Only supply disruptions drive commodity stocks higher right now--and here are two in South Africa

09/25/2012 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

In a booming global economy all that investors in commodity stocks seem to pay attention to is news about rising demand. China increases its imports of iron ore, and shares of Vale (VALE), BHP Billiton (BHP), and Rio Tinto (RIO) climb. Housing sales rise in the United States and take shares of copper miners such as Freeport McMoRan Copper & Gold (FCX) and shares of timber producers such as Weyerhaeuser (WY) up with them. Of course, there are always doubts about growth even during a boom, but investors aren’t doing much listening to the pessimists.

When global economic growth falters, like it has now, stories about demand have a harder time winning investor mindshare. When it comes to moving stocks, stories about excess or tight supply currently carry more weight.

Want an example from our supply conscious times? On Tuesday, September 18, crude prices and oil stocks fell on a surge in inventories as crude oil stockpiles rose by 8.5 million barrels to 367.6 million barrels. That blew through analyst projections of a 500,000 barrel increase. On the day, the price of a barrel of U.S. benchmark West Texas Intermediate fell 3.47% to $91.98. The price of shares of ExxonMobil (XOM) closed down 1.18%; shares of Pioneer Natural Resources (PXD) dropped 1.45%; and shares of Total (TOT) retreated by 0.88%. It’s not that investors don’t want to hear stories about rising demand for commodities and rising commodity prices—on September 18 analysts at Itau Unibanco in Brazil forecast that iron ore prices would rise to $95 to $105 a metric ton in the fourth quarter—it’s just that good news about demand has a hard time getting a hearing.

Which suggests a strategy for investing in commodities and commodity stocks during a period like this, one that’s dominated by stories about supply.

The strategy is simple—only invest in commodities where supply is tight, falling, or in danger of disruption. The best supply-side investment—if you can find it—is in a commodity sector where prices have been hammered by worries about rising supply—but where supply disruption is just around the corner. If you think those are tough to find, you’re right. It takes a lot of digging to ferret out a situation like that. Fortunately, (for investors, not for workers in the industry) I think we’ve got an extended supply disruption scenario now at work in the South African mining sector. I’m going to tell you about that today and suggest a few stocks that could run up on this disruption.

Let’s get down to specifics, okay?

I’ve put together a list of the Wall Street consensus on supply for some basic commodities.

Commodities where Wall Street is forecasting that supply will exceed demand—which isn’t good for prices, of course. Aluminum, nickel, zinc and thermal coal (coal for power plants) in 2013, according to Morgan Stanley. A third straight year with a glut of lead, says Barclays Capital. The International Energy Agency forecasts record oil demand in 2013, but also says that inventories are comfortable.

Commodities where Wall Street sees the potential for shortfalls in supply, which is good for prices. Gold, thanks to the turmoil in South Africa’s mining sector. Copper supply won’t meet demand for a fourth consecutive year in 2013, says Morgan Stanley. Corn and soybeans because drought in critical production areas promises to cut harvests when stockpiles are already at historically low levels.

The biggest short-term gains from a supply-side commodities strategy come when a commodity thought by consensus to be in supply excess turns out to be in scarcity. That requires a serious supply disruption of the sort that we’ve recently seen in South Africa’s platinum sector. A six-week strike that began on August 10 and ended only after violence took 46 lives shut production at the Marikana mine owned by Lonmin (LMI.LN in London or LNMIY in New York.)

The strike and mine shut down—and the threat of other mine shutdowns—completely reversed assumptions about the short-term supply/demand situation for platinum. The assumption had been that falling demand for platinum from car makers, especially European car makers, that use platinum in catalytic converters, would see supply out strip demand. That had sent platinum prices tumbling until the strike generated big revisions in the supply/demand picture. Suddenly platinum prices soared, rising by about 20%. Platinum miners without exposure to South Africa rose even faster. Shares of Stillwater Mining, the sole major producer of platinum in the United States, went from $9.49 on August 10 to $13.91 on September 14, a gain of 48%. Shares of North American Palladium (PAL), a Canadian company that is the only other major producer in North America, went from $1.50 to $2.15 a share, a 43% gain, in the same period.

The price of platinum fell on Wednesday and Thursday, September 19 and 20, on news that the strike had been settled with a pay raise of 11% to as much as 22%. And you might therefore conclude that you’ve missed out on this supply side chance.

But you’d be wrong. The disruption in South Africa’s mining industry is much too serious to be settled by the end of one strike. That strike was part of a struggle for control of the mining industry between rival unions linked to competing factions of the ruling African National Congress that are themselves contesting control of the party and the national government. All this is taking place in an atmosphere of very real worker anger over conditions and pay at the mines (and in the wider society where many people feel that the economic gains after Apartheid have gone to a small, politically connected elite) and deep mining company anxiety over potential nationalization of the mining sector.

