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Analyst report - shares
Sub-prime draining our resources
September 2, 2007
Brendon Lau, ShareAnalysis
What has the sub-prime contagion have to do with the mining sector? Fundamentally, not much. But if you looked at the performance of mining shares since the start of the crisis, you would think otherwise. The S&P/ASX 300 Metals & Mining Index toppled almost 19% in the last month, while the S&P/ASX 200 lost less than 12%.
There are four general reasons why mining stocks have been sold off. The first relates to the severe bout of risk aversion that gripped financial markets. Anything associated with 'growth' (which implies risks) got sold as investors sought the safety of government bonds. Second, adding to the pressure, base metal prices plunged dramatically as funds closed positions to cover losses on the equities market.
Third, there are worries that demand for industrial metals would drop if the sub-prime fallout brings the US economy to its knees. Finally, investors fear the debt market would freeze up, depriving miners of a source of funds to expand via acquisitions.
These fears are largely overplayed. Rio Tinto's (RIO's) US$40B loan syndication to fund its Alcan acquisition closed oversubscribed, while BHP Billiton's (BHP's) strong result last Wednesday was a breath of fresh air for the sector. Not only did BHP post a solid rise in profit that was in line with our expectations but it also said that demand for raw materials has been unaffected by the financial market turmoil. This did not surprise us, as demand for metals like copper hardly flinched when US housing construction fell sharply. The US is the second largest consumer of copper after China.
Meanwhile, Chinese industrial production grew 18% YoY in July and there are signs that industrial metals demand will accelerate in 2H07, even as Chinese authorities raised interest rates again last week. On the supply side, labour unrest in South America and bad weather continue to disrupt production and lend support to prices.
Although we are believers in the stronger-for-longer commodities theory, investors are forewarned that the easy profits are gone. A slowing US economy could take some steam out of China's engines. Economists also doubt that China can sustain its breakneck annualised pace of growth of 11.9%, regardless of the US turmoil.
While we believe base metal prices will stay at historical highs for the foreseeable future, metal prices could come off some more, especially when China's economy suffers an inevitable hiccup. This means diversified miners with scope to significantly increase production output would weather any downturn best. Single-resource miners and speculative explorers would likely bear the brunt of a sell-off due to rising risk-aversion.
Then there is the threat of the rising cost of production and exchange rate. The higher Australian dollar is a product of the commodities boom, and we would not be surprised to see our dollar head up again, especially if the US economy weakens from the sub-prime meltdown. This is generally bad news for Australian miners.
Fortunately, cost growth is likely to moderate from unusually high levels, especially if commodity prices do not push to new highs. The logic behind this is simple - if costs continue to grow at their current pace and commodity prices do not keep up, it would likely lead to period of hyperinflation, and that is not a likely outcome.
More articles from this week's CompareShares newsletter:
Markets: Is the party over for the US?
Forums: The mysterious world of stock forums
Superannuation: Stay with super or convert to a pension?
Ask the expert: How to determine the best stock to trade
Politics: Forget the mud, it's about interest rates
Stock of the week: Mermaid Marine buoyant
Smart Investing: Risks of beating the market
Analyst report: Is sub-prime draining our resources?
Commodities: Gold hasn't lost its glitter
Brendon Lau is the Editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. For a complete list of buy and sell recommendations for this sector and for a free trial of its web-based investor research services, please go to the ShareAnalysis website.
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions.
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