Commodity Investing in a Time of Rising Resource Nationalism
Commodities / Resources Investing Sep 07, 2012 - 11:36 AM GMTBy: Roger_Conrad
“Ever-deeper, ever-further” has been the mantra of major natural resource producers over the past decade, as emerging Asia has replaced the US as the world’s single biggest consumer and driven demand to new heights.
This unprecedented expansion hasn’t always driven up costs. In fact, major producers of everything from copper to platinum are uncovering some of the richest reserves yet seen with their massive investment. That’s helped keep a lid on companies’ overall production costs, which in turn has aided further investment. It has, however, elevated resource nationalism risk to heights not seen since the 1970s, when countries such as Chile expropriated assets from investors domestic and foreign.
Among the more alarming recent developments concern South Africa, long one of the world’s biggest producers of scores of key resources. In July, an increasingly violent clash between rival unions hampered production at a mine owned by Lonmin Plc (London: LMI), the world’s third-largest platinum producer.
The battle between the Association of Mineworkers and Construction Union (AMCU)—a nascent organization centered on less skilled workers—and the incumbent National Union of Mineworkers (NUM) concerned a demand for higher wages for rock drillers. NUM refused to strike in support and the result has been chaos at the mine. In August, riot police killed 30 striking workers at the mine, escalating tensions between workers and management.
Unfortunately, the battle is just the latest in a series of developments that has undermined investor confidence in South Africa. Mining companies today face periodic shortages of electricity, and wage costs have risen far faster than inflation. Most worrisome, politicians are now debating outright nationalization of much of the mining industry, as the ruling African National Congress struggles to maintain its monopoly of political power.
Given the country’s vast mineral wealth, investors are unlikely to abandon it entirely, unless forced out. But the Lonmin incident is a sober reminder of the political risks facing mining companies as they look for new sources of supply to meet rising demand.
South Africa is hardly the only country facing these risks. Violence among workers in New Guinea, for example, has interrupted production at major mines there. Other countries in Asia and Africa are also studying ways to get more from foreign mining firms. And while Australia has turned back a more draconian version of its proposed mining tax, even this investor-friendly country has been debating raising levies.
However, there are positives to resource nationalism. Most important, the growing risk it poses to supply helps build an effective floor under prices of many key minerals, just as Middle East turmoil has for global oil prices for decades.
With Chinese industrial production noticeably slowed from last year, this trend is likely to prove very important for global prices and producer profits over the next six to 12 months, or at least until the Chinese economy accelerates again. However, companies will only really benefit if their reserves and output can be maintained from outside troubled countries. Otherwise, output will drop and they’ll be victimized by lower prices and falling volumes.
One way investors can protect themselves is to stick to large, geographically diversified resource producers—or failing that, to focus on companies that get the majority of output from more politically stable countries where the odds of radical resource nationalism taking hold are lower.
North America is obviously the top choice, particularly Canada where the government has even been willing to allow foreign takeovers of resource producers. The Australian economy also has a long history of stability, the recent proposed mining tax notwithstanding. And despite the rise of bellicose left-wing governments in Argentina, Bolivia, Ecuador and Venezuela, Latin America remains largely open for mining companies’ business, particularly Chile and Brazil.
Accordingly, I like to hold a mix of mining companies. In general, companies diversified over several countries are safer, because they’re less exposed to negative shifts in regulation and/or flare-ups of resource nationalism. More focused companies are often smaller and therefore more leveraged to upside in the market for what they produce.
Resource nationalism is also a powerful driver for mining industry mergers, because larger companies are financially better equipped to weather interruptions in output caused by political strife and sudden regulatory shifts.
The biggest merger deal currently in progress involves Glencore International (London: GLEN, OTC: GLNCY), which has an outstanding bid for major metals producer Xstrata Plc (London: XTA, OTC: XSRAY), of which it already owns a sizeable chunk.
Given the expense and risk of going “ever-deeper, ever-further,” the odds of more big deals being announced in coming months continues to rise, as borrowing costs remain historically low and falling resource prices pressure earnings.
If you own a mining company that is affected by resource nationalism, your first course of action is to determine what’s actually at risk. In most cases, the market is likely to overreact to the danger and successful mining companies are skilled at finding compromise.
Freeport-McMoran Copper & Gold (NYSE: FCX), for example, is considering offering a portion of its PT Freeport Indonesia unit to the Papua administration of between 5 percent and 9.4 percent. The company’s Grasberg copper mine is among the most prolific and lowest-cost in the world; these operations have been closely scrutinized by government and at times interrupted by labor strife. Having local government as a de facto partner could go a long way toward settling that strife.
Other companies have been able to overcome the ill effects of resource nationalism by virtue of diversified operations. Canada’s First Quantum (TSX: FM, OTC: FQVLF), for example, saw its assets in the Democratic Republic of the Congo essentially expropriated but was eventually compensated and has since moved its investment to more hospitable terrain.
It’s a sure bet that governments in the future will continue to use their power to change the terms of contracts for some companies. When the investment in that country represents most or all of their operations, affected companies will be at risk of folding. However, if you stick to diversified miners, any emotional market reaction to a flare-up of resource nationalism will likely represent a buying opportunity. I uncover 5 solid commodity stocks in my free report, Top Rare Metal Stocks, which you can access here.
Mr. Conrad has a Bachelor of Arts degree from Emory University, a Master's of International Management degree from the American Graduate School of International Management (Thunderbird), and is the author of numerous books on the subject of investing in essential services, including Power Hungry: Strategic Investing in Telecommunications, Utilities and Other Essential Services
© 2012 Copyright Roger Conrad - All Rights Reserved
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