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Nesbitt Burns Institutional Client Conference Call for May 20, 2005
Don Coxe
Boston, MA
“Is This Deja View All Over Again?”
Chart: Copper price
kitcometals.com
Thank you for all tuning in to the call which comes to you today from Boston, the home of two world championship teams and the home of some great money managers. Since I last talked to you I’ve been talking to accounts in Manhattan, Greenwich and now Boston. I’m going to Chicago later today, very interesting trip. The chart that we faxed out was the copper price, spot price and the comment was “Is This Deja view all over again?”.
So I want to talk about what was a big topic of discussion in most of my meetings, which is the real setback that’s occurring in the mining stocks. The golds have had a really rough year to date with the gold index down 15 ½%.
But, the metal ores group, I’m using the Investor’s Business Daily category there, because they have 197 categories, which includes stocks in all the various markets here, it’s down 9.3% so it’s 7% behind the S&P year to date now. As recently as February, it was one of the top five performing groups over six months. And it’s fallen way down the list. So this of course has been a disappointment to us and to a lot of the people that are on the call. So I want to take you through what I see that’s been unfolding and also of course touch on other topics related to it.
I’ll first of all make reference to the recent political events in Canada because we’ve been talking about those for the last few weeks. For those foreigners on the call who are not up to date on this, there was a vote in the House of Commons yesterday, a vote of confidence and there was a tie vote, the Speaker broke the tie so the government will be in power for some time to come. The reason that it was a tie vote was because of the defection earlier this week of the prominent conservative or, I’m sorry, a prominent Tory, Belinda Stronach, who took a position in the Liberal cabinet and the position she took was the epicenter of the Liberal scandals that did not lead to allegations of huge corruption and threatened the previous Chretien government, the human resources portfolio, so it seems to be in good hands.
What this has done is given just a little bit of help to the Canadian Dollar which has upticked back above 79. I know there’s lots of people on the call who feel disappointed about this but the government has promised there will be an election after the report of the Donnery (?) Commission which will give the final report on the current revelations of corruption and kickbacks and bribes and scandals and so forth that went on for years and years and besmirched Canada’s name.
Canada has been gradually sliding in the index that’s published in…I forget who does it, one of the international groups analyzes corruption in countries and Canada used to be just about at the top, it’s been gradually declining, it’s still well-ranked and it’s undoubtedly going to fall much lower in those rankings. It’s not clear to me from an investment standpoint how important those are. Of course if you’re down with Zaire or Zimbabwe, it’s very important. But, as long as you’re in the top quartile, I’m not sure this is a big influence, although when Canada was up there, at or near the top, this gave Canadians bragging rights and recent events have presumably removed all Canadian sense of bragging rights and that will make it a little easier for me as a Canadian living in the US. So in that sense, in a modest sense, there’s some pleasure to be gained out of the fact that this issue will be brought to a conclusion within the next few months.
Now, on the theme of the chart and copper…and I gotta go back to a theme that I’ve been discussing lately in oil because copper is doing the same sort of thing. We’ve had a roaring bull market in copper for the last two years, but copper has stayed in deep backwardation throughout. Now, just reminding you of the terms here, backwardation refers to a commodity where the spot price is higher than the futures prices. And when you’re in deep backwardation, it’s sequential. Virtually each month is a lower price than the month before it.
The opposite to that is contango, where the futures prices are higher than the spot prices. And in a perfect contango, what you get is that they just rise on a nice gentle slope. And they reflect what is the traditional commodity situation which is that you take the basis, which is the spot, and you take the Eurodollar rate for holding a supply of this and add to it. The experienced gold investors on the call will recall that gold is always in a contango because of the way in which gold works. Which is that the out months are always a premium based on the combined interest rate and that was of course what Peter Monk and the Barrick people saw in the ’80s because gold was in a triple waterfall crash. What they did was hedge forward against those futures prices, borrowing gold from central bankers and others to make deliveries. So they achieved something that the Medieval alchemists would have thought was impossible, which is, turning falling gold into rising gold, but it was always gold.
Great maneuver, great maneuver. And it worked brilliantly for about 16 years. When something has worked for about that period of time, one comes to believe that it’s attained a financial law of nature. In the case of Barrick and Ashanti, they stayed at the party too long after gold had completed its triple waterfall, falling to $250 and by leaving their hedges on, of course, they’ve cost their stockholders money. In the case of Ashanti, the company was brought to the edge of insolvency because marking to market its futures, it was broke.
