A Politician in Every POT
Source: David Coffin & Eric Coffin, HRA Advisories (11/17/10)
"Large pools of cash are now scrambling to get into metals in response to policy concerns."
Longer term, we have no concerns but short-term things truly are overdue for at least a small pull back. Most of the expected good news has been delivered at a market level and buyers seem to be running out of reasons to keep buying. Add to that a tsunami of institutional money that, contrary to popular opinion and fund marketing brochures is often the last in, and we think things will settle for a while here.
A brief dollar rally began after the U.S. elections and the official announcement of quantitative easing 2 (QEII) by the U.S. Fed. The two created a great trading week in currencies, but more so in commodities. QEII has become a lightning rod for policy concerns surrounding the greenback. Combine this with on-going concerns out of Euroland and expectation of continued strength for hard assets, which we expect to continue for a while yet. While obviously good for the metals space, a more cautious approach by those who were early in the metal price moves should still be the order of the day.
It isn't clear whether the new Republicans in the U.S. Congress will extend a tax cutting focus to actual deficit cutting and the true fiscal easing that brings. They may push towards balanced budgets and create a cross Atlantic alignment which could prove highly useful, but that will be next year's story. The start of QEII makes it clear monetary expansion is still favoured in Washington. This "weak dollar" policy in all but name has been jet fuel for metal prices.
Large pools of cash are now scrambling to get into the metals space in response to these policy concerns. These require liquidity and ideally an element of leverage, as well. That has been bringing funds into mid-tier producers, and increasingly into explorers with larger assets on offer. This isn't, so far, a tide lifting all boats. Precious metals and copper are still favoured areas, plus situations that look like potential take-over candidates. We have some comment on what makes a junior take-over candidate, after some thoughts on a take-over that now looks unlikely.
The decision by Canada's federal government to not allow the bid by BHP Billiton for Potash Corp of Saskatchewan (POT-T, N) will be a starting point for further discussion. A lot of market minded Canadians either agree with the decision or at the least have been voicing mixed feelings on the bid. Many domestic commentators have suggested it's a bad omen for Canadian markets. We don't think so.
The government of Saskatchewan led opposition to the bid by labeling it a special case. POT has half of the world's defined potash resource in hand as well as 30% of current output. The deposits it mines are rich, but also deep and expensive to capitalize. Even though the province vested its shares of POT into public markets long since, it has concerns about revenue streaming and more simply about how major mineral suppliers are regulated.
BHP counterpoints that POT sells through a Sask-based marketing agent that handles all of the province's potash orders. It is the effective price setter for potash. BHP said it would do its own sales directly and let the market set prices, while pushing as much product into the market as it could. That might reduce the Sask government's tax revenues and jeopardize its other potash producers if it knocked prices down. Realistically this would be very unlikely to sideline existing production, but it could dampen new development.
These statements on marketing by BHP bid were what set off the alarm bells in Saskatchewan. The company may have expected a sympathetic hearing about breaking up a cartel-like oligopoly. However, BHP has used a similar price setting mechanism for iron ore and the breakdown of that system now appears to favor large sellers. But there is no reason to point fingers in either case—price setting systems for bulk minerals allowed miners to operate through decades of low margins. Oligopolies surround bulk minerals because no one else wanted to play.
Those low margins prevented capital infusions to mining, and hence supply constraints now that more buyers are available. The Saskatchewan government could adjust the taxing of potash to increase its revenue stream, but that's not its biggest concern. Large mining concerns have become big pools of wealth after a century in the wilderness, and the real concern is over who controls the authority that wealth brings.
In 2000, the BHP valuation (prior to the merger with Billiton) bottomed at $15 billion—or less than half its offer for POT. Today BHP is in the top 1% of corporate scale, and taking over POT is one of the few ways it has to expand at scale. The billions required for a new potash mine is much easier to find than it had been, but still requires a pool of expertise and underlying financial assurance to do. Canada giving that up, again, is the real issue.
Canada has lots of expertise in financing and developing deep mines. During the nickel company takeovers we and others argued that the equity gains could circulate back into start-up companies that are an important part of the country's mining market. Others argued that losing them and Alcan as independents "hollowed out" the Canadian industry, and that argument has gained ground in the past few years.
Market ethics were pushed aside to deal with the Credit Crunch. Canada's "plodding" banking sector enjoyed the fruits of its prudence while competitors imploded. A special case its true, and it wasn't just Canadian banks that eschewed the advantages in front of them. Two years from that nadir a much improved future for resource sectors is an established fact. Scarcity and allocation of resources is a growing, and a "special", concern.
Any area with a large share of a mineral market is going to be drawn in to those concerns. The POT output and assets will be a part of that. As a fraction of any corporation large enough to bid for them they could become levers that press the mining jurisdiction to choose between competing forces quite outside the potash business. We are in the mixed feelings camp, but do respect the simple truth that no one has a "right" response to the bid. A pause to rethink the rules even at the expense of blunting market forces makes sense for everyone this time.
M&A Continues Apace
The two copper companies we follow that are in the midst of being taken-over show two aspects of M&A. The Globestar deal prices in cash flow projections from its existing mine, with several other assets as a potential bonus for the buyer. The Antares takeover is based on an evaluation of a single asset still years from cash flow. What makes them similar?
Obviously both being copper stories does. That's not a coincidence. The Crunch related downdraft for metal companies has been worked out of the market, and copper's supply constraint is topical. Some will question whether that's a red flag for the sector. History does indicate that take-over heats up at the bottom and the top of warehousing cycles—when assets are cheap or when buyers are flush. In this secular cycle it is about buyers being flush, which may signal an intra-cycle consolidation point. Few believe it's a true top for copper, including us. That being true, more of the same is likely.
Another important similarity is a regional upside potential for the buyer, each at its own scale. The Cerro de Maimón mine is the only one dealing with VMS deposits in central Dominican Republic. Since these high-grade systems tend to travel well, that makes the Globestar buyer the regional go-to for other deposits in the district. While Antares' Haquira is a one off, it is in Peru's rapidly expanding copper belt and this gives buyer First Quantum entry to arguably the best place to expand outside of its African base. So yes, location is important.
That leaves scale and quality. While shareholders would prefer discoveries to be large, it's actually buyers' scale that is important to the deal. The Globestar operation is a scale we have been avoiding at exploration level since the crunch, but it's also profitable for a smaller producer. For metals with diversified supply like copper or gold there are buyers at most deposit scales and the GMI bid now opens up the field for other deposits of this scale. Scale is more important in subsectors with fewer buyers, but keep in mind that very small markets don't need big deposits. Quality is more important to them.
Quality is a big subject that we will leave for now, outside of comments in the various updates.
It's a secular bull market for metals and resources. We've been saying that for nine years. And we've been right. Another thing we've been right about is the growing importance of the Yukon as an exploration destination and, more recently, Area Play. HRA was there early and continues to follow several of the biggest winners in the play and is tracking dozens of others for potential inclusion in HRA publications.
CLICK HERE to access your FREE Yukon Report from HRA now! HRA initiated coverage on 15 companies since early 2009 – the average gain to October 10, 2010 is 278%!
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