Anglo American (AAL.LN in London or AAUKY in New York), the world’s largest platinum producer, and Aquarius Platinum (AQP.LN in London or AQPTY in New York) have indeed been able to reopen mines thanks to a heavy police presence, but I think both are susceptible to new strikes. Most of these actions have been wildcat strikes not sanctioned by the National Union of Mineworkers, long the dominant union in the industry and one with strong ties to the current leadership of the African National Congress government. Instead dissatisfied workers have turned to the rival and more militant Association of Mineworkers and Construction Union, saying that the National Union of Mineworkers has become too close to the big mining companies and that its leaders have lined their own pockets while neglecting their members. A case in point is that of Cyril Ramaphosa, once head of the National Union of Mineworkers, but now a multimillionaire businessman, who, union members are well aware, bid 19.5 million rand ($2.3 million) for a prize buffalo earlier this year. (The average black South African made 26,000 rand a year in 2010, the last time national incomes were surveyed. That’s worth $3,144 at current exchange rates.)

The union vs. union struggle is, moreover, wrapped up in a fight for leadership in the African National Congress. Many leaders of the National Union of Mineworkers—Ramaphosa for example—are leaders of the party and the union supplies solid support for the government of President Jacob Zuma. The Zuma government was rightly rocked when, after the police killed 34 strikers at Marikana, the national prosecutor ordered the arrest of 259 miners and charged them with the murder of their fellow workers under an Apartheid-era law. (The charges were later dropped.)

On the other side is Julius Malema, once the head of the more radical African National Congress Youth League, but recently cast out of the party. He has called for Zuma’s resignation and for workers to use an Apartheid-era protest technique by making the mines ungovernerable.

And as you might expect, this economic and political battle isn’t limited to platinum mines. A wildcat strike has hit AngloGold Ashanti (AU), the world’s third largest gold producer by sales, at its Kopanang mine. (Kopanang was responsible for about 4% of AngloGold Ashanti’s gold production in the first half of 2012.) 15,000 workers at Gold Fields (GFI) have been on strike for six weeks.

The 11% to 22% wage hike at Lonmin alone would have been enough to rock South African platinum mining companies since about half of the sector has been losing money at pre-strike platinum prices and with pre-strike costs. Wages account for about 50% of costs in the sector.

But longer-term mining companies—in platinum and gold--are facing tough decisions on whether or not to make new investments in South Africa. If costs are rising and operating conditions are, to put it mildly, unpredictable, how does a CEO calculate a rate of return or justify a capital-spending budget to investors. Some companies, Lonmin for example, had begun cutting capital budgets even before the Marikana strike. Lonmin also faces the need for a major refinancing of as much as $500 million to $1.5 million, according to Investec. Think that’s going to be easy? Analysts at Investec have set a target price for Lonmin with a range of $22.58 to $0 a share. The shares closed at $9.65 on September 21 in London.

So, yes, I think there’s a good chance of further supply disruptions at South African platinum producers. Under the circumstances the pull back at Stillwater Mining as the strike moved toward settlement—shares were down 13.3% from September 14 to September 21—creates a good opportunity to buy into an ongoing supply disruption. As of the September 21 close at $12.06, the stock had already retraced 41.6% of its gain from the price on August 10of $9.49. A 38.2% retracement, technical analysis say, is often a good level for a buy after a gain and sell-off. If you want to be especially conservative, you might wait for a 50% retracement of the gain to $11.69. I think the current price is a reasonable entry point and I’m adding the shares to my Jubak’s Picks portfolio http://jubakpicks.com/ today.

The supply-side story for gold is potentially as strong. South Africa isn’t nearly the gold producer it was as recently at 1970 when it produced 79% of the world’s gold. Since then South African gold production has been in decline and production from countries such as China has been on the rise. By 2010 South America accounted for just 7% of global gold production.

But South African production is still a major factor in the global industry, especially when you consider that gold, unlike platinum, isn’t facing a supply overhang. In fact before the strikes in South Africa, the consensus saw gold supply with only a slight surplus over demand. In the second quarter, according to the World Gold Council, gold demand fell by 7% from the second quarter of 2011. But gold supply declined by 6%. And that kept supply—at 1,059 metric tons—roughly in line with demand at 990 metric tons.

Most forecasts for rising gold prices have been based on projections of increased demand for gold because central bank stimulus from the Federal Reserve and the European Central Bank will make gold more attractive as a hedge against inflation and a declining dollar. So for example, Deutsche Bank raised its forecast price for gold to $2,000 an ounce in the first half of 2013 in the days just after the Federal Reserve announced its third round of quantitative easing on September 13. Bank of America raised its forecast to $2,400 an ounce by 2014 at about the same time. Gold closed at $1,778 an ounce on September 21 making the gains to those two targets 12.5% (by the end of 2012) and 35% (by 2014,)

However, I think both those targets and especially the near-term target for the end of 2012 are likely to prove conservative if the South African industry is in as much turmoil as I think it is. On that possibility, I’d be buying shares of gold miners without exposure to South Africa. My two favorites are Goldcorp (GG) and Yamana Gold (AUY), both members of my Jubak’s Picks portfolio http://jubakpicks.com/ . If you’re looking for an additional play (or just a new one) I’d recommend Agnico-Eagle Mines (AEM.)

There are two other supply disruption scenarios that I’d keep my eye on as we get into the end of November and into December. One involves crude oil and a possible attack on Iran and the other involves cooking oil, palm oil in particular, and possible drought in the soybean-proudcing regions of Argentina and Brazil.

But those are commodities for another day.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Freeport McMoRan Copper & Gold, Goldcorp, and Yamana Gold as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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