Xstrata exposed to iron law

The price of mining shares has lost touch with reality. Those close to the action, such as BHP Billiton's boss, Marius Kloppers, say China's re-stocking of commodities, which has propelled both metals prices and mining shares this year, has ended, but the pick-up in developed economies needed to fill the resulting demand gap is not materialising. Yet metals prices and mining shares remain aloft. Something has got to give and, we suspect, the reality sketched by Mr Kloppers will trump pie-in-the-sky in due course. When that happens, few shares will be as hard-hit as those in diversified mining giant Xstrata, because its share price is especially sensitive to movements in metals prices.

There is a rational explanation for this. Xstrata was created by cobbling together a collection of middling assets via acquisitions. Thus in many commodities it was perceived as being higher up the production cost curve than diversified rivals such as BHP and Rio Tinto - the latter being blessed with extremely low-cost assets. Higher operating costs, most of which are fixed, equals more movement in profit, for good or ill, when commodity prices swing. Whether or not this is still a fair description of Xstrata is debatable. In its failed attempt at a merger with Anglo American earlier this year, Xstrata emphasised that in many commodities it is now a low cost producer. But the stock market continues to treat Xstrata's shares as if its high costs were still real.

For proof, take the beta - a common measure of stastistical sensitivity - of mining shares to the price of both copper and to a basket of copper, zinc, aluminium and nickel. Over the past year, Xstrata's beta has been far larger than that of any of its peers. If sustained, the outcome would be clear - Xstrata's share price would fall hard and fast if metals prices pull back.

Beyond this, Xstrata's particularly large exposure to nickel in its revenue stream - having become a leading global producer with the acquisition of Falconbridge - is a concern. The price of nickel has weakened noticeably since mid-August due to the weak demand globally for steel, yet many mining analysts think that nickel price has a good bit further to fall still, whatever happens to the price of other metals.

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Xstrata's chief executive Mick Davis has a reputation for canny deal-making. Yet, over the past two years, his touch has seemed less sure, especially as Xstata bought 25 per cent of troubled platinum miner Lonmin at top-of-the-cycle prices in 2008 only to see its value plunge as the global economic crisis hit. In the new economic climate, Mr Davis cannot get the financing he would need to buy out Lonmin completely. Though he might not want to, given that Lonmin now looks a worse buy than it did then. Yet how does he sell such a large stake in an orderly fashion? Then there was the face-off with Anglo American, in which no amount of argument over the fairness of a 'nil premium' merger of the two companies based on the compatibility of their assets was going to overcome the fact that shareholders in the target company expected a take-out premium.

Now, Xstrata cannot make a further move for Anglo American till the new year and its corporate destiny looks fuzzy. Behind much of this confusion lie questions over the intent of Xstrata's 35 per cent shareholder, the privately-owned Swiss commodities-trading giant, Glencore. Certainly, the relationship brings definite pluses. Glencore' marketing expertise in Xstrata's key commodities complements Xstrata's ability in managing and operating its assets. But this same marketing relationship scotched a take-out attempt for Xstrata itself by the Brazilian mining giant, Vale, as Glencore would not give up its privileges. And the way Glencore contributed some $2bn to Xstrata's jumbo rights issue earlier this year, only to get its money back almost immediately by selling a coal asset to Xstrata, did not look like a wonderful way to do business. That said, Glencore always lurks in the background as a potential white knight should anything go really badly wrong at Xstrata.