Copper Better Than Gold But It’s No Bargain
6/18/2012 @ 2:03PM |3,697 views
Where, oh where, has the commodities supercycle gone? I’m all ears for racy, leveraged stories, but commodities leave me cold, even after their latest sinking spell. Months ago, based on supply-demand metrics, the right price for WTI crude oil was $90 a barrel, not $110. WTI now trades in the mid-eighties, woebegone.
Welcome a big consumer dividend. The price of gasoline at the pump, down 10 percent, should drop another 10 percent this summer. Same goes for diesel fuel, so bills for heating or cooling your home come down. Meantime, metals and agricultural commodities like corn and copper keep coming in, at least 20 percent off 12-month highs.
While the clearing price for oil is $90 a barrel in terms of bringing in new production, copper’s clearing quote is closer to $2.70 a pound for new mines. Spot copper trades around $3.40, down from over $4 months ago with plenty of room on the downside.
The demise of coal came in a whoosh. Mines are closing from Pennsylvania and Kentucky to Australia. Steam coal prices crumbled as inventories at mines and utilities piled up. With the crash of natural gas prices, North American utilities rapidly shift from coal to gas. Shortly, our utility bills should decline, possibly for years to come.
Worldwide, high cost steel mills are shuttering as capacity utilization, including China’s, contracts. For major users of sheet steel like auto makers, materials inflation is history and their cost of goods, a big percentage of total operating expenses, must ease, possibly for a couple of years. Go, General Motors!
News at the margin is dismal: There are dozens of ships filled with coal floating offshore China looking for buyers. Debentures of coal producers rated BB to single B came in over 10 percent in recent months, several now trading in the eighties. International coal operators like Peabody Energy trade at 30 percent of last year’s high and at 10 times most optimistic earnings forecasts.
The outlook is less dreary for iron ore properties like Vale, but still tied to the level of Chinese steel production. Substitution of natural gas for steam coal is pervasive, a worldwide phenomenon likely to intensify until natural gas prices rebound at least 50 percent from current quotes. Even low cost Powder River Basin coal is impacted in export markets.
U.S. Steel, trading at $18 a share, saw a high water mark of $196 in June ’08 and a current 52-week high of $47. Maybe, traders and commodities speculators with ice water in their veins apply their talents here-in. Spot steel quotes easily could drop another 10 percent.
The market capitalization of X, this battle scarred warrior, is $2.7 billion. By definition this makes it a small cap property with an illustrious but antiquated name tag. Let’s hope they don’t run through working capital this cycle. Small cap stocks, incidentally, continue to underperform the S&P 500 and Russell Growth Indices. Growth outperforms value benchmarks and emerging market indices.
For money managers needing to own something in the materials sector of the S&P 500 Index, just a 4 percent weighting, there are DuPont and Dow Chemical, polite plays. Someday, I’ll pounce on Freeport McMoRan, a low cost copper operator with near impregnable financials.
Any materials stock with a leveraged balance sheet is suspect. U.S. Steel’s $4 billion in debt overshadows its market capitalization. This invokes Mike Milken’s old MAD ratio. When the market value of debt exceeds the market value of equity, the financing capacity of the company in question is minimal except at draconian, high rates of interest. Some coal properties are already there.
Chesapeake Energy is another good current example. The market value of its stock, $15 billion, doesn’t match up to its debt, but fortunately Chesapeake has enormous asset value with sizable marketable properties. This is what Carl Icahn and others see. I’ve just bought Chesapeake’s B rated debentures, selling below par and yielding over 7 percent.
Lemme tackle copper and even gold. Conceptually, I like copper, particularly Freeport, but don’t own it as yet. No gut feel for copper pricing which keys off China’s weakening GDP momentum, currently near 7 percent, rather than past years’ 9 to 10 percent.
If you believe the world’s central banks ease aggressively near term, copper has possibilities. Replacement cost for a new copper mine sits around $2.70 a pound. For Freeport, as low as $2 a pound on new mines. An important metric is labor and materials at copper mines escalating as much as 15 percent per annum.
Copper could fall to its replacement cost of $2.70 a pound before mines start to shut down, reducing supply. At $2.70 Freeport trades at 4 times 2014′s EBITDA. This is fair valuation. With copper a little higher than current spot prices, Freeport earns $3.50 a share. A good working valuation is 10 times earnings which is where the stock ticks.
At $3.50 copper two years out Freeport sells at 2.5 times EBITDA, a low valuation. In a zippy global GDP setting, volume growth could run up 20 percent, futures ticking at $4.50 a pound. On $2.70 copper in 2014, Freeport would earn a couple of bucks so the stock would bottom at $25. Currently, the risk gain ratio is an even 20 percent, upside and downside. Not good enough to tempt me today, but let the stock break $30 and I’m ready to pounce.
The siren call in oil is the premium investors are willing to pay for proven reserves in the ground. It’s very low now. Most integrated energy properties price in long term oil averaging no more than $90 a barrel, where I come out. The chart on Brent crude since March has cascaded down from $125 a barrel to mid-nineties so we’re almost there. Exxon Mobil and Chevron, the biggest properties show negative market results, year to date. Viscerally, my feel is oversupply globally for years to come. A strong dollar is another price depressant.
Professionals value oil stocks first on a top down price-earnings ratio and then on a bottom up net asset value per share. The sector is not exactly a screaming buy but fairly priced, looking for a catalyst in world demand. Still not there.
Like copper and iron ore, oil is tied to China’s GDP momentum. If GDP in China holds around 8 percent, oil futures today tick in equilibrium. I see supply outstripping demand for years to come so I’m agnostic on oil properties and stick underweighted.
Chevron and Occidental Petroleum are exceptions. Chevron for its dividend paying capacity and OXY for some growth in domestic reserves with no downstream properties to worry about cyclical variance.
Give a cold shoulder to gold. Supply and demand are governed by the ebb and flow of investment in exchange traded funds and central bank demand, both unpredictable metrics. A strong dollar depresses gold prices as macro hedges come off. Long oil, short the dollar trade is now dysfunctional.
Gold producers face comparable cost escalation as copper miners. Gold as a commodity escalated the past couple of years, but valuation for underlying equities like Newmont Mining and Barrick faded away. Reserve life is relatively short for these operators so exploration and development budgets hold in place. Mining gold is a slog. EBITDA ratios for these stocks aren’t low enough to tempt me.
The reciprocal to the end of the commodities supercycle is cost of living for all of us comes down. My pivotal variable in forecasting at least 2 percent GDP growth is consumer spending hangs in, helped by a low savings rate and a fair-to-good confidence level. Historically, in a low inflation setting, growth stocks outperform, not oil, copper and gold.
Apple sells at a lower valuation than Freeport McMoRan. Set ‘em on the track and see who outlasts whom. The magic of technology is a given. With easing quotes for copper and coal, padlocked mines turn into deep pits filled with stagnant pools of water. Not exactly a zippy iPhone construct.
Martin T. Sosnoff is chairman and founder of Atalanta Sosnoff Capital, LLC, a private investment management company with $6 billion in assets under management. Sosnoff has published two books about his experiences on Wall Street, Humble on Wall Street and Silent Investor, Silent Loser. He was a columnist for many years at Forbes Magazine and for three years at The New York Post. Sosnoff owns personally and / or Atalanta Sosnoff Capital owns for clients the following investments cited in this commentary: DuPont, Chesapeake Energy, Exxon Mobil, Chevron, Occidental Petroleum and Apple.