Tentative trading in MRX - Aug'07

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Hi all, I am trading aggressively just two stocks at the moment and keeping a sizeable amount of cash on the side. Why? Because I believe this market is going lower. I believe there is a lot more bad news to come, and fears might escalate if the credit rating agencies are called into question.

Most of the stock I am retaining is Matrix Metals (MRX.ASX), plus an explorer Alloy Resources (AYR.ASX). The reason being is that both companies were oversold and are expecting drilling results. Matrix is a low cost copper producer aggressively expanding output. It is ripe for a takeover by Xstrata if they find anything big. They recently entered production at are probably trading at a PER of 3x, and they have alot of upside besides. More importantly the chart is signalling to me a technical breakout.

The other stock Alloy Resources (AYR) is drilling a copper-gold target along the same geological trend as Pan Australian Resources (PNA.ASX). For this reason I am holding out for some excellent results which might just be the basis for a company-making mine. PNA have had some impressive results on this trend, so I'm hopeful for AYR despite the long development lead time.

- Andrew Sheldon www.sheldonthinks.com

Are you ready for the forthcoming gold boom?

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The global resources sector has had a bonanza period over the last 3 years, though the bulk of the fortunes made to date have been in the bulk materials (bauxite, manganese & iron ore), energy (uranium, oil, conventional gas, coal seam methane) and base metals (Copper, nickel, zinc, lead) sectors. The lagged has been the gold industry – particularly in the major commodity producing countries like Australia, South Africa and Canada.
Metal price Comparison
Looking at the returns of base metals, copper price was $0.80/lb in 1999 and now its around $US3.50/lb. Copper producers have never had it so good. Now consider the situation in the Australian gold mining sector. Despite a 70% increase in the gold price from $390 to $665 an ounce in the last 3 years in US terms, the 22% rise in the $AUD over the same period meant that the gold price in Australian dollar terms increased by just 40% from $555 to $775 an ounce.

Japanese gold producers have done far better given that the 7% depreciation in the yen over the same period means gold prices over the same period increased by 82%.
The fortunes of the gold industry
Currently the bulk of Australia's gold producers are facing difficult operating conditions, whether its staff or material shortages, rapid increases in mining costs or poor grade reconciliation. While their base metals peers have been raking in the profits, several gold miners have gone into administration, including BMA Gold, Croesus Mining and Gleneagle Gold. Others such as Batavia Mining and A1 Minerals have been forced to delay their projects rather than undermine the viability of their projects.
Consider that Barrick Gold's cash production costs rose 38% between 2005 to 2006 for its Australian and Papua New Guinean operations, whilst Newmont's costs rose 18% in Australia and NZ over a later 1 year period. More broadly, global gold cash costs have nearly doubled since 2001. Some producers have faired better than others, eg. Barrick has hedged much of its exposure to the Australian dollar at lower rates.
Gold outlook
Whilst the global economy becomes de-leveraged by falling asset prices and rising inflation, the gold sector is likely to benefit on both fronts because:
1. The value of gold to the total size of the global economy still has gold under-priced. Gold as we have already indicated has not risen like other commodities
2. Divestiture of other assets leads people into the safety of bonds, but gold for high returns. But gold is a very small market so expect volatility and significant price advances .

The paradox is that gold miners will benefit from the next leg of the gold boom for several reasons:
1. Gold was the laggard in the 2nd stage of the commodities cycle - but not this time - it will rise greatly whilst other metals fall off.
2. Gold (and other metals) will benefit from a weaker $AUD

