Australia is blessed with an abundant supply of natural resources and as such has been dubbed “the lucky country” by many economists and investors alike.  The mining boom of the first decade of the 21st century has yielded handsome rewards for scores of Australian investors.

As we enter the second year of the current decade, there are some who fear our luck may be running out.  Commodity prices experienced steep declines in 2011; most notably in the crown jewel of Australian resources – iron ore.  While many investors who fear the worst have moved to the sidelines, those who remain and those willing to get back in the game wonder whether the current slowdown is merely a temporary blip on the radar or a sign of worse things to come.

On the one side of the argument you have analysts from Moody’s Investors Service and Goldman Sachs predicting continuing downturn, with Goldman Sachs going so far in a recent report as to suggest the price of iron ore will be cut in half from its highs in a mere five years.  Moody’s is not quite as pessimistic but both see overabundance of supply as a driving force.  Moody’s also points out that increased automobile consumption in China has led to an oversupply of scrap metal.  As demand ramped up, producers put substantial capacity expansion plans in place.  Recent economic news out of China suggests demand may be slowing.  It does not take a PhD in Economics to predict that increased supply in the face of decreased demand will cause prices to drop.  The question on everyone’s mind is how much might demand actually drop and how soon?

In a bold and daring display of confidence, Fortescue Metals is going ahead with plans to triple its production of iron ore by the middle of 2013.  Their confidence is shared by investors as their recent $2 Billion dollar bond sale to fund the project was oversubscribed.

It has generally been an accepted maxim of commodities investing that to get outsized returns, pure plays are a better choice than diversified producers.  And amongst the pure plays investors need to look for the lowest cost producers.  Low production costs mean a miner is more likely to survive price drops.  Typically the lowest cost producers are the companies that control all aspects of the production process from excavation to processing to distribution.

If you are at all concerned about commodities slowdowns, the above maxim is reversed and diversified miners offer more protection against the risk of substantial price declines in a single commodity.  The following table represents the Top Ten mining stocks by market cap on the ASX, categorised in the Materials Sector.  Let’s have a look.

Company/Code MKT Cap Share Price 52 Wk Hi 52 Wk Lo P/E Dividend Yield
BHP Billiton/BHP $112,987M $35.18 $49,81 $33.68 9.31 3%
Rio TInto/RIO $28,294M $64.93 $88.85 $58.52 8.14 2.4%
Newcrest Mining/NCM $23,155M $30.97 $42.92 $29.51 17.92 1.1%
Fortescue Metals/FMG $18,621M $5.98 $6.84 $3.95 10.75 1.3%
Iluka Resources/ILU $7,022M $16.77 $19.46 $9,5 11.2 5.8%
Sims Metal Management/SGM $3,220M $15.64 $18.54 $11.54 18.23 2.9%
Oz Minerals/OZL $3,151M $10.06 $17.05 $8.7 9.83 5.0%
Alumina/AWC $2,989M $1.22 $2.72 $1.08 27.31 4.0%
Atlas Iron/AGO $2,711M $3.03 $4.34 $2.58 14.22 1.0%
Lynas/LYC $2,100M $1.22 $2.70 $.86

 

BHP Billiton (BHP)

Of the ten, no company is more diversified than BHP.  They are geographically diversified across more than 25 countries with products ranging from iron ore, to aluminum, to copper, to uranium, to silver, to diamonds, to coal, and to oil and gas.  In 2011 they entered the shale gas market in the United States.  The P/E for the ASX Materials Sector is 11.88 so at these levels BHP looks cheap.  Here is a ten year share price performance chart for BHP, compared to the ASX Materials Sector.

Rio Tinto (RIO)

Although many investors know RIO along with BHP and VALE in Brazil are the world’s three largest mining companies, did you know RIO accounts for 30% of the world’s supply of natural diamonds?  The company mines iron ore, copper, aluminum, and titanium with operations in Africa, Australia, Europe, the Pacific Rim, North America, and South America.  With a P/E of only 8.14, RIO should be attractive to any value investor.  Here is how RIO investors have fared over the last ten years:

Newcrest Mining (NCM)

Newcrest is a gold and copper miner with operations in Australia, Papua New Guinea, Indonesia, and West Africa.  Although copper is subject to falling prices in tough economic times, gold moves in the opposite direction and the increases in the price of gold during these times of economic turmoil bear this out.  Not all gold miners benefit equally however, and NCM is a case in point.  The company was recently downgraded to NEUTRAL by both JP Morgan and UBS due to operational problems in one of their mines.  However, if you believe the world is in for even tougher times and gold will the place to be, NCM is worth a look.  Here is how the share price has performed over the last ten years:

Fortescue Metals (FMG)

