Shane Nagle: Making Your Portfolio Pricing-Pressure Proof

The Mining Report: National Bank Financial (NBF) said in an Oct. 7 report that, when combined with its cautious near-term outlook for commodity prices, elevated multiples suggest the base metal sector is overvalued. Are there exceptions to that statement?

Shane Nagle: Since that time, we’ve seen a retracement in the multiples. The mining index in general remains near the upper end of historical ranges, as investor interest has gravitated toward large and midcap names with stable cash flow and strong balance sheets. Those companies are the exceptions, not only just within the base metal space, but within the mining space in general. Looking past those elevated cash flow and net asset value (NAV) multiples and focusing on companies with balance sheets sufficient to weather a prolonged downturn are the names that stand out as being most attractive.

TMR: Do you think the downturn will last several more years?

SN: Maybe downturn is the wrong phrase, but I think we’re still a few years away from another rally. If I can use copper as a specific example, there’s been a lot of investment on projects in the copper space throughout the past few years. About 15% or so of the current global demand is coming on-line within the next two years from the addition of several large projects (Oyu Tolgoi, Sentinel, Toromocho etc.), this is seemingly going to keep the concentrate market oversupplied throughout 2014-2015. There will probably be some general weakness in copper and base metal prices as a result of this.

The good news is the supply cycle tends to come in waves. Copper prices now are relatively low compared to what price levels are needed in order to make a lot of new projects economical. Projects are being canceled, delayed or suspended. Meanwhile, political factors such as permitting challenges are also pushing out production several years.

So maybe not a downturn, but certainly weaker fundamentals for a couple of years. On the other hand, things are looking pretty good long term, as a lot of the projects that would be slated to come on-line by 2017-2018 are not going to materialize in the current market environment.

TMR: Are we going to see similar sideways performance for nickel and zinc?

SN: Both nickel and zinc markets are oversupplied as well, but appear to be trending in opposite directions. There’s seemingly no end to the nickel supply, the wild card being the proposed export ban on nickel laterite ores from Indonesia.

People have made the case that there’s a great deal of zinc supply coming offline with the closure of the Brunswick and Perseverance mines. However, there are several additional projects, albeit smaller, coming on-line, as well as the extension of the Century and Skorpion mines in Australia and Namibia, respectively. Both markets may stay well supplied in the near term, but long-term fundamentals appear to be more supportive for zinc (which I think is the consensus view).

TMR: What’s your price deck for copper, nickel and zinc for 2014?

SN: For copper we’re using $3 per pound ($3/lb); zinc is $1/lb; and nickel is $7/lb. We’ll be taking a closer look at updating our estimates in the weeks to come.

TMR: Could base metal producers soon be ready once again to spend money on mergers and acquisitions (M&A)?

SN: I don’t think M&A is going to heat up within the base metal space. There’s been so much consolidation during the last decade that there’s not much out there to buy. The type of M&A that could still happen would be optimization of projects within larger mega-cap companies, like Glencore Xstrata PLC (GLEN:LSE; GLEN.HK:HONG KONG; GLN:JSE), where they carve out assets to the mid-tiers.

TMR: You don’t see companies like BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) or Rio Tinto Plc (RIO:NYSE; RIO:ASX; RIO:LSE; RTPPF:OTCPK) taking advantage of the market for base metals projects that are undervalued?

SN: There are very few projects of that scale that would interest those companies. They also remain under considerable pressure from their shareholders to limit spending. Glencore’s most recent comments were about curbing spending for the next few years in order to weather a downturn. Companies are still focusing on strengthening their balance sheets, limiting and reducing capital costs and optimizing their portfolios by shedding non-core assets. I think that’s the type of acquisition we’ll continue to see, not an increase in traditional M&A.

TMR: What will be the top performers among the base metals equities during the next 12–18 months?

SN: There’s very few companies left in the Canadian mid-tier space, but we’re focused on the ones that have stronger balance sheets and executable projects. Capstone Mining Corp. (CS:TSX), Lundin Mining Corp. (LUN:TSX) and First Quantum Minerals Ltd. (FM:TSX; FQM:LSE) are able to grow within their existing portfolios, have enough funding to complete those projects and still have some level of internal growth.

TMR: Capstone just put out its Q3/13 financials. Did they meet your expectations?

SN: They did. Capstone’s story is mostly about what it can do with Pinto Valley in Arizona throughout 2014. If it does a good job with the transition of Pinto Valley and is operating at full scale, production should increase to in excess of 220 million pounds (220 Mlb) in 2014 from around 105 Mlb in 2013. There are always risks with operating a project of this scale, and we expect some elevated costs initially, but getting the asset from BHP with the keys already in the ignition helps reduce some of that risk.