In every scenario the good or the best bet would be the Company must have the following qualities: production costs in 1st quartile across the industry and strong balance able to outsurvive any competitor. Whether we are talking about iron ore or aluminium Rio Tinto is the one.
Though every commodity market has different fundamentals the market dynamics are usually the same:
- rising prices impose increased capital expenditures
- it drives increased market supply
- followed by falling prices (as there is not enough demand)
- which triggers less capital expenditures, production cuts, M&A and bankruptcies
- which means less supply and again rising prices. Go to point 1.
Therefore the best cure for low prices is low prices and for high prices is high prices. As for today we are in point 4 of the cycle:
- commodities are trading 30-50% below marginal costs
- most producers are losing money
- substantial production cuts, project deferrals are in place
- major debt defaults, bankruptcies and restructuring numbers are rising
- extreme levels of commodities funds short positions
- some sectors equity value is close to zero (e.g. US coal)
For each commodity market there are three possible futures scenarios:
- two bizarre: let’s name first – cartel and second – last man standing
- the most probable: transformation and recovery
There is also a scenario when the world doesn’t need some commodity at all (no more oil, steel, aluminium, etc. please) but I think SA readers don’t consider it seriously (those who do can Google ‘doomsday cult’). Ok, let’s identify qualities of winners in each scenario.
Cartel scenario:
Key producers under pressure from their shareholders and other stakeholders will agree to curtail their production (like in 1994 did aluminium producers). Prices will rise above the level where ¾ of producers are profitable- to c. 1H 2015 level. The uncertainty will disappear and all the survivors’ valuations will increase.
In this case the largest upside will be in commodity producers from the 3rd cost quartile who will have viable options to gradually repay their debt. 1st and 2nd cost quartile producer stocks will also rise.
Therefore:
- Best bet: 3rd cost quartile companies with manageable debt at 1H 2015 commodity prices
- Good bet: 1st and 2nd cost quartile companies with manageable debt
- Bad bet: 4th cost quartile companies or companies with too large debt load
Last man standing scenario:
All the producers continue price wars till the moment when only one company shall stand. Though in real world such things just don’t happen it seems that Mr. Market considers it the main scenario. All right, let it be. Ask yourself the following questions:
- Who will be the last man standing? (my guess – the lowest cost producer)
- How much it will take till the end? (my guess – up to 5 years maximum)
- What will the company (last man standing) financials be after the end of the war?
Let me elaborate the last point. Whether there will only one company left it would have tremendous pricing power and opportunity to strangle any newcomer by targeting his markets (like Standard Oil did in its best days). I guess this Company value would be more than the whole industry capitalization today.
Therefore:
- Best bet: lowest cost company with strongest balance sheet able to outsurvive any competitor
- Bad bet: any other company
Transformation and recovery scenario:
IMHO, this scenario is most probable case as it occurred many times before. The scenario is very similar to the last man standing scenario expect for the war is finished faster with capitulation of high cost producers and companies with high debt load. In some cases (aluminium producers in China) I think the industry will experience consolidation and capacity curtailment in other demand would grow up to current supply. It will take some time but the end is clear.
Therefore:
- Best bet: 1st and 2nd cost quartile companies with manageable debt which can sweeten the deal by paying dividends even at current depressed prices
- Good bet: 3rd cost quartile companies with manageable debt
- Bad bet: 4th cost quartile companies or companies with too large debt load
In every scenario the good or the best bet would be the Company must have the following qualities: production costs in 1st quartile across the industry and strong balance able to outsurvive any competitor. Whether we are talking about iron ore or aluminium Rio Tinto is the one.
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