Metals prices are falling – so why is now a great time to buy mining stocks?

It's been a bad year for metals prices - and the outlook remains grim. But now could be a good time to buy mining stocks, says Matthew Partridge.

14-02-03-iron-ore

Iron ore: down 15%

Last year was a bad one for metals and the companies that mine them.

The price of iron ore fell by more than 15%, while copper fell from above $8,000 per tonne to around $7,400.

It's hardly surprising. The backdrop for commodities looks grim. Weak economic data has raised fears of a Chinese slowdown, while the US Federal Reserve's taper'has seen money flee out of commodities. That's sent prices lower again this month.

Things don't look like getting any better either. Unlike last year, the Fed seems to be sticking to its guns. Last week, Ben Bernanke's final act as Fed chairman was to reduce money printing by a further $10bn a month.

Time to sell then? Not at all. I think now could be a very good time to buy

The future is not bright for commodities

And that could spell opportunity. You see, while the market has priced in a lot of bad news for the sector, there are several more upbeat signs that investors are so far ignoring.

Metals prices can only fall so far, for a start. The current price of many major metals (including zinc, nickel and copper) is very close to their cost of production. Even iron ore could be affected if prices keep falling.

This is important, because beyond the short term, commodity prices tend to be dictated by the marginal cost of production. That makes sense. If companies can't make money by producing a commodity, they'll stop doing so. If they do, that means supply will drop, which in turn pushes prices higher again.

Demand may also be more resilient than many people think. Even if China does slow down, the government is still spending huge sums of money on infrastructure. The state company that manages China's electricity grid has said that it will increase spending on the grid by at least 13% this year, which suggests more demand for copper.

It's a similar story in India, as it deals with the huge task of upgrading its inadequate power network; and in Africa, where many countries continue to grow rapidly. And this year, the US construction industry will also make a large contribution to copper demand, with housebuilding activity jumping by 18% last year.

Miners are becoming leaner and meaner

Mining companies have to reinvest a certain proportion of their profits into exploration and new production that's vital if they are to keep finding new reserves of metal to dig up. But during the good times, they have arguably been ploughing too much money into uneconomic projects, on the assumption that prices would just keep going up.

However, now they are becoming much more selective about what they will invest in. That means investment spending has fallen, and so their free cash flowhas risen.

Most are currently using this cash flow to reduce their debts. But James Sutton of JP Morgan's Natural Resources Fund reckons that next year they will also start to increase the amount of money returned to shareholders though dividends and buybacks.

This reduced investment has also helped to cut costs in other ways. When capital spending was high, miners subcontracted a lot of their work to smaller engineering firms. This was a flexible, but expensive solution subcontractors made very healthy profit margins, especially when their services were in demand. The miners also had to spend extra on making sure the work was carried out to a decent standard.

But with less work being done, miners are saving money by doing the work in-house. This is squeezing the margins of those subcontractors who remain in the business. And it should help the more efficient miners to weather falling metal prices.

How the taper could be a big boost for mining companies

However, there is one side-effect of the taper that will benefit many mining companies. Most miners operate in emerging markets. So their costs, such as wages, are in emerging-market currencies. But the income from the commodities they sell is denominated in dollars.

The taper has led to money rushing back to the safe haven' of the US. That is making the dollar stronger. Meanwhile, emerging-market currencies have been particularly hard hit by the taper. So miners' costs quoted in emerging-market currencies are falling, even as their sales quoted in US dollars are rising.

One company that looks particularly attractive to Sutton is mining giant Rio Tinto (LSE: RIO). Its position as one of the lowest-cost miners means that it can sustain further price falls before its profitability is under threat. At the same time, several past investments are due to bear fruit shortly, which should mean that its 2016 production levels will be 49% higher than 2011 levels. It has a solid dividend of 3.5%, and trades at 8.5 times 2015 earnings.

If you'd rather spread your risk a bit more, my colleague David C Stevenson recently picked his three favourite mining investment trusts. If you're not already a subscriber, you can get access to the piece plus your first three issues free here.

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