Fortescue is strictly a pure play iron ore producer, the largest in Australia.  However, they do not qualify in any way as a low cost producer, lagging far behind BHP and RIO.  They have substantial expansion plans and management claims to be committed to becoming a low cost producer.  Despite their cost issues and despite concerns over commodity price drops, February and March 2012 Broker Recommendation Reports have all seven of Australia’s major investment advisory firms placing a BUY rating on FMG.  Brokers can be wrong, and if there is a major global slowdown in the offing, FMG will suffer.  Here is how the shares have done over the last ten years:

Iluka Resources (ILU)

Iluka Resources mines mineral sands most investors have never heard of, like ilmenite, rutile, synthetic rutile, and other titaniferous concentrates, as well as zircon.  However, what they produce is used in a wide variety of applications, from paper and plastics to paint and chemicals.  In theory then, it would take a severe global economic downturn to adversely affect the demand for the variety of minerals produced by Iluka.  Even with a P/E close to the sector average, the share price has outperformed of late, as evidenced in their ten year chart:

Analysts believe ILU’s performance has been driven by the demand for its titanium and zircon in both China and India.  With the prospect of less government spending on infrastructure and real estate in China impacting zircon sales, ILU could suffer in the event of the hard landing in China feared by investors worldwide.  However, on 09 March, 2012 Credit Suisse reiterated its buy rating on the company in the belief the company’s other minerals will allow ILU to withstand the potential shock.

Oz Minerals (OZL)

OZL is an Australian based copper, gold, and silver miner with a strange history.  The current company was created out of a merger in 2008 and the resultant entity promptly sold most of its assets to China Minimetals in 2009.  This left them with a lot of cash and one operating mine.  Without a track record, OZL is a high risk investment at best; even should the price of copper not fall through a hole in the floor.  Analysts are still waiting to see what the company plans to do with the cash on hand.  Here is their ten year price chart, which reflects the odd story very well:

Alumina (AWC)

Alumina’s P/E ratio of 27.3 is almost two-and-a-half times greater than the sector average of 11.88.  The investment community must see something not all analysts do, as the most recent analyst recommendations have 3 downgrades to HOLD and NEUTRAL with three brokers maintaining BUY ratings.

AWC is an Australian based aluminum miner operating with a joint partnership with American aluminum giant, Alcoa.  Alcoa has suffered through the GFC as aluminum is not in short supply and subject to swings in commodity pricing.  AWC has benefited from the Chinese growth story and as such is at high risk of falling off the cliff should the China slowdown be severe.  Here is their share price chart:

Sims Metal Management (SGM)

Sims is actually headquarted in the United States with substantial operations in Australia.  Think of them as the world’s largest junk dealer, or metal recycler if you prefer.  They buy scrap metal from multiple sources and process it into forms suitable for later melting at steel mills and other base metal producers.  

High prices for iron ore make the purchase of recyclable metals an attractive prospect.  It would seem obvious that the reverse would also be true.  As the price of iron ore drops, so should the demand for recyclables.  While there is little question there will be customers with scrap metal to dispose of, the average investor has to wonder what the impact of substantially lower iron ore prices would be on the pricing structure of recyclables.  Australia’s brokerage community, however, appears unphased as the most recent recommendations published include 6 BUY ratings and only one HOLD.  The following chart of their 10 year share price performance adds to the puzzlement of why so many brokers are so high on this company:

Lynas (LYC)

LYC has yet to turn a profit but their position as a miner of one of the few rare earth mineral deposit sites in the world outside of China has created enough interest to turn this former penny stock from trading at 86 cents a share to a lofty $2.70.  Here is their ten year price chart:

Rare earth minerals are needed in a variety of high tech automotive and electronic applications and the deposits at Mt Weld right here in Australia are considered the richest in the world and they offer the only real alternative to China’s control of these valuable commodities.  Estimates are MT. Weld could provide 20% of world supply.  In addition, their operations could yield as much as a 27% pricing advantage over high cost producers in China. 

Despite this attractive proposition, LYC is subject to sovereign risk faced by any mining company operating in foreign countries.  Key to the future of LYC is a processing plant to be built in Malaysia.  On 02 February, 2012, the Malaysian government finally granted a temporary license to proceed.  LYC has growth potential in a world increasingly frustrated with Chinese dominance of this small but important market.  Japan is hoping to import as much as 8,500 tonnes of rare earth minerals from Lynas by 2013.  While not immune to another GFC, the kinds of high tech products requiring rare earth minerals are most attractive to higher end customers, who tend to suffer less in a global slowdown.

In summary, diversified stocks such as BHP and RIO as well as higher-risk plays Iluka Resources (ILU) and Lynas (LYC) may survive better than others in the event of a commodities slowdown. However, a sharp downturn would put pressure on all stocks across the board – so buyers beware.

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.

>> Next article – click here to read other articles