This article appeared in the February 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
These 10 trends will give you a head start in resource-sector investing.
By Allan Trench, author
The Australian sharemarket fell about 14 per cent in 2011, with the materials sector, which includes metals and mining companies, dropping more than 20 per cent.
Resources sector initial public offerings (IPOs), although plenty in number were not immune to the weak market conditions. As measured at the end of 2011, just 18 (23 per cent) of the 78-strong class of 2011 minerals IPOs finished in positive territory - less than a quarter of new listings recording an end-of-year closing share price above their initial listing price.
Macro-economic challenges - most notably sovereign debt-linked weakness in Europe - and a slow economic recovery in the United States were the key drivers of markets globally. Natural disasters caused by earthquakes in Japan and New Zealand, coupled with the Queensland floods, added to risk-aversion in resource shares.
Commodity prices trended down over 2011 as economic uncertainty grew. Base metals finished down between 20 per cent (aluminium) and 30 per cent (tin) from the start of the year, with periodic sell-offs resulting in price corrections in March, May, August and September.
Bulk commodities were less volatile. Coking coal, for example, kicked higher because of the Queensland floods in the first half, and then fell back as doubts arose that China's policies to curb inflation would weaken the outlook for steel demand.
Given a weak second half, commodity prices finished 2011 below their average calendar year prices. But recent weak market sentiment should not detract from what, on average at least, was a positive year for commodity prices; 2011 prices were pretty much up across the board compared to 2010 commodity price averages.
Silver and palladium were among the best price performers on this basis, up 73 per and 39 per cent respectively compared to 2010, even outperforming gold, which finished up 28 per cent in US-dollar terms on a year-to-year average price comparison.
Tin was the strongest year-on-year performer of the London Metal Exchange (LME) contracts, up 27 per cent on 2010, and metallurgical coal led the bulk materials, finishing some 30 per cent higher on average.
Investor favourites iron ore and copper finished in the middle of the pack, up 15 per cent and 17 per cent respectively in year-on-year average terms. Manganese was the exception, falling 25 per cent compared to 2010.
So what of 2012? Here are 10 trends and insights about commodity prices and resource stocks:
1. Gold to stay in favour
The consensus among analysts is for gold prices to remain strong through 2012; with upside potential should a specific negative macro-economic problem emerge. The principal candidate is a new eurozone debt crisis, but a run on the United States dollar is also a possibility, triggered perhaps by further monetary easing. Heightened global political tensions are always in the background for gold, with Iran, the broader Middle East and North Korea perennial candidates as "hot spots".
2. Fewer 'lumpier' mineral sector floats
Boutique "nano-cap' minerals floats of $4 million or less will still find a way to market with the backing of networks of high-worth individuals and broker provision of investor spread, although there is likely to be fewer minerals IPOs than in 2011. Expect typical 2012 IPOs to be "lumpier", meaning that more advanced mineral assets such as predefined coal and iron ore resources will come to market and seek to raise tens of millions rather than the typical $3 million to $5 million that has characterised minerals IPOs in recent years.
3. Strained supply infrastructure to support bulk commodities
Mining companies, particularly miners of coal and iron, often bemoan the slow progress in improving government-linked infrastructure. This has meant bottlenecks in port, power and rail in Australia and overseas. However, the already-strained infrastructure has a silver lining because it prevents major new supply (which can help lower commodity prices). This means that weaker demand for bulk commodities will be offset by constraints on supply.
4. Base metals to follow the global economy
Copper, aluminum, lead, zinc, nickel and tin - the LME contract metals - all follow the global economic trends in their short-term price patterns. Economists' global growth expectations have been downgraded for 2012, so year-on-year price gains in these base metals are unlikely. A predicted market surplus in nickel is one example where 2012 average prices will struggle to match 2011.
5. Zinc supply squeeze to come, beyond 2012
Investors may not realise it, but the system for financing mineral projects acts to accentuate year-on-year price volatility in the base metals sector.Typically, new projects only receive finance approval too late, so prices have already risen and the projects often fail to capture the metal price upside before market balance is once again restored. The most compelling instance at present is the future supply of zinc to the global market. Modest prevailing zinc prices and a surplus of 2011 metal leaves banks wary about financing new projects in the galvanizing metal. This is despite analysts' forecasts of markedly higher zinc prices by around 2015 as supply fails to keep up with projected demand.
