The New Boom in Metals

The mining sector has been in the doldrums for 20 years. But now, with demand for metals soaring, prices are on the rise again. Is this the start of a bull market in commodities?

In terms of the overall market, small. The capitalisation of the global mining sector is about $240bn, less than the market value of General Electric.There are a handful of huge global players, a number of them listed in London, such as BHP Billiton, Anglo American, XStrata and Rio Tinto, but also hundreds of smaller players, most based in mining countries, such as Australia, South Africa and Canada. Over the last 20 years, the industry has consolidated and shrunk as it coped with a savage collapse in metals prices, caused by the Japanese economic decline and global disinflation. From a peak of 335 in November 1980, the Reuters CRB index fell to a low of 183 in October 2001. In the last year, however, the sector has staged a remarkable recovery.

How strong has the recovery been?

The FTSE World Mining index, which includes all the UK-listed mining stocks, is up 40% this year on the back of soaring metals prices. The Reuters CRB index has bounced back to 240 as investors sought refuge from equities in the commodity markets. Similarly, the GSCC Industrial Metals index, which includes aluminium and copper, is up more than 20% since November 2001. Precious metals, such as gold and silver, are up nearly 40%. Platinum prices are at a 23-year-high, and silver and nickel have hit three-year peaks. Nickel and copper have recorded gains of 47% and 17% respectively this year. Recently, the new-found enthusiasm for metals has been driven by the recovery in the global economy, and above all by excitement at the prospects for the Chinese economy.

Why is China so important?

Because, with the exception of zinc, it is a large importer of commodities. Its economy has been growing at 8% a year, yet much of its 1.3 billion population have yet to own the fridges, cars and dishwashers the West takes for granted. "China has entered a metals-intensive phase in its growth, similar to Japan in the 1950s and 1960s and South Korea and Taiwan in the 1970s and 1980s," Jim Lennon of Macquarie Securities told the FT. It imports three times as much iron ore and steel as the US, comprises 18% of demand for copper, compared to 16% by the US, and buys 34% of the world's crude steel.

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Why is the industry so risky?

One reason is that the process of exploration and development is long, capital intensive and far from guaranteed to produce returns. It can take ten to 15 years, for example, to exploit copper and zinc mines. In the 1970s, the mining industry acquired a reputation for being financially reckless, squandering millions on the exploration of American copper mines, African platinum and other schemes that came to nothing. Many of these were abandoned when prices fell and investors lost large amounts.

Can another bust be avoided?

Most analysts think so. One reason is that there is a shortage of supply to meet the rising demand, thanks to the low levels of investment in recent years. In previous metal-price booms, mining companies have got carried away and increased their exploration budgets, upped production and embarked on reckless takeovers, notes Kevin Morrison in the FT. But there is little sign of that happening this time.The mining firms are being run like other businesses, with the focus on returns on capital. As a result, exploration budgets have been slashed across the sector, resulting in few large discoveries of any metal in recent years. In Western Australia, for example, exploration spending has halved since 1997. At the same time, high-cost mines have been closed, leading to a run-down in stockpiles.

What are the risks this time?

There are political and regulatory risks. First, many mines are located in unstable countries. "Political instability," warns Rio Tinto, "can result in civil unrest, expropriation, nationalisation, renegotiation or nullification of existing contracts, mining leases and other agreements, changes in laws, taxation policies or currency restrictions." Even in relatively stable countries, there are political risks. In South Africa, for example, the industry faces upheaval as a result of the government's new black economic empowerment policies, while in Western Australia, investment has been discouraged by land access problems arising as a result of the native title debate over Aboriginal rights.

Is currency a risk?

Yes - most commodities are priced in US dollars, while their costs must be paid in local currencies. Anglo American, Rio Tinto and BHP Billiton, for example, have most of their costs in Australian dollars and South African rand. Both these have risen this year in response to the falling dollar, and this has wiped out some of the benefits of higher prices. Recently, analysts have lowered their earnings forecasts for the leading mining groups to reflect this. Ominously, many economists expect further falls in the dollar over the coming years.

Will the boom keep going?

Some analysts think we are at the beginning of a new bull market in commodities. "There have been five bull markets in commodities in the last 100 years," says Hugh Hendry of Odey Asset Management. "This looks set to be a big one." Indeed, even at current levels, metal prices look far from expensive, according to Ian Henderson, manager of JP Morgan Fleming's Natural Resources fund. Just to get back to 1993 levels, they would have to rise about 50% from where they are today. To get to the 1987 peaks, they would have to double from where they are today.