On yer bikes, then

Now I get it. Tech stocks have new paradigms and new business models and a boom. Commodity stocks don't have booms; they have "supercycles". So, just ignore all that bullarkey I spewed about the dot.commodity boom.

Metals making for sweet spot 'supercycle'
Citigroup lifts price forecasts for copper, nickel, aluminum

Citigroup, forecasting tighter global supplies of copper and nickel, reversed its bearish stance on various metals Monday, saying those commodities, and more modestly aluminum and gold, are likely to make the most of a "supercycle" sweet spot.
Metals have shrugged off interest-rate jitters, intermittent weakness in oil and gas prices, several rounds of profit-taking and seasonal demand slowdowns, among other events, according to Citigroup.
Analyst John Hill wrote that a "drumbeat of operating outages/shortfalls" could introduce an extended period prices at more than $2.50 a pound for copper, more than $7 a pound for nickel and more than $1.25 a pound for aluminum. "As a consequence, we expect a wave of upward earnings estimates revisions, both short- and long-term, and a very favorable environment for the equities.
"This represents a significant change of opinion on copper and nickel, where the Citigroup global team is abandoning a longstanding bearish stance due to the prospects for synchronous economic growth, structurally tight inventories, sluggish new capacity additions, and recurring operating outages/shortfalls," Hill wrote.
The report upgraded shares of both Inco Ltd. and Alcan Inc. to buy and raised Phelps Dodge Corp. to hold. Inco rallied 1.4% to $49.74, while Alcan rose 0.7% to $45.62 and Phelps Dodge -- which Citigroup lowered to a sell late last year, a move it now concedes was a mistake -- gained 2% to $76.69.
As revised, Citigroup's forecast for copper prices is lifted to $1.85 a pound in 2006 and $1.50 a pound in 2007; nickel prices are expected to go to $6.23 a pound in 2006 and $5.75 a pound in 2007; aluminum prices are expected to be $1.02 a pound in 2006 and 90 cents a pound in 2007; and gold will reach $553 an ounce in 2006 and $560 an ounce in 2007.
"We continue to adhere to the Commodity Supercycle theory, believing that the combination of 15 years of underinvestment, thorough-going corporate consolidation, mounting regulatory/ [non-governmental organization] pressure, and input cost escalation are conspiring to prevent the industry from mounting a meaningful supply response to 'peak-peak' prices," Hill wrote.
This does not imply "perpetual levitation" for metals prices, according to the analysts, but rather sustainable "higher lows" in commodities and company earnings as well as financial catalysts in the form of balance sheet repair and common-stock and special dividend hikes and share buybacks.

Now that may sound like the earth has moved for Citigroup, especially having advised they are "abandoning a longstanding bearish stance". But this is what they had to say a year ago:

In Support Of The Super Cycle Thesis
February 09 2005 - Australasian Investment Review – (AIR)

Having hedged their bets for the past year the commodities team at Smith Barney Citigroup has now reached a definitive conclusion – commodities are in an extended cycle that in turn is part of a ‘Super Cycle’.This marks a change from their stance over the past twelve months where they considered the ‘Super Cycle’ to be a genuine possibility but felt there was insufficient evidence to confirm the thesis.

Citigroup’s admission runs parallel with commodity specialists at Macquarie and GSJB Were re-iterating their support for the Super Cycle theme.

While noting the commodity cycle is reaching maturity and is therefore producing some sell signals, Citigroup is confident of a sustained period of earnings growth and a quality of earnings not seen before in the sector and which will be enough to outweigh the conventional sell signals.

So what does a ‘Super Cycle’ mean? Importantly, it doesn’t mean commodity prices will simply rise in a straight line, as there will still be price cycles.

Rather, the ‘Super Cycle’ produces a sustained period of trend increases in real commodity prices, which is driven by higher trend growth as major economies industrialise and urbanise.

This is accentuated by the fact that increases in supply are insufficient to offset the resulting higher demand. The broker suggests the current cycle began in 2002 with China as the catalyst, given its current period of high economic growth is highly materials intensive.

As the cycle continues, Citigroup explains real commodity prices will continue to trend higher, to the point where the trend decline experienced over the last 30 years will reverse.

What are the implications of such a cycle? The obvious answer is higher commodity prices, with the broker having revved up its 2007 commodity price forecasts such that they now are above its long-term forecasts. While prices generally are expected to rise, some commodities are expected to outperform within the cycle.

In Citigroup’s view, the preferred commodity exposures in this cycle are the bulks – iron ore, coking coal and alumina, along with aluminium, zinc and gold.

In addition, the broker expects shareholders to notice an important difference between a ‘Super Cycle’ and an ordinary cyclical increase in commodity prices.

The broker highlights that resources companies can expect to generate strong free cash flow during the next few years, resulting in the transformation of balance sheets in the sector. On current forecasts the broker forecasts gearing levels in the industry to fall by US$13.7bn this year and another US$18bn in 2006, resulting in the possibility of the industry achieving a net cash position by 2007. Unless this cash is distributed. In addition, the broker notes equity currently remains more expensive than debt, meaning debt repayment is not the most efficient use of cash for most companies.