Gold investment strategy
There is no question that gold miners offer superior exposure to rising gold prices than gold metal (coins or exchange traded funds), but you need to be selective. Consider the following:
1. Location: Seek gold miners located in non-resource based economies, or economies in which mining represents a small portion of the global economy (China, USA), as these countries will not experience stronger currencies as gold prices increase. There are a number of miners in Africa (Resolute Gold, Sub-Sahara Resources), Thailand (Kingsgate Cons), as well as explorers. Eg. Azumah Res, Castle Minerals in Africa.
2. Gold resources: Look for gold stocks that have a large inventory of gold resources because they offer a longer mine life. We are looking for a life of 15+ years. We are more impressed by miners that have large gold inventories because they are more likely to be taken over.
3. Low cost production: Look for miners with lower cash production costs, whether because they have higher grades than normal, significant credits for associated metals, or very favourable ore characteristics, eg. Large, tabular, shallow ore bodies suitable to cheap bulk extraction.
4. Low capital costs: Look for miners with low capital costs, whether because it’s a simple gravity separation process only, a cheap heap leach operation, or they have conscripted a third party plant for toll treatment.
5. No hedging: We don’t want to see gold price hedging, or if they have hedging, it should be for a small proportion of production or will be paid out soon. We should reflect favourably on producers that hedged their currency at lower rates, but any fresh currency hedging now would be a negative factor. We want maximum exposure to the gold price increase.
6. Scalability: We should look favourably upon gold producers who have the capacity to scale up production from existing plant through minor modifications or resource upside.
7. Discounts: We would prefer stocks trading at a discount to market parities. Particularly projects which have low gold grades, so they have the greatest upside from higher prices.
8. Options: We are particularly interested in stocks that have low-priced options because they offer low-cost entry into promising stocks.

A lot of Australian companies are looking outside Australia to find larger ore bodies, as well as to reduce mine costs. Sino Gold's open pit mining costs are one-third the Australian costs, while the salary of a skilled mining operator is about one-fifth of the equivalent Australian labour. This shift in exploration overseas and lost prospectivity has taken its toll on Australian gold production, since it has fallen to its lowest level in 15 years, whilst China had overtaken Australia as the world's third-largest producer. But the other reason gold exploration has floundered is because gold prices have lagged, so more money has gone into uranium, iron ore and base metals. The number of new IPOs for these metals has way surpassed new gold floats. But the major miners still like Australia and see it as part of a global portfolio with lower political risks helping to offset the higher costs.

- Andrew Sheldon www.sheldonthinks.com

Universal Resources (ASX.URL)

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In the process of doing some research for the copper stocks listed in my previous posting, I came across a comparison of copper stocks in a Exco Resources presentation. It is a table which computes the value of insitu (in-ground) copper resources in terms of stock market capitalisation (ie. $A market cap /tonnes of insitu copper). You might wonder why the discrepancy in values. For the most part its because of:

1. Stage of development - the stocks ranking over $1000 are in production, the stocks in the $300-500 range are still developing resources. They have not prepared a feasibility study so the project sponsor can't give you an accurate picture of realistic cashflows from the mine scheduling for ore block extraction. Without that info there is greater risk attached to the project.

2. Recoverable grade - Its apparent that most of the projects have a recoverable grade of around 1% copper. The exception is URL - with a grade of 0.73% Cu. That has to impact on mine profitability...but there are other issues - the big ones being economies of scale, strategic objectives and our forward-looking price assumptions.

So why is URL so low?

Before we get excited there are several things we need to know about URL. The company controls alot of copper - 933,000 tonnes of it, worth billions. These resources are spread among 10 pits, so there is even more upside in exploration potential around the mine planned pit margins and even underground potential below the pits.

The marginal grade of the ore has a big impact on mine value. The forecast cash cost of the mine is $1.10/lb compared to likely $0.60-0.80/lb for the other projects, which have higher grades and less onerous capital expenditure demands. URL need to raise $340mil compared to their much lower market capitalisation of just $25mil. Consider that if we assume an unreasonably high (current) copper price of $3.50/lb, the project has a NPV of $960mil. But if we assume a capital cost of $2/lb, the project has a NPV of $140mil. Thats a huge difference.

