BlackRock’s Evy Hambro discusses dislocations between commodity prices and valuations of miners’ equities

Whilst commodity prices remained relatively robust in 2011 – in fact, copper posted its highest ever average annual price – many commodity-related equities were embroiled in the litany of challenges that unfolded through the year.

These included the Eurozone crisis, US debt ceiling debacle, earthquake in Japan, the Arab Spring, as well as concerns over low global growth and poor economic indicators, which shook equity markets during the bulk of 2011, driving volatility.

This heightened uncertainty has led investors to flee from risk assets, pouring into those investments traditionally considered to be safer havens, such as US Treasuries, UK gilts, gold and cash.

The dynamics between the gold spot price and the share prices of gold producers provide insight into the dislocation between commodities and the companies that bring them to market. The value of the yellow metal tends to go up in the periods of crisis as investors barricade their portfolios with bullion.

Likewise, during periods of extremely low interest rates, the opportunity cost for holding gold decreases; in fact, as inflation reaches elevated levels in many economies, that opportunity cost – the real return on cash holdings after inflation – is negative.

Yet these environments that favour gold holdings tend to be unfavourable for risk assets, as they often coincide with a high degree of market uncertainty. Gold producers are currently enjoying outstanding margins, but a quick look at their share prices would belie these favourable fundamentals.

Although in the short term, shares in commodity producers look less than appealing, the long-run fundamentals look favourable.

Supply and demand dynamics should prove positive as the infrastructure build necessary for Chinese urbanisation takes off.

While demand for industrial metals has subsequently ramped up, global supply has taken much longer to come online. In fact, structural change in the commodities sector can take 30 years or more, due to the levels of investment and political agreement needed for a new mine to be viable.

As a result, miners have struggled to keep up with this burgeoning demand, which has caused the price of industrial metals to rise. These heightened revenues have flushed miners’ balance sheets with cash, and as such companies are beginning to return this cash to investors in the form of dividends and share buy-backs.

Miners also benefit from strong operating leverage that has returned to the sector.

As a miner’s fixed costs tend to be high, percentage changes in revenue can translate into a higher percentage change in operating income when commodity prices are rising.

Put simply, it becomes more profitable to mine the same amount of metal and relatively more efficient to raise production if spare capacity exists.

In addition, the world’s biggest miners have been deleveraging: Rio Tinto cut net debt from £39bn in 2009 to £10bn in 2011, while Xstrata halved its debt from £13bn to £6bn over the same period.

The lower interest expense associated with less debt ultimately results in higher net income, leaving more cash available for capital investment.

Also, while supplies remain tight, production growth has nonetheless remained strong. Metals tend to be sensitive to recessionary threats such as recent fears of waning Chinese construction demand, but global metal production has nonetheless risen steadily.

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