How Low Can Mining Stocks Go?

by: Andrew Mickey October 17, 2008 | about stocks: ACH / BDD / BDG / BOM / BOS / FXC / GDX / HL / OXY / PCU / PTR / RTP / TCK    

Andrew Mickey

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Recession fears have taken their toll on almost everything. Even popular recession-proof stocks like Wal-Mart (NYSE:WMT) and McDonald’s (NYSE:MCD) have taken their lumps too. The worst place to be invested though has been in commodity stocks.

No one knows how bad this recession will be, how long it will last, and how great an impact it will have on the once-quickly growing economies of China and India which have propelled the commodity boom. Frankly, it all depends on when the world’s shattered confidence can be rebuilt. But with credit markets remaining tight, a stock market that has tanked, and unemployment on the rise, you can bet we’re not going to see the light at the end of the tunnel for a while.

This uncertainty has been a huge drag on commodity markets. After all, a deep global recession would send commodity prices plummeting further and could push them all the way back to historic norms. So far, recession fears and reduced demand for commodities have caused the Reuters/Jefferies CRB Index to fall 33% in the past few months.

The CRB Index is made up of a wide basket of commodities. Everything from oil to gold to livestock prices has an impact on the CRB Index. Energy and agricultural commodities are off anywhere between 5% and 60% from their recent highs. The biggest drag on the index has been the 50% to 70% drop in base metals over the past few months.

Base metal prices are down…way down and a global recession may push them down even further. As a result, I wanted to take a look at the “worst case” scenario for base metals and what impact it would have on energy and mining stocks. After all, if the recession really took a turn for the worse, base metals could return to their 2002 lows.

Think it can’t happen? Just take a look at zinc.

Zinc is used primarily in steel production. The downturn in the global economy has sharply reduced demand for steel. Falling auto sales and lack of new construction projects will have (and have had) a very negative impact on steel demand.

A commodity like zinc, which doesn’t have many other uses outside of steel, would naturally have its fortunes closely tied to steel. Right now, that’s not a very good place to be. Zinc prices continued their fall to 52 cents a pound earlier today. That price marks a 75% decline from zinc’s peak of more than $2.00 per pound in 2006 and is the lowest zinc price since mid 2005.

It’s not just zinc though; similar drops have occurred in nickel and aluminum prices. The world’s largest aluminum giant, Russia-based RUSAL, now says, “75% of aluminum producers in Europe, the United States and China were operating at below break-even with the metal trading at or below [current prices of] $2,500 per ton.”

The downturn in base metals has caused a tremendous sell-off in mining stocks. Leading the way down has been zinc, uranium, and fertilizer mining stocks. The combination of forced selling by hedge funds and falling commodities prices has pushed energy and mining stocks to new 52-week lows.

If we look at the current lows, they’re still not as low as they could go. If we consider the start of 2002 as the previous bottom in energy and mining share prices and use it as the “worst case” scenario, there could be some more downside left.

Take a look at the chart below (click to enlarge). In a “worst case” scenario, there could be some more downside to go.

As you can see, there could be a lot more downside left in commodity sector stocks. These companies are highly leveraged to underlying commodity prices and there is still plenty more room to fall if the world economy gets really ugly.

Of course, when analyzing the individual companies we also have to consider expansions, investments made over the past few years, and the general price level increases resulting from inflation over the past few years when determining the true bottom for these stocks. And I think the 2002 lows will not be reached, but in a market like this where uncertainty reigns and markets would rather err on the low side, it’s certainly not impossible. When earnings, fair value, and future growth are unpredictable, watching many of these stocks swing a bit lower over the next few months is not out of the question.

I realize most of these mining stocks are at the lowest prices they’ve been in a couple of years. But considering the overcapacity in the automotive industry, sharp fall-off of industrial production and the unknown impact of a global slowdown on base metal prices, there could be even more downside to come.

Most mining stocks have incredibly low P/E ratios and very high yields. For instance, Teck Cominco sports a current P/E of 4 and a dividend yield of 6%. But if copper and base metals prices continue their downtrend, earnings will decline sharply and the company will be forced to slash its dividend payments.

