15/10/2008 - 22:00

Gold, oil the best of commodity stocks

15/10/2008 - 22:00

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GLOBAL share markets have entered a netherworld that no-one working in the finance industry has ever experienced before, unless they were alive in the 1930s.

GLOBAL share markets have entered a netherworld that no-one working in the finance industry has ever experienced before, unless they were alive in the 1930s.

The stock market has become a liquidation sale, with the largest and most liquid stocks being sold down, because there are still a few hardy buyers willing to accept the risk and buy value. Shares of smaller companies are not even trading, only for lack of a buyer.

Punters who were margined out of the game six months ago are the lucky ones. Those with more prudently leveraged portfolios, consisting of blue-chip stocks, are now getting the margin call. Briefcase would not be surprised to see a few more boats, holiday houses in Margaret River, and trophy homes along the Swan come on the market at prices reflecting the current global financial turmoil.

Commodities, such as copper or rice, have a range of producers, whose costs form a global production cost curve, graphing the cheapest to most expensive tonnes. Once the price of a commodity falls below the production cost of the highest cost, 5-10 per cent of production, the price is said to have fallen below its marginal cost of production. Typically, as the price continues to fall, high cost or marginal producers either close down or trim back production in an effort to cut costs, which eventually brings supply into line with demand, so that price can stabilise and begin to recover.

After recent price falls, many industrial metals are already trading at or below their marginal cost of production on the global cost curve. Australian producers are now being protected by the weaker currency. Briefcase estimates that, at the current zinc price, at least half of total world production is cash-flow negative. Meanwhile, the price of nickel has fallen below $US6.00/lb, at which level a very large chunk of global producers will be thinking about shutting their doors. Locally, we have seen a response in Broken Hill, where high-cost zinc and lead producers, Perilya and Consolidated Broken Hill, have cut back and are high-grading their deposits, while Oz Minerals is swapping zinc production for copper at Golden Grove, since copper still trades at a profitable $US2.20/lb - but for how long?

Further base metal closures have been announced in Tasmania, while Poseidon Nickel has shut down development at its project. Briefcase understands that BHP Billiton's Ravensthorpe nickel laterite project is pushing the cost curve. It would not be surprising to see BHP bite the bullet here and mothball its $1.9 billion project, though it may prefer to wear any losses while it is trying to put on a brave face to woo the shareholders of Rio Tinto.

Briefcase has spoken previously about the potential for significant weakness in commodity prices, and it is pleasing to see that some of those bullish forecasts for iron ore and coal prices by some of the larger brokers are starting to evaporate. Certainly, the outlook remains grim, even for bulk commodities, which have previously been star performers. Briefcase sees bright spots in both gold and oil. The gold price has risen to more than $A1,300 per ounce and has the potential to lift to at least $A1,700 per ounce by early next year. Meanwhile, the oil price has bounced off support at $US85/bbl and is likely to remain range bound, supported by OPEC's ability to manage supply.

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Briefcase reckons he has something in common with about 70 per cent of the rest of the people on this planet, as we stare in amazement at the performance of the US dollar during the ongoing financial crisis - the currency of a nation facing huge challenges associated with its overblown fiscal and current account deficits. The US is a serial over-spender, using borrowings from other people's savings for consumption and yet, when the going gets tough, the US dollar strengthens. Who knew?

Briefcase is yet to see a satisfactory explanation for this phenomenon, but the usual line is that US corporations and citizens bring funds home in times of stress and when other investments look risky, individuals and corporations park cash in US dollar denominated bonds, which offer the security of knowing that, ultimately, the US Federal Treasury will always print out some nice new notes to repay your investment.

This supply-side push on the dollar has the effect of strengthening the currency, despite the unassailable fact that the US financial system looks like a complete basket case. Ultimately, Briefcase sees that the US's willingness to take on so much debt to bail out its banks will be hugely inflationary. It appears to me that the US government is simply creating money to pay for this. If you create money more rapidly than wealth, then you devalue that money and hence you have price inflation as the currency loses its value. No wonder gold mints in the US and Australia are running flat out to meet the demand for gold coin as a hedge against catastrophes.

There are a couple of impacts of this currency phenomenon on Australian investments, which point the way for investors. Firstly, the relative weakness of the AUD, which is seen as a commodity currency, provides a huge buffer to the earnings of local industry, effectively putting up a 30 per cent tariff on imports and cutting the price of exports to foreign buyers.

In addition, Australian companies with substantial assets or earnings in the US, or whose earnings are US dollar denominated, will benefit with increased earnings. In this category Briefcase includes Westfield Holdings and Macquarie Office Trust, both of which own blue chip property in the US, Westfield in the retail space and Macquarie Office in the office space.

There are of course other companies with US assets, such as James Hardie, CSR and News Corporation, but the ongoing downturn in construction and advertising spending is likely to leave these companies worse off in the medium term. Other companies on Briefcase's watch list include Transfield Services, which looks to be on its way to $4 per share, and United Group, both of which are strong, engineering and property service companies with significant assets in the US and whose share prices, in Briefcase's judgement, now fully discount the ongoing impact of the current economic environment.

Earnings from overseas businesses will now transfer higher income into the local Australian currency, boosting earnings per share. Transfield has come in for some criticism for its level of debt, which at about 80 per cent debt to equity, is probably at the top end of acceptable practice, but the business has a healthy interest cover of around four times and expected earnings of around 60 cents per share for this year, along with a dividend, likely to lift from 36 cents last year to around 38 cents this year. Both United Group and Transfield will no doubt see some slowdown in earnings growth this year and next as investment spending in the resources sector cools down, but both companies have very diversified activities, working variously with power generators, transport providers, water utilities and in property management, so they have manageable exposure to the more cyclical resources spending. In addition, United Group manufactures railway rolling stock, where it currently operates at full capacity. Given the share price performance of both companies -Transfield falling from $16 to $5 per share, while United has slumped from $21.50 to $11 per share - Briefcase believes both present long term-investment opportunities.

Because of the unprecedented tumble of the Aussie dollar, foreign investors can effectively buy Australian shares at a 25 per cent discount to the level seen in August, even before allowing for any market price falls.

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- Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au

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