Dig It!

Did you know that commodities prices have been falling for the best part of 20 years? It's hard to believe, but it's true: Moreover, this little analysed drop in prices will underpin an upward revison of prices in the Australian resources sector.

If you only look at one economics chart this year, look at the one below. It is the most interesting chart in all of economics. Commodity prices have been falling in real terms for 20 years. Now '” due to the emergence of China and to a lesser degree India on the demand side, and 20 years of under-expenditure on the supply side '” we are on the cusp of commodity prices sustainably retrieving, in real terms, some of those falls.

Current resource stock prices are a reaction to last financial year's underestimated earnings, cash flows, and dividends. We are seeing a rebasing higher of next year's consensus earnings based off what was reported in the year to June 2005, yet we haven't seen any analyst address their ridiculous commodity price assumptions yet.

The Australian bank sector rode a decade of home loan growth and house price rises, and used the free cash generation (after ripping out costs) to pay higher dividends and improve balance sheets. They offered superannuation investors the right combination of low risk earnings growth with rising fully franked yields. Long-term interest rates collapsed over the corresponding decade, and the grossed up yield of the sector became compelling. The earnings multiples in the bank sector advanced form 8 times to 13 times, and the index weight of the sector doubled as the market capitalisatons rose.

Banks in the early nineties were considered "high risk", but by the end of the decade they were considered, and still are considered, "low risk". I don't think resource stocks will ever be considered "low risk", but even a lowering the perceived risk in the sector to "medium risk" (due to the strength of balance sheets) will have serious p/e re-rating ramifications.

Moreover, the power of consolidation in the resources sector continues to be underestimated. Widespread consolidation in the resource sector, which is still going on, is also a key factor in this equation. Eighty per cent of the world's iron ore supply is now controlled by three companies (BHP, RIO and CVRD '” the Brazilian iron ore company), a consolidation that has brought great pricing power. Industry consolidation will continue to exacerbate the underlying commodity price cycle, and in many resource sectors "cosy oligopolies" are forming.

That industry consolidation alone makes this commodity cycle different from all others, and this is the key factor missed by all strategists and commentators who continue to forecast commodities will fall in real terms over the next few years.

But it's not just consolidation in the raw materials sector; its also consolidation in the manufacturing sector. Companies such as Mittal and Arcelor are driving up returns in the global steel industry, and displaying economic rationalism: for 20 years, the steel sector went for volume over price; now the leaders of the consolidation are putting price ahead of volume.

Consolidation is the key in cyclical industries, and when we see consolidation we see returns improving. The biggest p/e re-ratings occur in consolidators who find "final pricing power"; and there is nothing more powerful than a company that can lift its prices above and beyond the underlying commodity cycle.

More resources consolidation

There was further consolidation in the global resource sector this week with Xstrata buying a 19.9 per cent stake in Canada's Falconbridge. Xstrata's chief executive Mick Davis is a clear believer in the extended commodity cycle, as evidenced by his recent post-results commentary. Now Davis is backing up his belief with action. Falconbridge is a nickel, lead, zinc exposure, and it interesting that another large-cap global listed nickel exposure is in play.

There is a big resources sector "insightful trade" going on in nickel assets. The world's leading resource houses have made independent studies of global nickel market supply/demand fundamentals, and all conclude that supply won't be able to meet demand in the medium term.

Broker commodity analysts think supply will swamp demand in two years as projects such as Voisey's Bay and Goro come on line. And, therefore, forecasts for nickel prices are retreating 50 per cent from today's levels. The corporate world sees it completely differently, and they continue to see sustainable prices higher than today's spot prices.

Consensus versus reality arbitrage

The corporate world is taking advantage of this consensus versus reality arbitrage, and nickel assets are being snapped up left, right, and centre. The analysts think the companies are grossly overpaying for the assets, while the companies think they are getting medium-term bargains that pay back their initial investments in fairly quick time.

