Sometimes you can buy assets in the stock market for cheaper than what it would cost you to get those same assets in the private market. Taking advantage of the gaps between the two is what investing like a dealmaker is all about. Such a gap, it seems, has opened up in the mining sector.

I think the gap exists because people in the mining business understand two things that stock market investors have yet to fully grasp. First, there is a growing scarcity of high-quality mining assets. Second, there is a shortage of skilled workers. Simmons calls it a “blue-collar boom in mining.” So stock prices don’t yet fully reflect these realities, and prices are cheaper than prices miners get when they buy assets from each other – or start them up from scratch.

First, let’s size up the scarcity of high-quality mining assets, which has led to something of a race to lock them down. For evidence of that, we need look no further than the merger-and-acquisition market. For the first five months of the year, the announced mining takeovers tripled compared with a year ago. The total, about $200 billion in deals, puts mining mergers at the top of the M&A list for the first time since Bloomberg began compiling the numbers, in 1998. Over the prior two years, financial services companies have led the pack.

This feat is even more impressive when you consider the storm in which this financial torch has passed – amid a U.S. recession, growing inflation and an unfolding credit crisis. Global M&A overall is down 37%. Yet there is the mining industry atop the dealmakers’ pile, grinning ear to ear and still flush with cash for even more and bigger deals. The world’s biggest mining transaction ever would be BHP Billiton’s $147 billion bid for Rio Tinto. Transactions this size would have been unimaginable even five years ago.

What this means, in my view, is that mining companies think it is cheaper to buy mining stocks than it is to open new mines. It’s pretty simple. If you can buy eggs for $1 or raise your own for $3, you buy eggs all day long. New mines are hard to bring online. And it takes a lot of time. As a Morgan Stanley adviser recently put it, “If companies want to grow, they can either find something that might take 10 years to develop or buy something,” he said. Even so, exploration is up, as well.

There is a lot of risk with new mines, too. Especially since many of the new sources of mines are in politically unstable parts of the world, like Africa, or are difficult and expensive to mine. What new deposits have been found also tend to have lower grades. That means the resource isn’t as concentrated and there is more filler to process to get to the good stuff, be it copper, zinc, iron ore or what-have-you. Repeatedly, too, I hear mining companies warn about rising costs – for labor, equipment, energy and transportation.

The newer twist to the metals story is the power supply problems of many countries – South Africa, Chile, China and others – all important producers. Years of underinvestment in power supply – an issue I’ve written to you about before – is a global problem. And you can’t fix it by flicking on a switch. It takes years to build power plants and add capacity.

South Africa is a particularly egregious case of power shortages. The effect on production is devastating. In the first quarter, mining output fell 22%, to its lowest level in 40 years. Mining companies in South Africa face the risk of repeated power outages and/or forced reductions.

Chile is suffering from severe power shortages, too. It depends on Argentina and Bolivia for natural gas. As the latter two countries consume more natural gas, they export less to Chile. Chile’s water levels are also 40% lower than a year ago. Since Chile depends on hydroelectric power, this is a big problem. Electricity costs are skyrocketing in Chile. As it makes about 35% of the world’s copper, its ability to expand or even maintain that production in the face of power shortages is in doubt.

These are just two examples, but there are certainly many more. Another factor holding back new supply and making existing mining operations so valuable is the lack of skilled people. Companies doing everything from mining coal to operating offshore rigs all note the big challenge in finding enough qualified people.

The traditional skills are in short supply – people who can run a machine shop or a mining operation, for example. These skills are also not easily acquired. Yet a wide gulf exists between what these people make and what the guy running a mortgage trading desk on Wall Street makes.

As Michael Aronstein, a longtime money manager and strategist, recently put it:

“The relative compensation [difference] between somebody who is sitting on a derivatives desk and a guy who actually can diagnose and repair a locomotive has probably reached its millennial extreme... But that’s going to change. I think we’ll see the narrowing of all these spreads, a process that started at the lows in ’02.”

Add all this up – the hot M&A market, the power supply problems, worker shortages and more – and the bottom line is that supply is having a hard time meeting demand.

And demand is there, fueled by booming economies in China, India and Russia. In fact, much of the M&A business comes from these three countries. They need new supplies of metals to keep up with demand at home. For example, Aluminum Corp. of China and Sinosteel have spent more than $16 billion buying mining assets across the globe. These companies are looking to secure raw materials such as coal and iron ore.

Mining stocks, not surprisingly, have done well over the past couple of years, even as the broader market has gone nowhere.

For example, S&P’s Metals and Mining ETF, a decent proxy for mining stocks, has doubled over the past two years. The overall market has barely budged.

Yet the view from the ground, as the foregoing argues, seems to be that mining stocks may still be too cheap.

Regards,

Chris Mayer

No doubt, for several of the reasons outlined, SAN is in "play!"

Just a matter of time. After the recent "thrashing" $3 to $5 is beginning to look like a "bonanza!"

A disgrace considering the fundamentals!

RUF