Thursday, November 22, 2012

Flies in the Molten Nickel: Mining Stock Prices = K / QE

After college in the 1970s,  my first job in the actuarial department of a small insurance company lasted about seven months, after which I worked in the employee benefits department of Inco Ltd., then the capitalist world's largest miner of nickel (Inco was an acronym for International Nickel Company).  Founded by JP Morgan as the nickel trust, and formerly one of the 30 Dow Jones industrials, Inco was  a sleepy, old firm on a 1950s model.  It was not a global monopoly because the Soviet Union controlled a large share of  the world's nickel, but Inco was considered a monopoly of the free world's nickel supply.  Its chief competitor, Falconbridge, was one fourth its size. The monopoly picture changed during the 1970s when third world producers received government subsidies and forced significant downsizing at Inco.  Inco suffered a strike in the late 1970s, and I recall calculating pension benefits for hundreds of miners taking early retirement rather than layoff. Also, Inco made an ill-advised acquisition of Rayovac Batteries.  Thereafter, its stock price was stagnant for two decades.  That changed in the millennial decade with the rise in commodity prices that began in 2001.  According to Wikipedia in 2006 Vale, a Brazilian natural resources behemoth, purchased Inco for $18.6 billion.  To date, that was the largest acquisition by any Brazilian firm.  Vale Inco is now the world's second largest nickel producer following Russia's Norilsk Nickel.

In this week's Kitco Commentaries Rick Mills writes about the world's nickel market. Nickel has a wide range of industrial uses, and government-funded green energy programs are likely to make use of it.  Mills notes that there are two kinds of nickel deposits:  sulphide and laterite.  He adds that there is no simple separation or mining technique for laterites: "Laterite projects require large economies of scale at higher capital cost per unit of capacity to be viable. They are also generally much higher cash-cost producers than sulphide operations."

Although 60 percent of the world's nickel is in laterite deposits, they are low grade and difficult to mine.  Mills states that cheaper-to-produce sulfide deposits, which are the source of 58% of the world's nickel, are depleting. Nickel mining, like mining in general, is capital intensive.  Mills states that the average capital input for mining is one half of total costs, while for the economy in general it is 21 per cent.  Moreover, capital costs have been increasing.  Vale's New Caledonia plant has faced repeated setbacks.  In May 2012 Vale declared force majeure, allowing it to ignore contract obligations, because of an accident at the mine's sulfuric acid plant, according to Reuters.  The Brazilian government has halted production at Onca Puma because of effects of the Onca Puma mine on the Xikrin and Kayapo tribes in northern Brazil. Vale had failed to pay damages to the tribes. Meanwhile, Mill states this:

Indonesia (the world’s top exporter of nickel ore) enacted an export tax system, effective May 6, 2012, under which a 20% export tax is levied on 14 raw ores of Indonesian origin, including nickel – the result was to drive hundreds of small miners out of business and sending Chinese laterite buyers elsewhere. This is the first step by Indonesia towards a full ban on the export of minerals that is scheduled to begin in 2014.

Mill states that 35 years of underinvestment have limited new discoveries.  China has been demanding nickel so that demand has increased  since 2000.  Mill makes the case that now is the time to invest in nickel via junior exploration firms.

Nevertheless, there are three flies in the molten nickel: QE1, QE2, and QE3.  The large capital costs of mining are reduced by sharp reductions in interest rates, and this would improve natural resource producers' stock prices were it not for hyper-low interest rates' effects on competition.  Reductions in interest rates stimulate supply and competition. Because of increased production and competition, stock prices of mining firms are reduced during the initial phases of a monetary boom. Low interest rates reduce the very capital costs that impede production. The excess competition deflates commodity-and-stock prices. It is not until monetary expansion results in inflation that commodity prices start to rise.

Vale, one of whose many products is nickel, is selling at a multiple of six times earnings despite its five percent dividend.  That is a Great Depression-era valuation, suggesting a buying opportunity, notwithstanding the all-thumbs management history that Mills describes.  At the same time, gold stocks have fallen precipitously over the past two years.  The initial market reaction that gold will go up because of monetary depreciation has petered out.  Along with Vale, mining-and-natural resource stocks are selling at Great Depression price-earning multiples.

The sector needs to go through a period like the 1980-2000 one. Contrary to popular belief, the Greenspan Fed consistently increased the money supply, and that was associated with depressed natural resource prices.  The Bernanke Fed is the most stimulative in history, but I suspect the metals price depression won't be that long because there had not been a Volcker Fed to raise interest rates and stabilize the economy prior to the monetary expansion.  Inflation in the coming decades will be worse than in the 1970s, and the Fed will have limited power to reverse it. However, these outcomes are at least two years away, and probably more.  Gold-and-commodity stock prices will increase once the stimulative effects of the monetary expansion are dissolved. My guess is three-to-five years or more.

At the same time, Mills is right. It is not too early to buy nickel stocks. Vale's five percent dividend is a draw.  Mills doesn't like Vale because of its diverse range of products.  The natural resource sector in general will rise with nickel, and it's nice to count some shekels from a five percent dividend while waiting for a turnaround in the commodities sector. 

Incidentally,  I have been buying gold and other stocks, and junior nickel miners are of interest.  

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