6. Specialty commodities will test investor patience, mineral sands excepted
The rare-earths sector captured the market's imagination in 2010 and in the first half of 2011. Since then, market sentiment for rare earths has cooled rapidly. In part, this sudden transition of rare earths from "hot" to "not' is due to a price pull-back in the commodities. However, prevailing prices of rare earths in 2012 are still many times higher than just a few years ago. The change in sentiment towards rare earths was also driven in 2011 by the lack of an established Australian success story in that sector - meaning a company already reaping the rewards from high prices. None of the new generation of rare-earths producers, led by Lynas Corporation, have yet delivered new supply to the global market.
The mineral sands market is in stark contrast: market leader Iluka Resources was a strong performer in 2011, fully capturing strong zircon, ilmenite and rutile prices. Investor sentiment in the boutique specialty metals and fringe commodities - such as lithium, vanadium, rare earths, potash, phosphate, tungsten tantalum, cobalt, molybdenum and even perhaps tin - needs the Australian equivalent of Iluka in one or more of these markets to reveal "what success looks like" to investors. When that eventuates - or at least gets closer - investors in juniors and explorers in each of these commodities must remain patient.
7. Mergers and acquisitions to flourish
Business development managers sitting in mid-tier and large mining companies spend a lot of their time doing variations on one basic calculation. Investment bankers active in the minerals world work on the same calculation too. Collectively, they seek to answer the question whether it is cheaper to buy additional metals production (via merger and acquisitions) or to discover and develop new resources in-house.
The weak market performance of mineral equities in 2011 has tipped the scales towards M&A for 2012. That is, even when allowing for an acquisition premium, it is now looking far cheaper to buy up other companies to grow future production rather than to grow your own by commissioning new in-house projects. M&A activity will increase in 2012 in the minerals sector as a consequence.
8. 'Greener' uranium to return to favour
The introduction of the Carbon Tax in the second half of 2012 will gradually act to sway investor sentiment back towards uranium as a "green", low-carbon energy source. Uranium needs some help right now: general market sentiment and public perception towards the energy commodity have been dealt a major blow by the Fukushima accident in Japan and ongoing remediation. Although all signs point upwards for uranium in price terms, the rise may be a gradual one.
9. The market is primed for mineral discovery
Many investors are keeping their cash on the sidelines of the market at present, awaiting a suitable trigger to put it to work in the sharemarket. Nothing quite gets the equity market excited like a new mineral discovery; perhaps Sandfire Resources' 2009 discovery of high-grade copper in Western Australia was the last standout example. Mineral discovery is always rewarded handsomely, and may get an extra leg-up if a major discovery occurs in a marketplace where there is excess cash on the sidelines.
10. Weigh up the risks
The 10th insight is a straightforward and precautionary note, namely that "It Will Not Be Different This Time" - meaning that investors always need to carefully weigh up all the risks involved with mineral sector investments. They are well advised to seek professional guidance and do extensive research before jumping into "the next big thing", be that tin, zinc, copper or even the next new gold float that comes to market.
About the author
Allan Trench is a professor at the Centre for Exploration Targeting, University of Western Australia; a professor of energy and mineral economics at Curtin University Graduate School of Business; and an independent director to a number of ASX emerging resources companies. He is the author of several books and his next, Australia's Next Top Mining Shares, is due for publication in April (Major Street Publishing, Melbourne). He is a non-executive director of Kimberley Rare Earths, a rare earths explorer that listed in 2011.
ASX Exchange Traded Commodities (ETCs) provides useful information about how to use ETCs to gain pure exposure to the gold price and other metals. ETCs track the performance of an underlying physical commodity or commodity index, enabling investors to gain direct exposure to the underlying asset without the need to trade futures or take physical delivery of the commodity. Aside from the underlying asset, ETCs are very much like exchange traded funds (ETFs) and are traded and settled on ASX, just like shares, making them both accessible and affordable.
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