Industrial commodities have been hammered for months now, but the trend seems to be shifting, writes Yiannis Mostrous of Global Investment Strategist.
The copper market suffered a volatile 2011 due to supply disruptions and investor concern about a global economic slowdown. Some analysts estimate that worldwide copper production last year was at its lowest level since 2008.
Indeed, Freeport McMoRan Copper & Gold (FCX) alone lost roughly 235 million tons of copper production from its Indonesian segment, following a labor dispute and the temporary suspension of its milling operation.
Total reported inventories of refined copper declined globally by 380,000 tons in 2011, while demand rose 5.1%. Copper inventories have been in steady decline for some time.
As a result, the supply/demand imbalance in the copper market is expected to persist for at least another year, as current production remains insufficient to cover demand despite slowing global economic growth. With copper already in tight supply, further disruptions to copper production could mean the metal will be bid higher.
Additionally, we continue to believe that the Chinese economy will avoid a so-called “hard landing.” Although Chinese policymakers have dampened the country’s rapid growth and cooled its overheated real-estate market, the Middle Kingdom will still deliver gross domestic product (GDP) growth in excess of 8% this year.
Nevertheless, China’s demand for commodities remains robust. In fact, China’s copper imports surged in December to a record of nearly 407,000 metric tons, an increase of 78% from the year-ago period.
Freeport McMoRan, our favored copper play, is the world’s largest publicly traded copper and molybdenum producer. For every 10-cent change in the price of copper, the miner’s EBITDA (earnings before interest, taxes, depreciation, and amortization) rises or falls by approximately $400 million.
The firm’s major assets are the Grasberg mine in Indonesia, the Cerro Verde, El Abra, and Candelaria copper mines in South America, the Tenke Fungurume copper/cobalt mine in the Democratic Republic of the Congo, and the Henderson molybdenum mine in Colorado.
During the fourth quarter, Freeport McMoRan generated $746 million in cash flow from operations, a substantial decline of nearly 64% from the year-ago period. At the end of the quarter, the company had $4.8 billion in cash, $3.5 billion in long-term debt, and $1.5 billion available on its credit facility. Only $4 million of its long-term debt is slated to mature through 2016.
The company’s outlook for 2012 assumes an average price of gold of $1,600 per ounce, $3.50 per pound for copper, and $13 per pound for molybdenum. Based on those projections, management expects to generate operating cash flows of around $4.7 billion this year. Meanwhile, 2012 capital expenditures are expected to total $4 billion.
Freeport McMoRan is one of the best-run companies in the mining industry, and remains a buy up to $50.
Vale (VALE)
For more than a month, heavy rainfall has impeded iron ore shipments from Brazil, and that has created havoc in the industry. The rainfall has caused floods and resulted in the declaration of a state of emergency in several Brazilian municipalities.
As a result, Brazilian iron ore producer Vale declared force majeure (i.e., the inability to fulfill obligations due to unforeseen events beyond its control) on a number of its iron ore sales contracts. The company estimates a loss of 2 million tons of iron ore shipments so far.
Although the disruption in supply supports iron prices in the short term, Vale’s cash flows have suffered, as the rainfall has hindered its operations to the point of work stoppages. If the rains persist, the decline in Vale’s shipments could surpass 5 million tons for the current quarter.
Nevertheless, we remain buyers of the stock because the superiority of Vale’s assets will continue to generate strong cash flows. Additionally, patient investors are compensated by a solid dividend until the present situation passes. And Vale’s stock is poised to move higher once global economic growth improves.
Until then, investors should consider buying into weakness and collect the dividend. Buy Vale up to $40.
|pagebreak|POSCO (PKX)
This South Korean steel producer reported preliminary fourth-quarter earnings, indicating that operating profits fell by 11% year over year, largely due to a weak pricing environment.
At the same time, net profit was up 61% versus the prior year period because of currency-related gains—the Korean won appreciated against the US dollar by around 2% in the final quarter of 2011. Margins were also weak due to a rise in costs, while export steel prices fell even though export volume rose.
Although the company will release more details and offer guidance for 2012 next week, it should be safe to assume that management will adopt a conservative stance for the current quarter and maybe even the subsequent quarter.
However, relatively weak coking coal and iron ore prices should lower the firm’s input costs, and margins should improve by midyear. Recently, steel prices have moderately rebounded, so that could further improve the company’s margins.
POSCO also announced that it will acquire an 11.25% stake in Roy Hill Holdings, which is controlled by Australian iron-ore heiress Gina Rinehart, for $1.6 billion. POSCO previously purchased a 3.75% stake in the company back in January 2010. Once the transaction is complete, the South Korean steelmaker will control 15% of Roy Hill.
By 2014, POSCO expects Roy Hill to produce about 55 million tons of iron ore per year from its iron ore mine in Pilbara, Australia. The mine’s total reserves are estimated to be 2.4 billion tons.
Investors who follow the steel industry are well aware of the endless negotiations steelmakers pursue to obtain raw materials, namely coking coal and iron ore. As a result, POSCO has endeavored to increase its self-sufficiency with regard to inputs for some time.
Currently, the company is 33% self-sufficient in iron ore and coking coal, and it plans to increase that rate to 50% by 2014. POSCO’s investment in Roy Hill should provide much of the supply necessary to take the company to that next level.
The acquisition alone should increase POSCO’s iron ore self-sufficiency from 33% to about 45% starting in 2014, as Roy Hill’s mine is expected to supply around 13% of the company’s iron ore needs.
Although the acquisition did not come cheaply for POSCO, the increase in self-sufficiency removes some of the uncertainty regarding future input costs, improving the company’s ability to make long-term strategic plans.
The stock has rallied recently, but it’s still down on a year-over-year basis, so it remains cheap on a price-to-book (P/B) basis. With a 2.4% dividend yield, POSCO remains a buy up to $100.
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