For now, it’s best to take a “wait and see” approach for mining sector stocks. For investors that do want to start nibbling away at mining stocks, it’s probably best to use a more conservative investing strategy. One that will allow you to start buying today, have you positioned to enjoy the inevitable and likely sharp rallies, and still benefit from any further sell-offs. Although with markets as volatile as they are, there could be more downside to come.

Disclosure: I have no position in any of the stocks mentioned in this article.

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This article has 16 comments:

  •  
    Oct 17 12:57 PM
    Thank you for one of the best, most useful, articles I have seen on this site.
    Question: Can anyone point to an analysis of what the impact is on copper demand, of the change in home construction use of a substitute material for some water pipes called CPVC?
    Reply | Link to Comment
  •  
    Oct 17 01:24 PM
    Copper demand, like steel and oil has been fueled by huge demands in China in the last 2 years. Something mining people have been anticipating for 20 years. China are taking measures to secure metals resources in Africa but, they still are going to need the resources and technology necessary to extract those resources. So, western mining houses will still be around to supply that demand.
    Reply | Link to Comment
  •  
    Oct 17 03:18 PM
    One thought for low share prices: What if the major shareholders want TITLE? Beats paying off the little guys, and the same major holders control the money center banks, so the mines can't get loans either. Just a thought.
    Reply | Link to Comment
  •  
    Oct 17 05:03 PM
    the large growth in demand for base metals over the last decade has been from the BRIC countries. Those countries may have slowed down in their pace of growth, but they are not in recession. The demand at the margin will fall while the developed world goes into recession, and some of the supply pipeline will be shutdown. In turn, as supply falls from the market and the growth continues in the developing world, pricing pressure will again return to the base metal. While nobody can predict with certainty when demand will again exceed supply, it seems clear that it will do so (unless you believe that the BRIC countries will not continue to industrialize). Patient investors who buy at the levels these stocks are currentlly trading at, will be rewarded.
    Reply | Link to Comment
  •  
    Oct 18 08:55 AM
    Andrew,
    I concur with the appreciation of your thoughtful piece. Would you be good enough to take a longer term view, back before the 2002 trough? What were the parallels with the 1974, 1987 and 1998 bottoms? Are they even relevant, given the different structure of world demand?
    In any event, thank you. Are you watching the Baltic Dryships index for a clue on the near term bottom of metals prices? Being long some of these stocks, I'm watching quite eagerly.
    Turbo
    Reply | Link to Comment
  •  
    Oct 18 09:43 AM
    enrico - PVC pressure pipe can replace copper in localities where building codes permit it. the principal advantage of the pvc is improved labor productivity. some people question the long-term safety/reliability of the pvc under pressure. make sure there isn't any bisphenol-A in the vinyl.
    > jack
    Reply | Link to Comment
  •  
    Oct 18 10:24 AM
    Interesting article. Thank you.
    Reply | Link to Comment
  •  
    Oct 18 10:43 AM
    Great article! Way too much of my portfolio is in PCU and add to that I have some FCX. It was at least good to see that PCU is lower than 2002 levels. So, maybe it won't go down much further. Now if I had more money to spend, I certainly think this would be a good time to buy these commodity stocks. They might not be quite at their bottom, but I would think that they are almost there.

    I guess with all stocks now, those who can wait a while have the advantage.

    About CPVC: I used to sell it and thought it was wonderful, but when I went to put new plumbing in my old house, I used copper. Copper does have that nice feature of cutting down on germs as water flows through it. And I would think that right now, it's about as cheap as CPVC! Lol.
    Reply | Link to Comment
  •  
    Oct 18 11:37 AM
    interesting sobering thoughts, thanks - needed that :-)
    Reply | Link to Comment
  •  
    Oct 18 01:15 PM
    The big question for mining and other commodity stocks is as to whether the BRIC's and parts of Asia slow down more than anticipated. Currently, the thinking is that they will but for only a brief period such as 1 year.