Xstrata started this cycle of mergers and acquisitions four years ago with the purchase of MIM, at a price that, at the time, analysts considered very full. MIM would have paid for itself in cashflow by now, and Xstrata could sell it for close to triple the price it paid. Xstrata is still buying assets, as is BHP Billiton. And I suspect they will prove to be much better judges of the sustainability of the cycle than any broker commodity analyst.

I believe BHP Billiton didn't even pay a control premium for WMC Resources, and bought it at a discount to its Net Present Value (NPV). You could argue that WMC Resources would now be trading above the $7.80 price at which BHP got control, because all of its commodities have rallied 15- 20 per cent in price since the deal was done. BHP bought irreplaceable, long-life, high-grade, politically stable assets at a discount to NPV and with no control premium. How is this possible?

Consensus is wrong, and let us hope it stays that way

It is possible because the Australian broking community is getting this resource cycle grossly wrong. We operate in a consensus-hugging world, but there's just one problem with that when it comes to resources: consensus is wrong and it has been for two years. Let us hope it stays that way, because it creates tremendous money making opportunities.

Consensus remains grossly wrong, and we are now starting to see selected LME metal futures show flattening forward curves. We first saw these flattening forward futures curves in NYMEX Oil 12 months ago '” and we all know what has happened there. These flattening LME metal futures curves are a significant development.

Zinc no longer stinks

Over the past year, LME zinc inventories have fallen 23 per cent (5 per cent fall in the past month). The zinc price has rallied 30 per cent in $US terms, and 23 per cent in $A terms in that time. LME zinc is approaching US60 cents a pound, but most interesting is that the LME futures curve now forecasts zinc to hold its price right out to 2007.

Are we entering another period for zinc like the late 1980s and 1997?

Financial year 2004-05 saw a lift in the zinc market and significant de-stocking of zinc inventories on and off LME. The zinc price has recovered from 15-year lows, and there is a clear likelihood of further rises over the next 12 months as the cycle of de-stocking continues

The key point today is that the supply side is not going to be able to meet demand levels, with all times running at full capacity and China now a significant net importer of zinc metal. The concentrate market is short of product and smelters are supporting the producers to maintain production rates and conduct exploration.

Looking further out, there are no developments of note in the pipeline; in fact, zinc exploration is still not a priority for the sector.

The extended resource cycle is huge for regional Australia

The resource cycle is not simply changing the risk profit of the resource sector, it is also leading to industrial-company transformations for those servicing the sector.

Over the last few days there have been better than expected results from United Group (UGL), OneSteel (OST), Bendigo Bank (BEN) and APN News & Media (APN). All those results have been driven to varying degrees either directly by the resource sector or by the wealth effect of the cash generation of the resource sector.

United Group (UGL) is emerging as Australia's next Wesfarmers (WES). It has all the same characteristics that WES had a decade ago. As a consolidator, it has dominant positions in all its highly cash-generative businesses. Margins are improving across all its businesses, as are ROEs. Eighty per cent of UGL's earnings are now infrastructure linked supported by the substantial and long-tailed capital works upgrade cycle that is under way.

UGL now has exceptionally strong market share positions: no. 1 in rail design and fabrication (70 per cent share), tunnelling services (90 per cent share) and property services. In property services, UGL has 85 per cent of all Federal Government contracts. Consensus earnings expectations for 2005-06 appear conservative, despite upgrades today, and I continue to recommend UGL as a core portfolio holding.

Wrong and wronger

OneSteel (OST) also blew consensus earnings forecasts out of the water this week, and it would be hard to find a sector where the average analyst has added less value than the Australian steel sector.

The analysis of this sector has been myopic and absolutely incorrect, all based off global macro analysis that pays no attention to the unique dynamics of the Australian steel industry. Let us hope this inaccurate analysis continues, because it allows us to generate huge returns in these highly liquid, cheap, and strongly yielding, stocks.