But consider the strategic value of a centrally located copper processing facility in one of the most important copper provinces in the world. Xstrata has recognised the potential of these resources since it has contracted to earn a 51% stake in the underground potential (below 200m depth) by spending $15mil. Really $15mil figures means nothing since they can withdrawal after a lesser commitment. In fact the company has screwed up because Xstrata - one of the world's largest copper miners, gets a strategic stake in a huge mine for little outlay, and effectively locks out the competition from dealing with URL. Companies like Teck Corp of Canada. Clearly these copper deposits and and any centrally-located processing plant associated with these deposits has a strategic value. The value its greatest for Xstrata since it already has significant capital invested at Mt Isa Mines (having taken over MIM several years ago). Clearly the deal is sweeter for Xstrata if it can:

1. Find higher grade copper ore through exploration

2. Take over other explorers with higher grade ores in the area

The URL clearly did not see the strategic importance of this project. I would argue that they should have got a firmer commitment on capital expenditures for the testing of the UG potential (the SEET project), or raised more capital to test the UG potential themselves...if only with a few deep holes.

Going forward, URL is a company with a $25mil market capitalisation (292mil shares at 8.8c) and $7mil in cash. Aside from some uranium exposure, the attributed value of their project is $18mil. That seems very low considering the exploration potential of its ground, the outlook for copper prices and established resources. For this reason I bought a stake, in the hope that:

1. Xstrata will make a takeover offer for URL after it has:

a) Proven that higher grade ore exists below the existing pits

b) Found higher grade ores in the area through its only exploration efforts

c) Taken over other companies in the area, or negotiated control over additional high grade ore

Any of these steps would justify Xstrata taking over URL. Given the lack of competition that URL management have effectively excluded, its likely that Xstrata will be able to purchase the company for about double its current value.

So this is a hard stock to pick because Xstrata need not be in a hurry...they have until 2010 to expend $15mil to earn their 51% stake. But in case you are thinking that copper prices might sink to $0.8/lb like they did in the late 1990s, think again...we are in the midst of a commodities boom driven by China, India and other countries. We are not likely to see copper prices under $2.00/lb for some time, and I think $2.50-2.80/lb is a more likely average price. So I see the URL project NPV around $300-500mil. But I dont expect shareholders to see much of that. Xstrata will play hard ball, just as they did over the Windimurra Vanadium project. It seems Xstrata is very good at extracting value from small company managers that under-value the value of their assets. The problem is a lack of commercial/strategic skills in our small mining companies. Take a look at the URL and you see geologists (scientists) and mining engineers (operations). You dont see commericial/strategic thinkers. Thats a problem...because thats a huge source of revenue/value.

I'm sure you are familar with the notion of Australia 'selling the farm' at extraordinarily low prices. Well its not just us, its foreigners as well, as its a global phenomena. Its a lack of capacity for conceptual thinking and the general knowledge required to support it.

Anyway I bought some URL because it offers value from:

1. Further exploration success - by URL or Xstrata

2. Prospect of a URL or neighbour takeover (Exco Res, Copperco)

3. Xstrata (SEET project) drilling success

Haven't decided if it will be a short term trade or a longer term investment. Lets see how the drilling results unfold. At 8.8c its unclear to me whether they will fall to 8c support or even lower.

- Andrew Sheldon www.sheldonthinks.com

Copper stocks - Aug'07

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You could be forgiven for thinking that the world is about to end, that the continents are about to slide into the sea...given the recent equity market slide. This is not totally unwarranted that stocks took a slide over recent weaks, but the rationale seems somewhat dubious. Personally I think its more about profit-taking than fundamentals. Or is the market worried about inflation? Well in any respect there seems little justification for the recent slide in small copper mining stocks in recent weeks - an average fall of 30% according to the Sydney Morning Herald. Gold stocks didnt fair as badly, perhaps suggesting that gold is deemed to have more upside.

Well we should be accustomed to mining stocks falling with the general malaise of the stock market, and we are accustomed to the spec-end of the market being punished more than the blue chips, despite some very favourable fundamentals. As www.basemetals.com/Copper has suggested copper prices have risen 22% this year to $US8,0000/tonne on the basis of tight stockpiles. London Metals Exchange (LME) stockpiles have fallen 42% this year, and more tightness is expected. Interestingly copper prices are still short of their previous high of $4.04/pound reachd in May 2006, but the market seems to be pricing in a fall based on the calamity in th sub-prime market. Might equity investors be seeing a fall before the metals market?

