http://www.hraadvisory.com/pdfs/mm_dec09_20_22.pdf

20 – MINING MARKETS – DECEMBER 2009 –
insight
Now that 2009 is drawing to a close, it’s time
to read the tea leaves and gauge how the metals markets
might perform going forward.
The U.S. dollar story is as much about the shift of
wealth to the East and disenchantment with Western
governments’ fiscal management as it is about
the perils of Wall Street. It’s following a path trodden
by many imperial currencies before it, and there are
good reasons to think the dollar will be at lower levels
before its fall ends.
The gold market continues to look good, as do the
gold explorers added to our Hard Rock Analyst (HRA)
list this year.
With that said, we’ll move on to look at the base
metals complex. Commodities in general and metals
in particular have been among the best performing
sectors of the market this year. This has led to a lot of
confusion among traders and commentators. Many
view current metal prices with great suspicion because
they are not doing what they are “supposed”
to. There has been grudging acceptance of recent
moves in precious metal prices, but prices for other
metals have many screaming “bubble!”
Are current base metal prices all about liquidity
and hedge-fund trading, or have there also been fundamental
changes in the market that point to good
things ahead? We are very much in the “good things
ahead” camp.
That said, most tradable metals are definitely getting
a heavy assist from the declining dollar. There is
no doubt some of this year’s renewed strength in base
metal prices is from traders using them as “anti-dollar”
trades or hedges against potential future inflation.
That does not negate the big picture story however.
Metals are in a secular bull market. While the
rapid reversal of fortunes comes as a shock to some,
this is what a secular bull market looks like.
For some perspective, take a look at Chart 1. This
49-year chart of the Commodity Research Bureau (CRB) metals
sub-index (copper, zinc, tin, steel and lead, mainly in scrap
form) shows just how dramatic the move that started in 2002
has been.

There are several important takeaways from this chart. The
first is that the last cycle, on the left side of the chart, ran for
about 18 years, which is roughly the average for a secular commodity
cycle. The current cycle is seven years old. The other is
that, as dramatic as the current lift is, it’s not that much larger,
in percentage terms, than the last one. The cycle in the 1960s
and ’70s entailed a 300% move from bottom to top in the index
versus a 350% move to the 2008 high.
Secular bulls share a couple of important differences with
bear markets. One is a pattern of higher highs as successive
economic cycles are passed through during the longer secular
trend. That is apparent in the last secular bull, with higher
highs in 1970, 1974 and 1980.
We are not through the first cycle in this secular trend but
the pattern should be the same with higher highs once a decent
global growth rate has been fully established again.
A final point worth noting with this chart is the timing of intermediate
tops in relation to recessionary periods which are
shaded in pink. During short term or “warehousing” cycles,
prices tend to peak well in advance of the onset of recessions
as supply growth overwhelms demand. This is apparent on the
chart where the index peaks well ahead of the start of recessions
during the 1980-2000 periods.
In contrast to warehousing cycles, secular bull markets
often have intermediate tops that do not arrive until a recession
is underway. This is because supply is much tighter and
becomes overwhelmed not so much through over production
as by a demand drop brought on by recession itself. Market
watchers who expected years of price weakness were drawing
on experience gained during a 20-year secular commodity
bear market.
The general tightness of supply, and the U.S. dollar’s continued
fall, help explain why metal prices started moving before
the current recessionary period ended. You
can see from the right side of the chart that
the bounce is impressive in terms of both
scale and speed.
Although there was a climb in warehouse
inventories for base metals in the past year,
those increases were much smaller than increases
during the 2000 recession, which
was significantly milder.
We got bullish about copper in the midst
of the market crash, because inventories
were topping out at a fraction of the levels
reached earlier this decade. We’re still bullish
longer term, but we added some shortterm
caution and suggested some profit taking more recently.
The reason for that caution is a more recent reversal in the
warehouse inventories that hasn’t been reflected in prices yet.
After dropping by 40% earlier this year, London Metal Exchange
copper inventories are again close to their winter peak
but there has been only a marginal pull back in copper prices.
