Commodity super-cycle seems to be a runner again

By Neil Hume

Published: November 12 2010 20:58 | Last updated: November 12 2010 20:58

Remember the commodity super-cycle? It had quite a following in the City of London about five years ago. The idea was that the emergence of big new industrial superpowers such as China and India would drive a spectacular bull market in commodities that would last for years.

Of course, things didn’t work out that way and commodities crashed back to earth in 2008. But the recent performance of commodities and related stocks suggests that investors haven’t completely given up on the idea.

In the year to date, the mining sector has outperformed the FTSE All-Share index by almost 12 per cent; the share price of BHP Billiton, the world’s biggest miner, has hit a record high, as has the price of gold and copper. And there are plenty of investors who believe that there is more to come, especially as the Federal Reserve has launched a second wave of quantitative easing.

Indeed, since Ben Bernanke, chairman of the Federal Reserve, hinted at the end of August that he was considering another round of asset purchases, the mining sector has been rising and has outpaced the wider market by 11 per cent.

Investors have alighted on commodities and related stocks because they are seen as a good place to hide from inflation and dollar debasement. But has this flight to commodities pushed valuations too far and could the sector suffer a setback?

Merrill Lynch says no. It reckons that metals prices (and by extension mining equity) will rise further in 2011 for a number of reasons. One is QE. As mentioned earlier, commodities are a hedge against inflation and a weak dollar, and depressed bonds yields will help push capital into emerging markets, where it will support economic growth. A big positive for miners. Other reasons include increased demand for commodities from physically backed exchange-traded funds and China.

Merrill says demand in China remains resilient and recent moves by the authorities to tighten credit are positive because they underline the strength of the economy. As such, Merrill believes that copper could hit $11,250 a tonne next year. That’s about 25 per cent above its spot price.

Others, however, are worried. Citigroup believes that valuations are stretched and the benefits of higher commodity prices will be offset by rising costs.

This point has also been picked up by other analysts, such as Paul Galloway of Bernstein Research. He says investors have yet to realise the impact a weak dollar will have on costs. Over the past couple of years, the currencies of producer countries (Australia, Canada, South Africa and Chile) have all risen sharply. For companies that report in US dollars but incur costs (wages and labour) in local currencies, this has a negative impact on profits and cash flow.

The severity of the hit varies from company to company. Platinum producer Lonmin is very sensitive to currency movements. If the dollar weakens a further 10 per cent against the South African rand, Mr Galloway estimates profits could fall by 30 per cent next year. In contrast, Kazakh miners Kazakhmys and ENRC are much less sensitive because the Tenge is pegged to the US dollar.

There are other issues, says Mr Galloway, which mean that the healthy margins enjoyed by the industry could be checked. These include declining ore grades and a lack of new discoveries.

Miners are faced with government interference on issues such as taxes, environmental regulation and, as BHP Billiton has just discovered to its cost, M&A activity. Indeed, these are some of the factors which have triggered the savage stock market derating of “big oil” companies over the past decade.

For now, investors aren’t interested in these issues. And perhaps they are right to ignore them. After all, the flood of cheap dollars into emerging markets and commodities has the potential to push the mining sector higher still.

In the long term, of course, excessive capital flows into emerging markets and commodities are not healthy. But, as Keynes observed: in the long run we are all dead.

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