As a result, shareholders are likely to see significant increases in either dividends or capital management initiatives, such as the higher dividend and share buyback announced by Rio Tinto (RIO) with its profit result last week.

How these returns are made will depend on the environment for the company, with Australian and Latin American investors likely to see special dividends due to the tax advantages associated with them, while investors in the UK and the US are likely to see a higher level of share buybacks for the same reason.

As the broker notes, historically bullish cycles in commodity markets have come to an end for one of two reasons - declining demand or increases in supply.

While the broker expects demand for commodities to fall from the highs seen last year, continued strength in China and the US is to ensure demand remains above trend levels. But how is the market placed in terms of additional supply coming on stream? The broker estimates the ‘Stay in Business’ level of capital expenditure in the industry is about US$15bn annually.

Assessing the global capex spend for resource companies is obviously difficult, but on the broker’s forecasts this year’s total should hit a cycle peak of about US$30bn, suggesting some serious expansion in supply capabilities. But this isn’t an immediate problem in the broker’s view, as there is a lag time between capital expenditure and new supply coming on stream of about three years.

Also, the broker points out the Asian financial crisis of 1997 had severe repercussions for the resources industry generally, as the resulting evaporation of demand from Asia coincided with the end of a major capital expenditure cycle, forcing prices to fall sharply.

As a result, little new capital expenditure was made in the late 1990s and first few years of this decade, meaning the money being invested now is going into new projects with longer lead times, which emphasises the likelihood of a long lag between investment and new supply.

The broker also notes that after being burned in the Asian crises, companies themselves are now far more disciplined in terms of capital budgeting. Recent years has thus seen most companies place an emphasis on growth via the development of their own projects, as with most resource stocks having run somewhat already this is a far cheaper growth avenue than acquisitions.

So, WMC Resources (WMR) notwithstanding, management teams are in favour of careful capital expenditure rather than looking for takeover targets. Costs are also playing a more important role this time, as operating costs have continued to rise through the cycle due to exchange rate movements, higher energy and raw material costs and the mining of lower grade material.

This means many companies are failing to deliver on what is expected to be higher margins arising from stronger commodity prices. This cost impact has also been the result of companies noting the tightness of supply in many markets, which has seen production on the basis of maximising volumes rather than minimise costs.

In addition, while supply is increasing for some commodities, the broker notes it is supply from higher cost projects, with operations at the top of the cost curve being brought into production or marginal areas being mined, as current prices make it economic to do so.

On the broker’s numbers, a large portion of the higher costs can be traced back to the appreciation of the so-called ‘commodity currencies’.

This has had a particularly heavy impact on Australian and South African producers as unfavourable exchange rate movements have more than offset any benefits from higher commodity prices, with the A$ gold price a good example in recent years.

Despite these higher costs, the broker expects long-term average margins will still be broadly unchanged, meaning commodity prices will need to rise further to offset the higher input costs.

So where should investors look? As mentioned above, the broker considers the bulks to be among the most attractive plays currently. One characteristic of the bulk commodity industries is they rate highly both in terms of Return On Capital Employed (ROCE) and barriers to entry in the industry.

Backing up these advantages is the likelihood of continued favourable supply-demand conditions, with the broker noting that even despite recent capacity expansions by major producers of both iron ore and coal these markets are expected to remain very tight.

Aluminium and Alumina enjoy similar tight supply-demand outlooks, with the broker expecting capacity growth to be insufficient to meet projected growth in smelter capacity, forcing closures and the cancellation of some projects.

Zinc is also expected to move into a deeper deficit this year as concentrate supply is tight and supply increases will be limited due to production bottlenecks. For gold, the broker anticipates continued weakness in the US$ to support investment demand for the metal, while strength in ‘commodity currencies’ will pressure non-US gold producers.

Stock-wise, the broker lists several companies as among its preferred exposures. In bulks, the majors, BHP Billiton (BHP) and Rio Tinto (RIO) remain favourites, while Centennial Coal (CEY), Macarthur Coal (MCC) and Iluka (ILU) are also recommended.

For aluminium leverage the broker prefers Alumina (AWC), while Lihir (LHG) is the preferred Australian exposure to gold.

Several resource companies are seen as cheap, namely Zinifex (ZFX), Oxiana (OXR) and Minara Resources (MRE), with the broker noting the environment is less-favourable for single project or commodity companies with risks of production problems. (See Son of a Guambat's award winning portfolio: http://2005.studentshares.com.au/home.php?campusid=7)

Copyright Australasian Investment Review.

Now this is also interesting: Citigroup made a great deal of this latest conversion from commodity bear to commodity bull overnight Sydney time today, and so commodities were the major supports to the New York markets on an otherwise dreary day. Is it any coincidence that yesterday Sydney time the Aus market had yet another boom day, up almost one percent to 5088, with BHP Billiton and Rio Tinto front-running the pack? Yeah, I'm sure it is.


And now for something completely different, but cycle related. Baby Bat's best friend in high school, Nattie Bates, got gold in the Commonwealth Games. Onya Nattie!