“Hungry China will dig miners out of a hole,” said a headline in The Sunday Times this week. This may be true – just not quite yet. Chinese demand has been the main driver behind the huge boom in commodity prices over the last few years, but with the headlong rush for growth in the east now fading as western economies slump, the big mining groups are facing the prospect of having to survive the next few years without ever-increasing demand from the country.
Between 50% and 100% of the increase in demand for commodities over the past five years has come from China, according to David Roche of consultancy Independent Strategy. But for all the copper, iron and steel that China has fed into its construction plans and the talk about its rising domestic consumption, the fact remains that the country’s demand for commodities has as much to do with what it exports as it has with what it builds and consumes at home: about half of the commodities used in China end up one way or another in an export of some kind. So, as we stop splurging on Chinese-made furniture, TVs and shoes, clearly China-related commodities demand will soften.
That’s bad news for miners. Goldman Sachs’s analysts estimate that if Chinese growth slips to 8% next year (it is currently forecast to grow at 10%), the price of most metals will fall by 30%-plus. And whatever the bulls may say, by this time next year it is entirely possible that even 8% will look optimistic. Inflation is uncomfortably high, with wage costs exploding and food prices rising at a nasty 23% year-on-year. That means that just as China’s main export markets start contracting, Beijing is going to be forced to bear down on inflation (hence stifling domestic growth). Already, says Clem Chambers in Forbes, China’s ports are packed with tankers filled with metals no one needs to unload.
But falling Chinese demand isn’t the only problem vexing the miners, says Randgold Resources’ Mark Bristow. Their profits are also being squeezed by their own rising costs. Not only are fuel, salary and equipment costs slamming margins in their existing mines but they are spending a fortune in the effort to find new reserves ($7.5bn last year alone), something that, given the huge boom-time costs of securing sites, equipment and engineering expertise, is often not rewarding.
No surprise, then, that the big mining groups have also been buying smaller outfits – often at whopping premiums – to pick up new reserves. So much so that mining has replaced financials as the main driver for mergers and acquisitions – chalking up $199bn in the first five months of this year. The problem? “The industry hasn’t grown at all in terms of production,” says Bristow. “It’s simply got a larger market capitalisation and less profits.”
The total market capitalisation of the world’s leading mining companies has increased by 1,300% in the past 13 years. But with metal prices faltering – Goldman now expects zinc and nickel mines to close as the metal prices fall below current high costs of production – that might mean valuations have risen a little too much.
As David Stevenson says in the FT, using a cyclically adjusted pe ratio, the mining sector is on almost 60 times earnings, against a historical average of 16. “The mining industry is creating a dotcom-style bubble with dizzying market valuations, but which make no money,” says Bristow. If you are still holding mining stocks, you’ve had a good run (see below) and there will be a time to buy back in (the next few years should be only a blip in the upward march of most commodity prices), but take your profits for now.
Take profits on your mining stocks
This is not the first time we’ve suggested you take profits in the mining sector. Back in November, we said something similar and noted that if you sold you would have doubled your money on the likes of Rio Tinto (RIO) and BHP Billiton (BLT) last November in relatively short time.
Those of you who hung on would have seen Rio jump around from 5,000p to 7,000p and back to 5,000p in the past six months. And you would have seen BHP Billiton climb almost 40%, before falling back to its original levels in that time. From here we think it will fall further, as will most other mining stocks, regardless of how cheap they may look right now.
Xstrata (XTA) may still look reasonably priced on a forward p/e of 9, but it has risen nearly 70% since we tipped it in 2006. And while Goldman Sachs’s analysts currently like the look of Anglo American’s mix of coal, platinum and iron ore – it has just negotiated an 85% increase in the price of iron ore – it is worth remembering that the stock has risen 78% since we tipped it in November 2005. Anyway, price aside, how much iron ore will the Chinese want, once the country’s economy tanks?