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Coal, Copper and Ore: More Than Just Mines

The commentary below is for the benefit of our readers from opinion makers and writers not associated with Euro Pacific. We do not guarantee the accuracy and completeness of third-party authored content. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific, or its CEO, Peter Schiff.
By: 
Dian L. Chu
December 2, 2009

Broad capital spending cuts, and curtailed production have landed machinery companies in the pits but mining equipment makers will likely be among the first to emerge from under the recessionary rubble. The reason is that commodity prices are up substantially from their recent lows, at a time when the world is running out of all those precious natural resources.

Highly Coveted Resources

The main commodities driving original equipment and aftermarket parts demand include coal, copper, and iron ore. Developing nations are heavy users of natural resources including copper, coal and iron ore. The developing world is estimated to use roughly three to five times more commodities for every one percentage point of GDP growth than the developed countries.

Coal – Rush to Power

While coal production in the U.S. has slowed in part because of environmental concerns, such concerns haven't slowed developing nations coal rush to fuel industry and generate electricity.

According to BP Statistical Review of World Energy released in June 2009, global coal consumption rose by a "below-average" 3.1% in 2008, yet coal remained the fastest-growing fuel in the world for a sixth consecutive year. China is the world's largest coal consumer with a 43% share in 2008.

The main driver of demand for coal (and natural gas) is the inexorable growth in energy needs for power generation. Coal remains the backbone fuel of the power gen sector. In its World Energy Outlook published on Nov. 10, 2009, the International Energy Agency (IEA) projects coal to see by far the biggest increase in demand globally over the projection period of 2007 to 2030. The IEA further expects coal's share of the global generation mix rising 3% to 44% by 2030. (Fig. 1) China will account for the lion's share of power gen capacity growth.

The US EIA also projects world coal consumption increases by 49% from 2006 to 2030 (Fig. 2), and that China's coal consumption to grow at an average annual rate of 2.7% through the year 2030. Because China has limited reserves of oil and natural gas, coal remains the leading source of energy in its industrial sector. As China boasts 13% of the world's coal reserves, the country is expected to continue to meet a majority of domestic demand with coal-fired power through 2030.

Copper – Hard to Substitute

Right now, China seemingly is the only buyer of size in the global copper market. China's $586 billion stimulus package, launched late last year, is starting to stir demand, particularly among wire fabricators. In addition, strategic stockpiling and private speculative demand have reportedly also helped push copper prices up by more than 100% in a year (Fig. 3), as copper imports into China have more than doubled in the first nine months to 2.6 million tons.

State-backed research group Antaike predicted that in 2010, China's real refined copper consumption is expected to rise 8% on the year supported by the power, building and home appliance sectors. This year's consumption is estimated at 5.4 million tons, up 10.2%.

Another bullish sign for copper is the announcement of a technology agreement between Codelco and Rio Tinto (RPT), two of the world's biggest copper mining companies. This type of collaboration would have been unimaginable not so long ago. It also seems to suggest a supply constraint on the horizon for these two rivals to start this joint effort to discover new ways of uncovering more geologically difficult deposits.

While plastics, fiber optics and wireless have replaced copper in some of the piping and telecommunication applications, wiring for emerging economy's essentials such as cars, motors, and power generation & distribution are seen as fairly protected from substitution.

Ore – Drive to Build

BHP Billiton (BHP) chief executive Marius Kloppers underlined the scale of demand expected from fast-developing nations when he said China alone may require five times as much iron ore in the next 15 years as it had in the past 15 years. Also fuelling China's resource hunger will be further urbanization, with the country expected to have 220 cities of more than one million people by 2030, compared with Europe's total of 35 now. BHP is the world's biggest mining group.

In Its 3rd quarter 2009 earnings release, Vale S.A. (VALE), the world's largest ore producer, indicated it is restarting iron-ore plants idled during the economic contraction and boosting output of the steelmaking ingredient to meet higher demand from China, Europe, Japan and Brazil. Third-quarter ore shipments rose 36% sequentially, while average prices increased about 20%.

In the quarter, Vale S.A. sold a record 39.8 million tons of iron ore to China, where rising imports are almost certain mainly due to high local production costs. Vale S.A. estimated world steel output may rise 9% in 2010 to levels before the global financial crisis.

Auction & Rental Also Thriving

One interesting trend in the equipment sector is the thriving rental and auction business. Tight credit and slumping demand has incentivized companies to increase their equipment rental budget, thus avoiding large capital commitments, while equipment dealers are forced to farm out their fleet in the auction market.

United Rental (URI) Hertz Global Holdings, Inc. (HTZ) and are two big players in the heavy equipment rental sector. Meanwhile, equipment giant Catertpillar, Inc. (CAT) has crawled into the auction territory through Cat Auction Services, which is owned by CAT dealers and the Big CAT supports the brand.

Investment Threshold Crossed

Although coal and copper prices have declined from relatively high levels in 2008, prices currently remain above the investment threshold for new equipment, which is generally considered to be $1.30/lb for copper and roughly $41/ ton for coal, according to Caterpillar, Inc. (CAT).

Higher Margin Recovery

As customers are delaying new purchases opting to maintain existing equipment with after-market parts, the sector has seen its backlog taking a hit. But now companies are saying there's an increase in activity in regions including Australia, Latin America, and China. China alone accounts for 25-30% of global copper consumption, and is the biggest consumer of coal in the world.

Analysts said these regions and products tend to carry margins that are comparable to levels seen in the U.S. In addition, commodity related products in mining usually carry above average margins.

Increases in mining equipment demand will partly depend on the effects of government stimulation packages, and the continued stabilization of financial systems. Commodity prices, though tenacious, are extremely volatile. Nonetheless, the rally in commodities prices has led to increased investor optimism in recent months for mining equipment makers such as Bucyrus International Inc. (BUCY), Joy Global, Inc. (JOYG) and Terex Corp. (TEX). (Fig. 4)

Mining Gear Required

Goldman Sachs last week raised price targets on several coal miner stocks noting "Coal stocks have performed well... We believe the last leg up for coal stock multiples will come from greater recognition of supply constraints in the Pacific."

Increasing commodity production often requires incremental new equipment to meet the higher production schedules and also serves to increase utilization of existing equipment in operation. This trend should help with increased demand for the original-equipment business, as well as its after-market business going into next year and future years to come.

Play on Commodities & Emerging Markets

The mining equipment sector also serves as a good alternative to investing directly in the commodity and emerging markets. The sector should continue to benefit long-term from developing countries improving their infrastructure while consuming more raw materials. The valuation discount relative to their machinery peers should continue to narrow as commodity prices climb on developing regions demand and supply constraints.

Dian L. Chu, M.B.A., C.P.M. and Chartered Economist, is a market analyst and financial writer regularly contributing to Seeking Alpha, Zero Hedge, and other major investment websites. Ms. Chu has been syndicated to Reuters, USA Today, NPR, and BusinessWeek. She blogs at Economic Forecasts & Opinions.