And that has shown up in the oil industry in recent months where the oil curve in what was one of the great Page 16 stories of the last 12 months, during the time that oil moved from being a Page 16 story to a Page 1 story, because it was a bad news story, by definition Page 1 is ordinarily bad news, when you have all the oil stocks worth only 7 or 8% of the S&P, then the roaring earnings of the oil group were nothing but bad news, which meant that the drumbeaters for the market would feature all kinds of stories about the problems from rising oil prices.
But oil was deeply in backwardation until it swung into contango. What that did was to change the nature of inventories in oil. As long as you had backwardation, any purchasing manager who had inventories longer than were absolutely needed was in danger of losing his or her job. Because the boss could look and say “You idiot! Here you are holding this stuff and you could see that the next month and the months thereafter were cheaper, so why have more than we need?”
Once oil swung to contango, what you did was you had created a new incentive system, which was to hold extra oil. So therefore, we’ve gone from visible inventories of oil being very, very low, to them rising for fourteen straight weeks. Which has meant that those same people on Wall Street who for four years were predicting collapsing oil prices have now re-emerged from hiding - the shills and the mountebanks - and said “See, we were right all along. There’s much too much oil around in the world. Look at the way these inventories keep rising.”
This has taken oil prices down about seven dollars and a half a barrel, coincidentally or causally, and that’s been good news for the stock market generally and we’ve had a very good rally in the stock market, notwithstanding all the bad news – General Motors, Ford, hedge fund problems, all these kind of things that could have got us into trouble, they have been outdone by the good news on oil.
Something that was rather a small part of a lot of peoples portfolios has been a gigantic part of the story of the stock market.
But in all of that, what we’ve seen is almost no commentary on the significance of the contangos in oil. The contango now, just to finish up before I get to copper – this was as of the close yesterday – with WTI at 46.92, December Crude is 51.05 and even if you go out to December 08, it’s 47.42. So what this has meant is that those oil companies that kept their hedges, as they called them, the ones who had sold forward gigantically, it means that they are deeply under water. Oil company prosperity and being under water don’t mix. So what we have is a situation where the Canadian exploration companies seem to have done far more of this or stayed with it longer than the American exploration companies, so on the interlisted basis, the Canadian E&P companies are only up 2% year to date, US E&P companies are up 12.
Yes, some E&P companies in the US kept their hedges on, but they seem to have been more nimble about unwinding them than some of the conspicuous Canadian companies.
Now copper has had no such swing. It remains deeply in backwardation, with the spot price at the close yesterday at 145.80. December, 129.30 and July of 06 – that’s as far as they go, they don’t go as deep as oil – 121.80. And one of the effects of backwardation is it allows the analysts left on Wall Street who cover commodities and the oil analysts who are left on Wall Street who cover commodities as of three years ago, we could have had all of them in this hotel room I’m making the phone call from. And those who had kept their jobs kept them by getting people out of the stocks as soon as the commodity price went up. Because after all, there was a long crash, 20 years of it.
And so, in the case of the mining stocks and the metals, what we’ve had is the same kind of process, which is most of the analysts on Wall Street that is, that kept their jobs, did it by predicting falling prices and they’ve always been able to point to the curve itself as proof of their forecast. And that’s another example of my dictum that the best investment opportunities come from an asset class where those who know it best love it least because they’ve been disappointed most.
Why? Because the only way you get backwardation on a sustained basis on a commodity is because the producers sell forward. Now you have speculators doing things both ways but what speculators are unlikely to do is take deliveries of commodities. So they deal primarily on the curve with a little bit of money down, you don’t want to wake up in the morning and see twenty five tonnes of copper in your front yard.
Therefore, when we were told in oil that the price was rising because of runaway speculation in oil – this was the excuse advanced by those Wall Street oil analysts who for fourteen straight quarters predicted a drop in oil prices – and when they were wrong they had to attack speculator. Speculation is sometimes on Wall Street something to be rejoiced about, speculation against Wall Street’s consensus is evil, sinful and stupid and is to be condemned. So we had the bizarre situation that one of the things that did become almost an article of faith in the financial press was that there were seven dollars of speculation built into the oil prices.
Since it was in backwardation, that meant that they were suggesting that people were in effect shorting against the spot which sounds sensible…but who was doing it? Because it was the oil companies. And you don’t short the spot because by definition you’ve got to deliver. So the speculation in oil was in fact the commodity hedge funds and the oil companies who kept selling forward. Well they wakened up to the folly of their decision making by year end because of Rule 33 of having to mark to market.