As we can see from the attached charts, copper stocks have fallen on average 30% to their support levels on the basis of a 4.8% fall in copper prices in recent days related to the sub-prime loan issue. Despite the uncertainties in the stock market, the downgrading of copper stocks appears excessive, and the attached stocks offer some good buying opportunities. My apologies this is not a very clear chart - the stocks are:
1. Matrix Metals (ASX.MRX) -at 13.5c
2. Exco Resources (ASX.EXS) - at 30c
3. Copperco Ltd (ASX.CUO) - at 87c
4. Redbank Mines (ASX.RBM) at 12c
Some pundits are expecting the Federal Reserve Board to respond to the weakness in the US housing market with an interest rate cut. I however dont expect as much....I think the Fed will hold the current line. I dont believe the Fed would want to signal easier monetary policy at times of higher commodity prices and tight labour markets, even if 'junk loan' end of the property market and a few funs managers and investors are feeling the pinch. There has been no collapse in earnings, and no significant reduction in credit outstanding....so there remains alot of money sloshing around the global economy, so expect markets to resume their climb. I am expecting copper prices to recover to their previous high of $4.04/pound reachd in May 2006.
It can be said that I have a suspicious nature, but when you consider that one of the reasons that copper prices are strong (supply is tight) is that workers at several very large mines in Mexico and Chile are on strike. That being the case, you'd have to wonder whether price manipulation is going on. Given that the market is driven by such short term factors....it would seem to 'profitable' for several senior mining executives at the major producers to conspire to hold off on pay rises in conditions of very high inflation in the mining districts to push metal prices higher. Why would they do that? Well - because its easy and profitable. Consider what it takes:
1. Several senior mining executives at a metals conference to get together for dinner and talk about metal markets....understand producers are largely price takers....with many producers and few refiners.
2. Only a few executives need to conspire to hold the status quo on wages, to cause strikes, to prompt a temporary supply shortage
3. After copper prices have risen by a significant degree, producers lock in the higher prices in the derivatives market
4. The executives then seek a deal with the miners which results in a concessional increase in wages, and they commence the resumed delivery of copper concentrates into the market by selling into those derivative (futures, options) contractual commitments

This is not an outlandish proposition.....its a small community among the major mining companies. They are constantly talking about prices given the dominance of these players and the benefits of holding the line. They are not really competitors since on prices but volumes. And when there are tight volumes, it makes sense to hold back some for higher prices. I am reminded of Amcor, a paper producer that was involved in price fixing years ago. I think that was a rare occasion that a groups of executives were discovered to be engaging in price fixing. I think its more prevalent than we know. Makes you wonder whether Osama Bin Laden is playing the futures market from some bunker as he blows up US Iraqis?
The only way we can determine if this is happening is:
1. Correlating price movements with strikes and derivative contractual commitments
2. Correlate spot and derivative copper prices to see if the derivatives market is questioning the soundness of copper prices

Disclosure: The author holds Metrix Metal stock.
- Andrew Sheldon www.sheldonthinks.com

Gold stocks - Aug 2007

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Gold stocks are one of the most compelling sectors of the equities market for several reasons.

1. Inflation is emerging

2. Gold is technically close to a breakout. You might be thinking that gold has already risen a great deal, but it has not kept up with the other commodities. See my posting on my Commodities blog.

The next question then is how do we position ourselves for this phenomena. We already have the major stocks trading at huge multiples, so its worth looking at some of the smaller stocks.

Listed on the Australian Stock Exchange (ASX) we have:

1. Bendigo Mining: This company has recently fallen off considerably after it revised its gold resource estimation model that culminated in a significant downgrading of its resource inventory. Since the downgrade the company has found new ore resources in new vein systems.
2. Resolute Gold: Resolute has an operating gold mine in Ghana, Africa and is developing several others.

Stay tuned for more info.

- Andrew Sheldon www.sheldonthinks.com