Even by the standards of a market where new deals are announced every day, the resources sector is white hot: $139bn-worth of deals have already gone through this year. Dutch giant Mittal Steel seduced rival Arcelor with a $43m bid. Xstrata crept up on Canadian miner Falconbridge. And now, with Rio Tinto’s $36bn cash proposal to Alcan, the total value of deals is fast-approaching last year’s $220.5bn bonanza. This has many analysts worried that the mining sector is getting a little light-headed.
So is this a sign that we are approaching the top of the commodities supercycle? Far from it. There is nothing irrational about the current exuberance in the sector – in fact, the current levels of consolidation make perfect sense. As Cliff Feltham points out in The Independent, when a mobile-phone manufacturer is unable to satisfy supply, it just builds another factory. But a mining firm can’t react so quickly. First it has to locate fresh deposits, which in itself can take years and burn a billion-dollar hole in the budget. Then comes the really expensive bit – building the actual mine and delivering the materials to market. This has become even more costly in recent years because the boom in commodities prices has also stimulated prices for the equipment and expertise needed to construct a mine, as demand outstrips supply. So when faced with the choice of hunting down new resources, or just buying access to existing ones, the latter option often makes the most economic sense. As David Fuller points out on Fullermoney, Rio Tinto’s purchase of Alcan gives it critical mass in the aluminium market in one easy step, without having to hire a single digger. Of course, if miners are just buying one another up, rather than discovering new sources, this puts more pressure on supply.
Another factor that will ensure demand remains solid is China. The Shanghai skyline may have changed out of all recognition in the last 20 years, but China still has a long way to go in its industrialisation. Mammoth quantities of steel will be needed to build the skeletons of the new cities springing up around the country. New homes and offices will have to be floored and fitted with aluminium. Beijing’s plans to build 108 new airports by 2010 alone would be enough to justify a bid for any steel, aluminium or copper miner. China is already expected to increase its consumption of aluminium by 15% a year over the next five years, despite already accounting for 26% of global consumption. Rio Tinto expects China’s economy to grow by as much as 9% a year until 2015 and beyond, says James Harding in The Times.
And as millions of Chinese are lifted out of poverty, they will start to fill their homes with the trappings of a middle-class lifestyle – the fridge, the washing machine, the car. The same story will be repeated across India, Latin America and the developing world. This is a long-term trend – any short-term downturns in the global economy will merely slow it, not reverse it. All of this will require the mining sector to produce a wealth of raw materials in the coming years. So it would be hard to disagree with JP Morgan’s Ian Henderson when he asserts that “we have entered a secular bull market for commodities that may well give the sector 15 years of further growth”. We look at some of the best plays below.
Commodities: three miners striking it rich
Rio Tinto (RIO) has long been a favourite at MoneyWeek. The company makes a shed load of money, generating $1bn of free cash a month, but still trades very cheaply on a forward p/e of 11.8 for 2008. The deal with Alcan gives it exposure to booming demand for aluminium – a very attractive play on China and India’s building plans. Rio is also confident that it can squeeze $600m of cost savings out of the acquisition. The deal would make Rio the world’s largest producer of aluminium, a position it already enjoys in copper and iron ore. That might scare off private-equity groups, but it remains a very attractive play on the commodity supercycle for the retail investor. BHP Billiton (BHP) is another well-diversified miner that looks unfairly undervalued on a forward p/e of 12 for 2008. Earnings accelerated 70% last year on the back of resource demand from India and China. The stock pays a nice 1.6% dividend.
Of the smaller players in the sector, JP Morgan advises taking a look at Kazakhmys (KAL), Kazakhstan’s biggest copper producer, which is trading on a p/e of 8.5. JP Morgan estimates that this puts it at 34% below its true value, says Steve Hawkes in The Times. Given the high price of copper, it should make up the ground quickly.