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Martin T. Sosnoff Headshot

Copper and Coal, the Poor Man's Gold

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I am in love with copper, with coal, iron ore and oil, too, in that order, but not gold. Honchos scored with gold last year, but now gold is coming in, even with the Middle East in flux and incindiary.

My take on gold is negative because I believe the short the dollar-long gold spread is last year's news. Why should the dollar not gain on the Euro? Our GDP is back to a normalized 3.5 percent growth rate while Euroland stagnates, maybe for several years. In purchasing power the euro is 15 percent overvalued. Stay in London or Paris on a long weekend and you'll get the picture.

Euroland can't afford to raise interest rates while ours head higher. Many of us believe a 4 percent yield on 10-year treasuries is around the corner, and our negative real interest rates in the money market end next year. We face trillion dollar deficits this year and next, so dollar bulls can't wax rambunctious as yet.

My pro-copper-coal stance is based on world-wide GDP recovery to a 4 percent rate the next couple of years. Financial speculation in copper is intensive, but it accounts for only 2 percent of normalized production. So worldwide demand, particularly China, is the motive force for prices, not Wall Street speculation.

Years ago, new home starts in the U.S. was an important demand variable, but even with starts running under half the normalized rate, the trajectory for copper proved unstoppable.

Last summer, copper traded at $3 a pound. Now we've crossed the $4.50 level, an awesome recovery from the recession. China's infrastructure spending 40 percent of GDP was the motive power. Futures markets are instructive. With spot prices at $4.50 a pound, the intermediate term chart, like a ski slope, descends to $3.60 five years out. Disbelief in price sustainability is profound, based on the metal's historic cycliality.

Another variable is copper scrappage. There's no reuseable variable for oil and natural gas and coal, but copper scrappage accounts for approximately 20 percent of annualized production. In case you haven't noticed, any abandoned home overnight is stripped of its copper content by scavengers.

Offsetting this supply variable which going forward isn't material, production can't vary by much year-to-year. It takes a decade to bring in a major new mine, so annual incremental capacity is minimal. Shrewdly, major operators like Freeport McMoran mine high cost sites when prices spike and vice versa when demand diminishes.

Global consumption from the 2008 recession low has recovered some 10 percent and could rise over 4 percent this year vs. 2010. I'm excluding any material demand from the creation of a major exchange traded fund which needs physical possession to operate.

China's demand has risen over 13 percent, annually, these past 10 years, but some demand destruction based on current copper quotes is likely. Total global demand rebounded 11 percent last year, but is expected to rise only 4 percent in 2011, even less in outer years. This is enough to keep copper at $4.50 a pound if not higher in 2012. New mines never meet their time table.

Not only is copper production difficult to scale up, but so is coal and iron ore. For investment, the mining sector is multi-dimensional. Oil is somewhat analogous but different.
For all raw materials operators, rising costs is a way of life, particularly exploration, development and calls on capital. There are visible threats of higher royalty taxes in Chile, Brazil, even Australia, where the spike in metallurgical grade coking coal tempts a response.

These variables for copper, along with its cyclical history on price realizations and earnings hold valuation under 10 times perceived current earnings power. Rio Tinto is at 6 times and BHP Billiton at 8.4. The exception is coal where the going rate is closer to 15 times projected forward earnings.

Coal reserves are found in safer geopolitical environments like the U.S. and Australia. The Street senses a higher probability of pricing leverage the next couple of years and there is no variable of scrappage or demand destruction. Down the road, environmental negatives of steam coal burned by utilities shifts demand to natural gas, but this is 5 to 10 years away.

What I like about the mining industry is everyone's incapacity to forecast prices whether oil, copper, coal, aluminum or iron ore. Managements grossly underestimated inflation in commodities the past few years so capital investment in new projects is still limited to projects where management projected at least a 15 percent return on investment, using much lower assumptions than current spot prices for copper, coal and iron ore.

Turning to specific investment opportunities what strikes me is the colossal size of major international players in terms of market capitalization. BHP Billiton, not exactly a household name, sports a market cap of $250 billion. This is followed by Vale's $180 billion and Rio Tinto's $150 billion sized property. Freeport, the major copper play, is number 6 on the list at approximately $60 billion. These properties are dwarfed by Exxon Mobil but larger than most international oils.

They throw off enormous amounts of free cash flow, and this creates capital availability for acquisitions, share buybacks, even rising dividends. BHP made an unsolicited bid for Potash Corporation with a market cap over $50 billion. Buyout activity in the coal sector is surfacing, too, but nothing is cheap.

BHP Billiton and Rio Tinto trade below their 10-year valuation history using enterprise value to EBITDA multiples as the yardstick. Most market players and traders believe mining stocks stand within a year of peak earnings for this cycle. If this perception needs to be stretched out another year or more the sector remains in a buying range. Properties like Freeport rachet up and down in lock step with spot futures quotes.
My horses embrace BHP Billiton, Rio Tinto, Vale, Freeport McMoran and Peabody Energy. I'm partial to Freeport as the most leveraged earnings play near term if copper holds above $4.50 a pound. This is my indirect way of playing the Chinese economy and stock market which was a non performer last year and today is super sensitive to tightening monetary policy.

If I'm wrong, copper mines will be perceived as gigantic holes in the ground with a topping of green slimy water, a stagnant pool and a treacherous investment. The materials sector in the S&P 500 carries a weighting of just 4.5 percent.

Financials weigh in near 16 percent of the Index, but consider how volatile and treacherous banks proved during 2008-2009. Conceptually, I'd rather invest in a 4 percent sector then a 16 percent sector any day of the week.

Metals traders chant "Supercycle! Supercycle!" I'm agnostic but a player.