In the case of the mining industry, first of all the futures market, that is the far out futures market is a thin market compared to oil. The size of the open interest is very modest and in the out months in copper it’s extremely modest. Yes there is an OTC market in this and there are contracts arranged on those, but they go along with the prices that you see on the COMEX and the LME for futures. So, the question is, now that copper prices on the spot market have come down from their highs, we’re looking at a drop of about eight cents, and if you look at the out months, for example, if we take the farthest out contract with is July of 06, the high for that contract is 132 and it’s 121.80 at the close yesterday. Well, that’s something like a ten cent drop in the price of copper through the curve.
However, the mining stocks have been hit far, far worse than that. And what this is, is part of a story that the US economy is slowing down and that these are deep cyclicals and in addition that China is slowing down or is headed for a crash. And so since China – this is understood by a lot of people – sets copper prices at the margin by their demand, any slowdown in China must mean a drop in copper prices.
Well you’re going to have to slow China a long way to cut China’s consumption of copper. Because over the last few years, the ratio has been reasonably consistent, between the GDP figures for China and the percentage growth in consumption of metals.
Now, I haven’t got the exact figures on copper, but for copper, nickel, lead, zinc and aluminum together, the industrial metals, there’s a ratio of roughly three times. So if GDP goes up 8%, what you get is about a 24% increase in the base metals. Back of the envelope calculation but it’s useful to use.
So what you’ve got to understand then, is if China slows down, let’s say from 9 ½% last year to 6% this year and that’s below all but the most bearish forecasts, then copper consumption will be up somewhere in the order of 16 to 20%. But the growth in copper consumption that’s already occurred and the other metals has run down inventories dramatically over the last three years.
The only thing that could produce a real problem for the metal would be a combination of a cut in consumption by China and to some extent India, plus massive amounts of new production coming onstream. Well, there’s not a massive amount of production coming onstream. There are some mines, but not enough as long as you’ve got those compounded growth rates in consumption out of Asia.
So, my feeling on the metal prices themselves is that as long as we’re in backwardation, what it means is the sentiment in the futures market remains negative and is dominated by the companies, but the companies themselves have been so beaten up during the triple waterfall crash that their tendency is to sell forward and to lock in what they think are high prices.
Phelps Dodge has cautioned analysts for some time to use eighty-five cent copper in their forecasts. And so, although I don’t know specifically what Phelps is doing in the futures market, the tendency of a management that has that kind of view would be to sell futures contracts. And unless you’ve got a lot of speculators who are bullish, then you’re going to have backwardation as opposed to contango.
And for the mining stocks, the turn in direction of the spot and the futures of copper has been enough to produce a significant sell-off. Now, I’ve talked to scrap dealers because I know quite a few Midwest scrap dealers who are significant vendors to China and I’ve seen them as recently as the last month. They present a very different story. The story they tell me is that as of last year, that there was a specific edict out of Beijing to tell them to stop buying metals, which they did. And then after China came in at 4% GDP growth in the first quarter, they called their American vendors to stay ship us all the stuff you’ve been saving, we’re back in business. And you remember that China’s GDP growth came in at 9 ½% after that slow first quarter.
Talking to them recently, no indication from them that their Chinese customers have changed in their desire to be buying copper scrap. So on a couple of years experience that I’ve had of comparing what the scrap dealers tell me with what these great names on Wall Street say about the Chinese economy and Chinese metal consumption, so far it’s entirely to the scrap dealers and Wall Street has had it wrong on metal consumption the way they have in a much more conspicuous way on oil consumption and prices.
Summing it up then, my view is that on any reasonable time horizon, what you’re going to get is a rally in these stocks. But, the chart patterns are not reassuring and what we’ve seen in talking to some of the hedge fund proprietors, one of the things that some of them did when they saw that the metals were running - and they couldn’t have ignored that even though they weren’t being advised by Wall Street to buy them – is that they bought these stocks as a cyclical play and they shorted bonds. Well, they’ve been unwinding those positions because the Treasury bond market has done splendidly.
The sheer scale of their operations in the hedge world is truly amazing. I saw an item to the effect that the growth of Eurodollar deposits as measured in broad US money, is up 77% over three years. Now by definition, these aren’t deposits within the US, but they’re liabilities. And the great percentage of those would be hedge funds that are headquarted in the Carribean and so they’d be borrowing in EuroDollars to buy other things, Treasury bonds, corporate bonds, junk bonds and from time to time commodities and commodity stocks.
