Industrial Commodities Update
Below is an extract from a commentary originally posted at www.speculative-investor.com on 16th December 2007.
There's a good chance that the price of copper will drop to lower levels over the next few weeks, but the price decline from the early-October high of around US$3.80/pound to the current level of US$2.95 has removed a lot of the short-term downside risk. Our thinking is that the price could decline by another 10-15% before a bottom is reached, but looking out over the next three months the downside risk and the upside potential appear to be roughly in balance. It's a similar story with most of the other industrial metals, which is why we recently upgraded our short-term outlook from "bearish" to "neutral".
Our expectation is that there will be a tradable rebound in the industrial-metals commodity group during the first quarter of next year, propelled by seasonal factors -- the metals tend to be strong during the first few months of the year -- and stock market strength. The short-term relationship between the stock market and the industrial metals is clearly evident on the following chart comparison of the S&P500 Index and the copper price.
Below is a set of charts comparing the cash prices of copper, zinc and nickel with the 27-month futures prices of these metals. Notice the difference, in each case, between the performance of the cash price and the performance of the 27-month futures price. In particular, notice that the cash price appears to have formed a major top in both the zinc and nickel markets and is potentially tracing out a major topping formation in the copper market, whereas the price charts showing the 27-month futures prices look far less ominous. In fact, the 27-month futures price in the copper market made an all-time high as recently as October of this year and has only just pulled back to support defined by its May-2006 peak, whereas the cash price of copper is presently about 25% below its May-2006 peak. And in the nickel market, the 54% collapse in the cash price from this year's high to this year's low was accompanied by a far more respectable 30% pullback in the 27-month futures price.
The 27-month charts suggest that the long-term outlooks for the industrial metals are nowhere near as bearish as the cash charts seem to imply. This is probably why the stock prices of most of the world's major producers of industrial metals have held up so well in the face of plunging spot prices for the metals.
On a few occasions over the past year we've expressed our bullish outlook on coal. Despite its drawbacks, coal continues to be the world's major fuel source for electrical power generation and is likely to remain so for a very long time to come. Furthermore, it is an especially important fuel source in China.
As has already been the case with many other commodities, China looks set to create considerable upward pressure on the coal price over the next few years as it shifts from being a net exporter of coal to being a large net importer of coal. In fact, there were several months this year when China's coal imports exceeded its exports, which probably goes part of the way towards explaining the gains made by the coal price since the beginning of 2007. And as evidenced by the following weekly chart, these gains brought to an end the multi-year downward correction in the coal market that began around mid-2004.
Although we've been bullish on coal we haven't had any real exposure to this fuel source in the TSI Stocks List. Our Red Hill Energy (TSXV: RH) is an exploration-stage coal miner, but it is a dramatically under-valued asset play that happens to be involved in the coal business rather than a direct play on the coal price. To put it another way, RH will either be a failure or a spectacular success based on company-specific developments almost regardless of what happens to the price of coal, although a stronger coal market will, of course, make its massive coal deposit more valuable and increase the probability of a takeover.
We are now going to add a more direct coal play to the TSI Stocks List in the form of Patriot Coal (NYSE: PCX). We thought about waiting for the current stock market pullback to run its course before adding PCX to the List on the basis that general stock market weakness in the near future could lead to a more attractive entry price, but the coal sector has lately been demonstrating considerable strength relative to the broad stock market so the short-term risk seems to be more on the upside than the downside.
PCX was spun off from Peabody Coal (NYSE: BTU) in October. It operates coal mines in the US that have a combined total of 1.27B tonnes of P&P coal reserves and 24M tonnes/year of production. About 23% of this production is metallurgical coal and the rest is thermal coal. With 26.5M shares outstanding, its current market cap is around US$931M.
Here's a quick summary of what we like about PCX:
1. Its price-to-sales ratio is less than one, which means that by this measure it is selling at less than one-third of BTU's valuation (BTU's current price-to-sales ratio is more than three).
2. It is also vastly cheaper than BTU on a price-to-cash-flow basis.
3. BTU's chairman resigned from BTU to become chairman of the spin-off (PCX). It is very unlikely that he would have done this if there were anything wrong with the assets being spun off.
4. Both the CEO and the chairman of PCX have bought a significant amount of the company's stock in the $31-$35 range (near the current price) on the market over the past three weeks. Insiders sell the shares of their companies for many reasons, but they usually only buy if they believe the shares to be substantially under-valued.
PCX began trading less than two months ago, so the following chart shows PCX price data since late October and BTU (the parent company) price data before that.