MINING FINANCE
China and the Commodity Markets
David McKay
Posted Fri, 23 Dec 2005

[miningmx.com] -- IN September, Chip Goodyear, CEO of BHP Billiton, the world’s largest mining company, said the world had changed forever. Roughly 20 million to 30 million people in China were making their way from rural to urban centres. “They are saying: ‘This is our century’,” said Goodyear.

“Of the nine billion people on earth, some 2.7 billion are classified as consumers with 1.2 billion of these living within Western markets. The number of consumers living elsewhere is growing fast and could more than double by the end of the decade,” wrote John Meyer, an analyst for Numis Securities.

What this means is vaulting consumerism. The newly urbanised need houses and offices to work in as well as roads and cars to help them commute. And while they live in the cities, they also need the normal trappings of modern life from hairdryers to toasters. The demand on basic manufacturing materials is consequently huge.

The potential of China has been common knowledge for years, but in 2004 it was anticipated that the pace of the world’s fastest growing economy would start to slow. But 2005 has shown no let up. In fact, Chinese authorities are now having to impose measures to help slow down growth.

The impact on world stock markets has been significant. Net operating cash flows of the world’s top mining companies doubled to $41bn in 2004, according to a survey by PriceWaterhouseCoopers. The expectation is for further growth this year. In June, BHP Billiton was generating £22m in net profit per day. Xstrata, another diversified mining house listed in Britain, was generating £6m/day.

And the leverage of the mining companies to metal prices has become a significant factor owing to the runaway value of certain base metals, such as copper. Every 10% change in the copper price is worth $350m additional to Xstrata’s pretax earnings.

The outcome is that many mining companies have more cash than they know how to properly use. This is reflected in the $2bn share buy-back by BHP Billiton and a similar $1.5bn capital programme by Rio Tinto. Last month, Anglo American unveiled its own $1.1bn cash return to shareholders.

The question is whether the commodity boom can last another year. Some believe it can.

John Reade, a precious metals and currency strategist at UBS Investment Bank in Britain, said that the $50bn to $100bn invested in the world’s commodities markets by investment houses could be inflated by a portion of the funds diverted from the $50 trillion currently invested in general markets. “There is a wall of money on its way and coming to a commodity market near you,” Reade said.

Apart from the increase in demand from China, and to a lesser extent, India, there is also a structural problem in the world’s mining industry exacerbating the supply deficit. This is the years of under-exploration which has meant that mining firms can’t find enough new sources of metal quickly enough. There’s also massive pressure on resources needed to mine products – such as rubber tyres and machinery – and shipping under-capacity.

Johannesburg’s Resource Top 20 index subsequently gained 60% this year to end-November. Anglo American gained 58% in this period, BHP Billiton gained 56% from when it peaked in October. Even the smaller shares, such as Metorex, a once sleepy mid-tier mining firm, gained traction in 2005. It’s share price gained 96% during the year largely on the back of prospects for its copper/cobalt operations in the Democratic Republic of Congo.

In fact, Africa has been one of the major beneficiaries of the continued commodity boom during 2005 because it has opened up as a major investment destination, notwithstanding its political risks. For example, Actis, a Canadian fund, has established a pan-African $162m Canada Investment Fund for Africa (CIFA) in Accra, Ghana. It is joined by Cordiant, a prime Canadian emerging market asset manager.

The scramble for market share among mining firms has resulted in some interesting merger and acquisition developments. Xstrata has twice failed to breach the Australian market having been outbid for WMC Resources by BHP Billiton’s $9.2bn bid. Inco bid $12bn for Falconbridge after Xstrata had paid $1.6bn for a 19.9% stake in August. But one of the more interesting tussles was Anglo American’s bid for Kumba Resources, a two-year long struggle that was finally resolved in October.

Anglo owned about two-thirds of Kumba Resources, but Government had insisted it drop its stake to below 50% preferring instead to preserve the independence of one of SA’s best new mining firms. However, a meeting between Anglo CEO, Tony Trahar with President Thabo Mbeki earlier this year, ostensibly about the British firm’s end-year results which had just been published, settled the matter.

Months later, Anglo American unveiled a plan to split Kumba into halves and separately list Kumba’s iron ore assets in which Anglo would have a controlling stake. This was the key. In the world of commodities, iron ore is the prom queen.

Used in the fabrication of steel, annual contract prices for iron ore between miners and their, predominantly Chinese and Japanese buyers (steel producers) were settled at a 71.5% increase in April. This was already on the back of an 18.6% price increase last year, and ahead of another quantum leap in pricing in 2006.

Companies producing iron ore can’t fail but to make themselves a fortune. It’s also one of the reasons that the world’s mining companies are falling over themselves to produce more of the stuff.

But is the commodity market about to cool. One alarming factor is the activities of a Chinese state trader, Liu Qibing, who took short positions in July and August on about 130,000 tons of copper on the London Metal Exchange, agreeing to deliver the metal by December 21 at $3,300/t. He bet prices would fall so that delivery could be made with supplies that were cheaper.

According to sources, the Chinese government is now out of pocket by an estimated $300m and Liu is under house arrest. The incident shows a lack of corporate governance in trading circles and is indicative of the excesses of a market at the top of its cycle.