So as they unwind their positions, they can swamp what’s going on in the garden variety world that I work in. And so this whole question as to whether A) the US economy is slowing down, first question, B) whether the global economy is slowing down pending recession…all of this produces huge swings in Hedgeland. And I’m very impressed with how well they’ve been able to unwind their positions and I don’t know whether they’ve completed their sales of the commodity stocks as against their bond bet, but I think we’re bound to be some way along.
I was unable to have one meeting with a major hedge fund because on the day I arrived, all their top people were engaged in a large-scale unwinding of liabilities and assets. So I’m aware of the fact that the process is big, it’s going on, but it hasn’t ruffled the market much. And in fact the indicators that I look at in the market have indicated that we’ve come through this extremely well.
So, the fear is that hedge fund problems could lead to some major financial collapse a la Long Term Capital…much overdone. First of all, there’s 7,000 of them now and to an extent now they cancel each other out. Mr. Greenspan has been arguing that they supply liquidity to the market and now because of their numbers, the failure of a few of them is not a threat to the system. And he could well be right, because particularly those who do spread trades as opposed to the macro funds who take specific bets, then as they’re unwinding these positions, there’s always hedge funds on the other side of these.
So, where does this leave us? Well, it leaves us in a position where the stock market now wants to be encouraged by weak oil prices and by the evidence of a continued low inflation. But the strength of the bond market which indicates that the housing bubble can continue, because the Ten Year note, if it had broken down and interest rates had climbed through 5, 5 ¼% on the Ten Year note, what that would do would have enormous impact on the housing industry and I think talking to a lot of top managers, that’s really one of the things that they’re looking at, is they fear that the thing that would really blow things would be if we had a sudden break in the housing bubble like we had in the early 90s, because it’s so much bigger this time and it’s on such a grand scale. Now that we’ve got over 40% - I believe is the figure I saw – of mortgages coming in at either adjustables or interest-only’s, because of the people who are buying second, third, fourth, fifth houses as investments, it’s clear that this is becoming the most vulnerable area of the system. But it’s not directly in the financial system itself except as to where that mortgage-backed paper ends up.
I think for those of you who are planning summer vacations at the moment, the chances are pretty good that you’re not going to be out of town at a time that something horrendous happens in the market now. We certainly look more secure than we did six weeks ago.
As far as those of you who are holding the mining stocks, we’re looking now, if you use current prices for the metals as opposed to future prices, we’re looking at multiples like six times, or even less for Phelps Dodge, nine times for Inco, eight or so for some of the others. The only one that’s in the teens is BHP Billiton, it’s entitled to a higher multiple because it’s a superb company and because so much of its earnings come from enormously profitable oil and gas production in Australia and the Gulf of Mexico.
So, like you, I’m distressed that these stocks have traded down to such tiny multiples, but I’ve talked to enough people who say that we’ve learned from the past that two things: if the Dollar is strong, we sell the mining stocks. And if their multiple is low, we sell them because we only want to buy them when the multiple is high. Because there’s a pattern that when the multiple is low it just gets lower and when they’re high the multiple can get higher. And there’s twenty years of evidence to support those statements.
Problem with that is those are the twenty years of the triple waterfall. It remains to be seen how that works out now that the triple waterfall is over and we’re in a new and long-term bull market for the group. The group’s market cap remains trivial and therefore, those people who take significant positions in it can have undue influence.
Diversified mines remain at 1/10th of 1% of the S&P index. So, there’s only a few people who understand these stocks. There’s only a few people who are playing them significantly and some of those who did were the pure momentum players, have sold them because of what’s happening to them elsewhere.
All of this is a process of base-making and so we’re going to see a base forming soon, unless, unless we do in fact have a sharp decline in the global economy. And in a funny kind of way, the fact that we’re not hearing talk of $60 oil is good news for the base metals. Because what it’s meant is that the single biggest threat to the global economy may be moved to the back.
And who knows, the other threat which is that the Fed may be too puritanical and drive rates to a level that produces a severe slowdown, maybe that will be put off a bit as a result of the evidences of already slowing particularly in the leading indicators.
So I would say steady as she goes and it requires some courage, but these stocks, which I considered very cheap a few months ago are very, very cheap now but that doesn’t mean they can’t get very, very, very cheap.
