims Metal Management (SGM), while reducing their positions in OzMinerals (OZL), Lynas (LYC) and Mount Gibson Iron (MGX).

In a recent investor commentary, the Goldman Sachs Fund Services Team explained some of its buy/sell decisions:

•    MML offers low-cost gold production and a significant opportunity to expand its resource inventory through near-mine exploration.
•    We increased our position in FMG due to the exposure to current high iron ore prices, which are generating very strong cash flows. We also believe the company has stgeloped a strong infrastructure position in the Pilbara.
•    SGM maintains a very conservative balance sheet and benefits from geographic diversification, and as such is now our preferred steel exposure.
•    OZL returned in excess of 45% over the course of 2010; given this premium to valuation and what we perceive to be some short-term risks around the copper price, we believe our investment thesis has largely played out.
•    LYC was sold out of the portfolio after a period of strong performance driven by the significant rise in the price of rare earth elements.
•    We elected to exit MGX due to a lack of progress in resolving its corporate governance issues.

Thus, its view is that the Australian resources market remains strong and diversified. Asset managers are moving out of energy into materials, perhaps waiting for some more stability in the Middle East, but even given such volatility, resources has remained a solid investment proposition. As Treasurer Swan says, we shouldn’t expect the “rivers of gold” to continue flowing from the commodities boom; however, stronger commodity prices in recent trading have given grounds for cautious optimism.

As Stevenson explained, “There are plenty of good fundamental reasons why commodities should have paused for breath. Higher input prices are self-correcting to a degree so it should be expected that the rise in energy, metals and foodstuffs in recent months would be reflected in falling US gasoline sales, lower than expected GDP in the first quarter on both sides of the Atlantic, worse than feared jobless figures and higher oil inventories.”

“Despite the recent gyrations,” Stevenson said, “the structural case for commodities remains strong. China’s share of world energy consumption is expected to rise from 10% a decade ago to 25% in 10 years time. We are in the middle of a fundamental shift in the balance between the supply of and demand for commodities which overshadows the more cyclical factors at play.”

>>Back to the newsletter to view other articles – June 5th 2011

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