The situation for zinc, lead, nickel and aluminum is more
extreme, with all of these metals now exceeding their spring
inventory levels while trading near 52-week highs. Either
there are pure anti-dollar and inflation insurance trades being
placed, or traders are exceedingly comfortable about forward
metals demand. We think both of these statements are true
but, with inventories rising, it would not take much bad news
to see a substantial price correction in the short term.
For that reason, we counsel caution until LME inventories
are again clearly in decline or a metals price correction has
occurred. Timing is unsure at this point but we are hoping to
see inventory draw downs again early in 2010 as economic expansion
in the western economies starts to gain some traction.
Longer term, we anticipate the mining sector will continue
to struggle to meet demand.
The debt crisis affected mining companies just like many
others. During the preceding few years, many mid-tier and major
producers focused on M&A activity as a growth driver. This
worked for some, but resulted in increased debt loads, particularly
in the case of the largest international mining houses.
Even though metal prices held up better than expected,
these companies were forced to cut capex and exploration expenditures
heavily due to high existing debt loads.
Many of these companies are starting to increase spending
again but many large projects are either stalled or have
had their projected start-up dates moved back by two or
more years. It’s likely we will see a repeat of the 2004-2008
periods where the market gets “surprised” by rapid inventory
declines as the debtor economies stabilize.
Things have been even tougher for the juniors in the base
metal space where financing is still a struggle. Until investors
have enough comfort to reward companies
for good base metal exploration results,
there will not be another major uptick in
spending.
Spot the Bear Market
It’s generally acknowledged that the major
stock markets are in a secular bear market
that began in 2000. This may be a caution,
but it’s important to remember secular commodity
bull markets tend to occur in tandem
with equity bear markets. That’s especially
true if the bear markets don’t happen to be
in the countries driving demand growth.
– MINING MARKETS – DECEMBER 2009 – 21
Vol. 2, No. 4, Dec. 2009
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22 – MINING MARKETS – DECEMBER 2009 –
One reason we were more comfortable early this year can be summed up by looking at the 10-year chart of the S&P, Shanghai and Mumbai Sensex stock indices. Other high growth and creditor/supplier economies like Brazil or Indonesia tell the same story.
It’s easy to make the case that New York is in the midst of a secular bear. The chart has gone nowhere in 10 years and is trading below the levels it occupied for most of the last decade even after a major rally.
Shanghai and Mumbai are a lot different. Technically, we do not see a case for either of these markets being in a secular bear market at all. At the height of the meltdown Shanghai and Mumbai bottomed at 50% and 100% above their 1998 levels, respectively. As we moved through this decade, correlation between the three markets lessened. It’s still fairly strong and the view of Wall Street as the equity “mother ship” still has validity, but the hold of New York on the rest of the world’s bourses is weakening and we expect that trend to continue.
These are major changes that do not happen overnight, but there is a clear and growing shift in financings to other currencies and other financial centers.
There is, of course, a good and simple reason why the charts for China and India’s main stocks exchanges look so different from New York: these countries were not in recession.
It will be a long time before these economies can replace U.S. consumer demand but they, and a few others, are already the driving force in the metals market. The developing world is accounting for an ever-larger percentage of world metals demand and already account for virtually all the demand growth.
If you want to know what resource prices will do, there isn’t much point in focusing on New York or London unless you are only interested in currency effects. Metals have outperformed expectations because of demand outside the G7. If the G7 countries can generate moderate growth in the next couple of years, that will simply add to the pressure on the mining sector to keep growing output.
We expect recognition of this fact will grow in the markets, as will the recognition that resources are one of the best ways to play the world’s growth economies while still trading in North American markets in home currencies.
There will be potential for negative surprises for some time, given the mess the US financial sector has made, but the drivers of the secular metals bull market are still intact. That applies not just to the countries that are generating high growth rates but also those that can help satisfy that resource demand.
For proof of that, you don’t need to look very far. Another exchange that didn’t see the lower major lows and lower highs this decade that define a secular bear market managed it largely thanks to a robust resource sector. That exchange is the TSX. MM
THE AUTHORS ARE BROTHERS AND CO-EDITORS OF THE HRA ADVISORIES NEWSLETTERS, WWW.HRAADVISORY.COM, AND APPEAR OFTEN AT MINING INVESTMENT CONFERENCES AROUND THE WORLD.
Vol. 2, No. 4, Dec. 2009