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What If Every Day Was Sunny And Spot Prices Stayed High Forever? (just for discussion - nothing more)
FN Arena News - April 20 2006
Long term commodity prices are determined as the average real price of that commodity over as much time as is deemed appropriate – maybe decades. In forecasting prices out to several years (and then discounting values to arrive at stock valuations) an analyst will always assume a reversion to the mean – that is, the further out you go the closer the price for any commodity will be to the long term average price.
The same is true for required currency assumptions.
The twenty-first century has brought about a challenge to the traditional way of thinking, and of measuring. The China effect has brought about talk of a "super cycle", or "stronger for longer" or a "secular change in prices". However you label it, it's all about shifting away from the long term curve into higher territory on a new long term basis. A step-jump.
Japan had the same effect post-war, but post-war did not see the same level and sophistication of stock analysis we have today. Many of today's asset pricing models were developed and refined in the sixties and seventies. So suffice to say, China has upset the apple cart (or maybe shaken all the sleepy apples off the tree).
Over the past couple of years, the concept of a super cycle has been a source of debate amongst resource analysts. One by one those analysts, if they weren't already major bulls, have capitulated. How can they denounce the super cycle concept when commodity prices keep hitting levels not even the most bullish were expecting?
With monotonous regularity, resource analysts have all but apologised to their clients and shifted up commodity price assumptions in the wake of spot price movements. Most no longer attempt to "predict" nearer term prices, but rather let spot prices lead the way. Not to do so has proven otherwise fatal, and analysts don't want to be the one calling a stock a sell just before it doubles in price.
The hard nuts, and maybe the old hands, are still preaching caution on a longer term basis. It is not hard to believe that the heat must eventually filter out of the commodities market, and that these current heady numbers will prove a necessary but unusual aberration some time down the track. Some time – but still prices keep going up.
The weight of demand – not just from the likes of China, India and co, but from investors who have never bought straight commodities before in their lives –continues to outstrip tardy supply developments. There is no real end in sight. Analysts have their views on maybe two, three or five years before things start to catch up. Some also throw in a little warning about overblown prices that could come a-crashing down with some violence, but crashes are never easy to pick.
Suffice to say, it will be something unforseen, rather than foreseen, that might trigger such an event.
Analysts are also careful to point out increasing costs in the resource industry, but such developments take a back seat when margins are astronomical. There is clearly some element of feedback loop in costs – for example, the cost of a new truck used in mining will be inflated by higher component and raw material costs, as will the cost of fuel. Could this be the sleeping trigger?
Meanwhile, analysts can only use spot prices as the overriding factor. On the release of Oxiana's (OXR) production report, UBS noted that the Golden Grove project had hit its straps just at the right time to deliver more zinc at ridiculous prices. Costs have increased too, but what the hey, don't forget Oxiana is unhedged.
Credit Suisse analysts have had to wrestle with their demons over Oxiana as well. In June last year they downgraded the leveraged miner directly from Outperform to Underperform. At the time, the share price was less than $1.00. Today it is more than $3.00.
In a report this morning, Credit Suisse has joined the capitulation team. This is what they said:
"Our concerns about costs, project delays, capex blowouts, grade and production outlook at various [sic] of OXR's assets are immaterial when compared to the leverage offered by OXR to booming commodity prices. We find it untenable to maintain a focus on long-term value at conservative commodity prices, when markets are quite clearly indicating this is not important. This applies both in terms of commodity prices themselves and OXR's equity valuation. We still have reservations over long-term valuation if and when commodity prices moderate, but we are shifting our focus for valuation to present year earnings, on high, but lower-than-spot commodity prices."
The analysts lifted their recommendation on Oxiana back from Underperform to Outperform, and took their latest target price from $2.00 to $3.65.
In the same daily report that featured Oxiana, Credit Suisse also proposed a somewhat flawed, but nevertheless interesting exercise (by the analysts'own admittance). Fresh from frustration over mining company valuations the analysts have said okay –
what if today's spot prices become the long term average?
What if indeed. Under this scenario (and as CS notes, making absolutely no adjustment for likely increased costs) Alumina (AWC) would fall to a 2008 price/earnings of 6.3x from 18.6x.
Its net present value would rise from $6.50 to $25.76 – an increase of 296%. Want some more?
All major miners' PEs would fall to single digit numbers, if they weren't already. NPV increases include BHP Billiton (BHP) from $17.58 to $43.95 (150%), Portman Mining (PMM) from $8.05 to $11.48 (43%), Rio Tinto (RIO) from $63.01 to $97.73 (55%), and Zinifex (ZFX) from $6.88 to $25.96 (277%).
These are NPV numbers, without applicable premiums. While CS ascribes an NPV of $17.58 to BHP it is currently trading at around $31.25. The analysts' target price today is $35.79.
Imagine where resource stock prices could really be!
But this is just an exercise, and a fanciful one at that. If anything it smacks of Credit Suisse analysts saying "C'mon, if you wanna get silly, let's get really silly!" They are quick to point out that the concept of extrapolating commodity prices into perpetuity (the "long term") is just not correct.
Long term prices are not fleeting numbers.
So once again all we can say is: how long can this gone on? No one can rightly say.