That’s it, any questions?
Tom GIlbert: Hi Don. Bull market corrections are always pretty vicious but when you think about all the performance money that is in the marketplace now with 7,000 hedge funds as well as mutual funds…how do you change…I mean is this something that we’re just going to have to get used to, this type of volatility? These deep corrections in groups that have performed very well, even though the fundamentals still seem to be intact?
Don Coxe: You make a very good point, because my experience of course was gained primarily in the pre-hedge fund era and to the extent that I had to follow hedge funds it was because they would be associated with disasters and therefore they were bad news situations. But now that they are a significant proportion of my personal client base in the sense of institutions that ask me to talk to them, what I’ve learned is that the sheer range that there is out there, the sophistication of some of them, when you see a firm like Bear Stearns announcing that something like 35% of their earnings come from deals with hedge funds, boy, they are gigantic and because they are able to take such fast moves and are willing to take such fast moves, that yes, they can have a degree of influence which is to me amazing. And maybe you’re right, that we’ve just got to expect those kinds of corrections.
When the positions were acquired against a liability on the other side, as opposed to a long-only organization like a mutual fund which may have built an overweighting in an S&P benchmarked account where they got all of ½ of 1% in their portfolio in mining stocks which meant that they had a 400% overweight and when they unwound that, that would do some harm to the market but not the kind of thing that we’ve seen in the sell-off in stocks such as Inco and Freeport and the aluminums. The aluminums have been…from this you can only conclude that aluminum has been replaced by plastic by what’s happening to some of these stocks.
I guess you’re right, it’s just a new kind of era in the sense of who it is that’s actually doing the trading day in and day out and what their percentage of impact is. Thank you, any other questions.
Tom Dusmette(?): Hi Don. Don, would it be possible for you to produce, maybe in some commentary or some form that list of stocks that are kind of the benchmarks that you use in those areas that are so cheap? Because, when we’re going to look at these things, having a summary list that we can look at that doesn’t have much around it is a great resource when we’re trying to figure out what we’re going to do on a given day. It makes for quick reference.
Don Coxe: I will take that suggestion and I’m going to be writing Basic Points next week, so I will include in the next issue of Basic Points the stocks that are in my mind when I talk about these groups, which will constitute not necessarily a recommendation but you’ll know what it is that I’m saying when I say that we’re doing well or we’re doing badly.
Tom Gilbert: Thanks, Don, one more question. I wanted to get back to a little bit about what you just talked about. In regard to the performance money that’s in the marketplace today, is there a higher likelihood in your opinion that there could be more disconnects relative to the performance of an equity group vs. the fundamentals? What I mean by that is most people would try to glean something from the market where the market was leading and the stocks would be a telling indicator that there is a slowdown that’s coming. However with the performance money that we have, is there more of a likelihood no that that could be bad information that the market is giving us?
Don Coxe: Thank you, that’s an excellent question. What to me would be a much better indication than the stock prices would be a significant change in the futures which would indicate that although the futures were in backwardation but if the backwardation were more intense…for example, if we’re sitting at 140 copper and the December copper has been trading at a discount of eight cents and it suddenly went to an eighteen cent discount, that wouldn’t be noticed by many people. I would certainly notice that, because that would indicate that in that sector of the curve if that many players who are pretty knowledgeable thought that there was going to be a big drop relative to the spot between now and then, that would be a pretty strong evidence that some informed people thought the game had changed. What’s happened is the backwardation has sort of stayed in the same kind of curve, which suggests to me it’s simply a policy of the companies to hedge forward a certain amount of their production. And that the amount of speculation doesn’t change much from time to time. But that’s a very, very good point, I’ll think about how we can illustrate that.
Thank you all for tuning in to the call, next week I’ll talk to you from Chicago.
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Don Coxe Profile from the BMO websites:
Donald G. M. Coxe is Chairman and Chief Strategist of Harris Investment Management, and Chairman of Jones Heward Investments. Mr. Coxe has 27 years experience in institutional investing, including a decade as CEO of a Canadian investment counseling firm and six years on Wall Street as a 'sell-side' portfolio strategist advising institutional investors. In addition, Mr. Coxe has experience with pension fund planning, including liability analysis, and tactical asset allocation. His educational background includes an undergraduate degree from the University of Toronto and a law degree from Osgoode Hall Law School. Don joined Harris in September, 1993.
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