Let dozy bears lie, run with the bulls

Access Economics polled 50 economists for their forecasts for commodity prices in 2007, and the median forecast is for a 50 per cent decline in commodity prices by2007. Sorry readers, that is red rag to this bull, so here goes.

First, any survey of 50 economists is almost a good joke in itself; second, the vast bulk of economists' bearishness on commodities is based on the "supply response".

Nobody seems to consider the demand factors because they all think a wave of supply will cause prices to collapse. There is no mention of global consolidation leading to pricing and supply discipline; or any mention of the rising cost of materials and shortage of skilled labour and equipment pushing back the supply response.

There is no mention of pricing protocols that the world's big resource companies have adopted, and it is clear the average economist believes the global resource sector has learned nothing from previous boom/bust cycles.

Backwards-looking analysis of commodity cycles is why we continue to be able to make money in the Australian resource sector. The economists look backwards for guidance, set their commodity forecasts unrealistically low, and then we watch the analysts play a quarterly game of revising up consensus earnings estimates in a trailing way.

It's better to listen to the resource companies than the economists. Inco, the number two world nickel producer, points out that the second quarter of 2005 saw the highest average price in 16 years. And Inco, remembering that it controls two of the three big projects coming online in the next few years, continues to think the supply side is tight.

Inco says that, driven by the strong global economy, nickel demand has been very good through the first half of 2005. The London Metal Exchange (LME) benchmark cash nickel price averaged $US7.44 a pound in the second quarter, the highest in 16 years and the third highest since the LME began trading nickel.

In the second quarter, the stainless steel industry, the principal end-use market for primary nickel, experienced an oversupply situation as production from several new facilities came on stream, resulting in an inventory build-up in China and elsewhere. Several stainless steel producers have planned reductions in production in the third quarter. The result has been a dip in the LME cash nickel price during July (on July 25 it was about $6.50).

With the continued strong demand for nickel from several non-stainless steel applications, including the aerospace market, and a belief that this oversupply and related inventory situation in the stainless steel sector will be reversed, we believe strong demand will continue and market conditions will remain tight. This should continue to have a favourable effect on nickel prices in the final quarter of 2005 and in early 2006.

LME and producer nickel inventories remain critically low and growth in nickel supply will continue to be limited because many producers will struggle to increase output.

BHP Billiton is also bullish on nickel fundamentals. Its decision to go ahead with the Ravensthorpe expansion and its move on WMC Resources had to be based on a bullish view on nickel fundamentals. Nickel moves to 10 per cent of Net Profit After Tax over the next few years, and perhaps even more as strong nickel prices are sustained.

Nickel looks like being the star commodity of 2006-07. The problem is that most of Australia's mid-cap nickel sector has been gobbled up by global consolidation. To get pure nickel exposure, we have to go right down the market cap food chain to Independence Group (IGO), or up the shorter mine-life chain to Jubilee Mines (JBM). Minara (MRE) has real leverage, but it comes with process and production risk and Lion Ore (LIM) lacks liquidity in its Australian listing.

So, how do we get leverage? We have to buy BHP or Consolidated Minerals (CSM), stocks that will deliver dividend surprises in the financial year results. BHP's production report confirmed its mines are operating at full tilt.

Costs, costs, costs

When investing in Australian resources companies, be very aware of cost pressures, operating and capital, and of time delays. There is plenty of evidence coming through in the quarterly reports, and it will be properly quantified in the August financial figures. Be extra careful if you have not seen solid appreciation in the underlying commodity; if the operation is technically challenging; or if the company has heavy financing requirements (debt or hedging), which further limit flexibility.

A good first-hand example of rising costs in the resource sector comes from Consolidated Minerals' (CSM), where a mining truck tyre is up from $8000 to $22,000. CSM is now trying to source tyres from Russia. Truck tyres are not optional, they are essential.

And then there are skilled-labour costs. They guys driving the mining trucks now get $120,000 a year. A junior geologist's salary s up from $66,000 to $110,000, a project geologist's from $90,000 to $120,000, and a senior geologist now earns $150,000.

Market rates mean CSM's overall salary bill will rise 10 per cent if it is to keep its people. And this is not a CSM-specific development; it is industry-wide. We believe the revenue line of the resources sector is underestimated for 2005-06, as is the cost line, but not to the degree of the revenue line.

Miners poaching stockmen

It seems the skilled-labour shortage is also being felt in the cattle industry. The Australian Agriculture Company (AACO) says stockmen, engineers and truck drivers are being poached by a mining industry offering hugely lucrative packages to people willing to operate in remote locations. This is yet another example of the chronic shortage.

The good news for AACO and rural Australia is that cattle prices are still rising. In the eastern states, the young-cattle indicator is 10 per cent up on two years ago and 20 per cent above levels during the worst of the drought.

Why are miners poaching stockmen? Look no further than BHP Billiton's fourth-quarter production report for the answer. It shows a company operating at "supersonic" to get raw materials out of the ground. This is what we want to see from our key resource recommendations. It's all good to have high commodity prices, but you simply have to get the stuff out of the ground. Production is the key, so look at the production growth from BHP across all divisions.

In the June quarter, petroleum products were 16 per cent up on the March quarter. Other June-March quarter comparisons show copper up 8 per cent, iron ore 5 per cent, coal 8 per cent, diamonds 19 per cent, energy coal 13 per cent and nickel 53 per cent.

These production figures ensure that the forecast of Southern Cross Equities analyst David Radclyffe of a full year BHP Net Profit After Tax of $US6.5 billion will be achieved, and we strongly suspect that the 2006-06 consensus estimates are too low.

Show us the money

With the earnings in the bag, what is now needed are dividends. The next leg of resource stock out-performance will only occur if there is genuine dividend growth. It is absolutely essential that the resource sector takes this opportunity to pay big dividends to attract genuine superannuants to their registers. This is the only way to get long term price/earnings (P/E) expansion in the sector, so the sector must show investors the money this reporting season.

Small-cap miners are paying up, so it appears the smaller-cap end of the sector is getting the message. A good example is nickel producer Independence Group (IGO), which intends to pay a final dividend of 5¢, taking the full year dividend to 8¢. Encouragingly, this is struck from a 40 per cent payout ratio, so, in effect, the dividend growth is coming from profit growth. We continue to forecast dividend growth in 2006-07 for IGO, and believe a fully franked 10¢ is achievable. On today's prices, IGO trades on a prospective yield of 7 per cent, and this will lead to P/E expansion.