    The worst case is thatb they slow down and go into a protracted recession. That is not widely belived in at this moment. That's what gives me pause on buying anything. World growth has been funded by bad debt and cheap money. That has to be reconcilled going forward. We are not there yet.
    Reply | Link to Comment
  •  
    Oct 18 01:19 PM
    China and India each have a population of over a billion, so the demand for commodities from these two countries will continue. Per capital consumption in these 2 countries is minimal and has room only to go up and not down. This will put upward pressure on the commodities in the next 5 years, inspite of the current crisis. Also the Central government in India has recently announced steep wage hikes as a result of the 6th Pay Commission. This will create confidence and a definite boost in commodity demand, in the next 12 months or so. So this is probably a great time to buy at these firesale prices.
    Reply | Link to Comment
  •  
    Oct 18 03:06 PM
    By one important measure, they’re cheaper than they have been since 1985. They’re 20 percent less expensive than they have been, on average, over the past 100 years. And yet they still may have a ways to fall.

    On Friday, after lurching back and forth, the Standard & Poor’s 500-stock index closed at 899. That meant the five-year p-e ratio was just below 12. (The corporate earnings data isn’t all available yet, so this is an estimate.) It was last that low in late 1985. Over the past 100 years, the average p-e has been about 15.5.

    There are two things to keep in mind, in the event that you consider these ratios to be a sign that now is the time to buy. First, the p-e ratio typically falls well below its long-run average during a bust. It fell to about 6 in both the 1930s and early 1980s.


    Reply | Link to Comment
  •  
    Oct 18 03:09 PM
    Second, remember that there are two components to the p-e ratio: the ‘p’ and the ‘e.’ Based on the kind of recession we may now be entering, it’s entirely reasonable to think that corporate earnings will fall, maybe significantly. That would mean that stocks would also have to fall just to keep the p-e ratio in its current place.

    I don’t pretend to know what is going to happen with stocks. They’re certainly not overvalued the way that they were for most of the last decade. But the fundamentals also don’t make it obvious that we’re at the bottom or on the verge of a sharp snap-back.

    Reply | Link to Comment
  •  
    Oct 18 03:41 PM
    Many of the mining companies have decreased or shuttered higher cost operations, those that require expensive remediation, sulfuric acid, or are energy or warter hogs in energy tight areas, or the parched regions of SA, Aus and S.Africa. Small and Junior precious metal miners are also most exposed to the tightened credit problems.

    The Baltic Dry index drop not only reflects earlier fuel costs, but also the deleveraging of bets on commodities' prices by SWF's and Hedge funds.

    However, many sound shippers (who've contracted lease rates through 2010-2011) have seen their valuations cut to half of book value :EGLE & GNK (Eagle and Genco) are examples, and may represent reasonable entry points.

    On this site a comparison of Freeport_McMoran to Southern Copper, indicated a relative advantage for FCX, but if PCU can resolve the Asarco problem, it will have similar valuations. I like to look at long-term (5-10 yrs) of the charts to see the cycles, and I buy when the dividends seem secure.

    The spot price of copper below $2.40, earlier this past week, was a cautionary note concerning the increasing slowdown worldwide ...some call it "Dr.Copper" as a measure of the worlds's healty commerce and growth.
    Reply | Link to Comment
  •  
    Oct 24 10:19 PM
    Very much appreciate your analysis. Along with all of the geniuses and idiots out there, I have also been taken for a ride in this market. Good to hear a conservative, reasoned approach to investing in what in all appearances looks like a winning sector in the not-too-far-away future.

    Reply | Link to Comment
  •  
    Oct 30 01:54 PM
    THE BIGGEST MINING COMPANIES ARE TOXIC COAL AND AIR POLUTING OIL THEY COST SO MUCH THAT THE PUBLIC IS TAPPED OUT FOR GOLD SILVER AND COPPER IF WE CAN GO TO SOLAR WE CAN ELIMINATE TOXIC COAL AND TERRORIST SUPPORTING OIL THEN WE CAN USE THE OTHER MINERALS FOR GROWTH .AT LEAST WE COULD AFFORD COPPER FOR WIRES AND GOLD FOR ELECTRONIC USE AND JEWELRY BUT UNTIL WE CAN FREE OURSELVES OF OUR ADDICTION FOR COAL AND OIL WE CANT EVEN AFFORD MCDONALDS
    Reply | Link to Comment
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