17/12/2008 - 22:00

OPEC may have Russia over a barrel

17/12/2008 - 22:00

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LAST year, in a deal which was value destroying for the shareholders of base metal miner Oxiana Limited, that company merged with Zinifex Ltd to become Oz Minerals.

OPEC may have Russia over a barrel

LAST year, in a deal which was value destroying for the shareholders of base metal miner Oxiana Limited, that company merged with Zinifex Ltd to become Oz Minerals.

The merged group is now led by Andrew Michelmore, a one-time protégé of Sir Rod Carnegie, who will forever be remembered by old timers in the industry as the man who sold Western Mining for an absolute pittance to BHP. It would be frightening to think what Western Mining's Olympic Dam, Incitec Pivot's Phosphate Hill project and the nickel business would have been worth 12 months ago.

Oz Minerals holds excellent base metal and gold assets and has strong exploration appeal. However, following its mishandling of the refinancing of debt obligations, the wisdom of its board and competence of its senior management have come into question. Meanwhile, the commodity cycle does not favour investment in this company until well into 2009 or more likely, 2010.

A virtual closure of debt markets on the back of sub-prime debt crash among banks and a crippling of equity markets, thanks to the activities of our clever cousins on Wall Street, has left much of Australia's primary industry open to corporate advances by long-term customers in China.

Chinese metals and energy companies, backed by government shareholdings to a larger or lesser extent, are now able to virtually take their pick of plumb Australian assets which have become distressed over the past year. Banks have left companies out to dry and the equity market is not interested in anything other than a deeply discounted bank or half priced engineering issue.

Perilya Mining's capitulation to China's third largest zinc smelter is a sign of the times and will be particularly concerning to the owners of smelters at Point Pirie in South Australia, which need to run at full capacity treating lead and zinc concentrate from Broken Hill to remain commercially viable.

Chinese companies have also been active in Western Australia's iron ore projects, with Gindalbie leading the charge, while involvement in the Puffin oilfield project is surely the first of many such partnerships in the oil and gas arena.

As 2009 rolls on, Briefcase expects to see a regular stream of announcements concerning new investments in projects and companies by Chinese-based organisations. Overall, this should be a synergistic relationship. Australian companies have the technology and the products, while Chinese partners bring cash and markets to the table. If there is any worry it is the prices at which the Chinese will get set in these assets. Global financial stress is creating many bargains, with entry prices set at pennies in the dollar on the basis of long-term value metrics.

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There's talk from some in the mining industry that increasing amounts of ice in parts of the earth's polar regions should be taken as some sort of evidence to rebut concerns over global warming.

Briefcase knows that, as summer rolls on, the fridge also has increasing amounts of ice build up and it's not because the weather has gotten cooler or because the setting on the fridge has been cranked up. The formation of ice and snow has to do with humidity in the atmosphere. Below a certain temperature, you get more ice when there is more water in the atmosphere. In a dry environment it may turn freezing, but you get very little in the way of ice.

Briefcase would conclude that an increased level of ice in some polar regions would in fact support climate change. Just as central Australia is getting wetter, so the polar regions could lose their Arctic desert climate and become wetter. Thicker icepacks in some regions, while glaciers retreat and sea icepacks thin out, all seems to be consistent with rising temperatures and would not in my humble opinion be confirmation that the world is cooling down.

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Lessons learned from 2008 included the impact of a totally new area of risk for share investors. It is no longer sufficient to understand a company's operating fundamentals, gearing and interest cover, or its cash-flow expectations, as well as gaining confidence in its management.

Investors now need to try and figure out if any of their fellow shareholders have over-leveraged their holdings in a way which could force the company's share price lower and imperil the investment of all other shareholders, should forced selling become a feature of the market. Until there is some sort of register of information on who is leveraged into stocks, knowledge of this potential ticking time bomb will be opaque at best.

During the past few months, we have seen otherwise strong companies with sound management, a growing revenue and reasonable interest cover being smashed in the market because a couple of the company's shareholders had used their shares as collateral for too much debt.

The other lesson apparent from the 2008 market is that the use of shareholders' equity for rampant risk taking by a management team, which is not also a key owner of the business, can derail that company. Business owners or proprietors tend to be more prudent with their own capital and more risk averse than employees, who are working with other people's cash. Owners have their own capital at risk and look not only for the best value, but also to the increased the long-term value of their equity. Employees, look to short-term performance, since they are motivated and remunerated with bonus payments, which are often driven by short-term sales of whatever quality, or other key performance indicators that may have no link to overall wealth creation for shareholders.

It is most unlikely that an investment bank, which was owned by its partners, would have allowed management to gear its equity 39 to one, as we saw on Wall Street by the likes of listed Investment bank, Lehman Brothers. Over-leveraging, seen on Wall Street during 2006-7, was carried out by overzealous management of the corporatised and listed investment banks.

The lesson is that there needs to be more thought given to regulation in this area. Canadian and Australian banks avoided the worst of this behaviour, despite the best efforts of private equity, because they had better prudential regulation in place. The key for corporations going forward is to ensure that they have boards that are fully engaged as custodians of the welfare of shareholders. Non-executive directors should not be remunerated or given bonuses in the same way as executives, since this creates a conflict of interest. They need to maintain independence and the shareholders need to reward directors separately, based on different metrics from executives.

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Finally, a note on the unintended consequences of a weaker oil price. The graph (left) comes from a paper by former acting Russian prime minister, Yegor Gaidar. It shows a connection between Spain's declining plunder of South American gold during the 16th and 17th centuries and its eventual loss of empire, and Russia's declining oil revenue during the 1980s and the collapse of the Soviet Union.

Decades of mal-administration by Russia's inbred Politburo had turned Russia from a food exporter to a massive importer, leaving the Soviet Union reliant on its oil revenue to fund the wheat imports to feed its population.

During the mid 1980s, OPEC's decision to drive the oil price down below $10 per barrel left Russia and its satellite nations unable to afford the imports, so they went massively into debt. The subsequent collapse of the Soviet Union and Iraq's 1991 occupation of Middle East oilfields, were direct impacts of this period of low oil price. The question today is what will result from an oil price of sub $US50 per barrel? OPEC nations need an oil price of around US$65 per barrel to keep the wheels of their governments turning. Putin's Russia still needs oil revenue to prop up its façade of democracy, so 2009 should be even more interesting, if the oil price remains weak.

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

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