The global economy might be showing early signs of improvement but don't expect that to significantly boost commodity prices or mining equities in 2014. In fact, we predict another tough year is in store for the mining sector.
Prices of most major commodities fell 10 to 15 per cent in 2013 but it was gold that unexpectedly proved to be the worst performer; the yellow metal is set to end the year lower than it started for the first time in 13 years, having fallen by nearly a quarter during 2013 to around $1,250 an ounce (£780). Silver, platinum, copper, zinc, lead, aluminium, nickel, iron ore and most agricultural crops are also set to end the year substantially down.
This is in sync with new research from Citigroup, which shows nearly $30bn-worth of investment has left the sector via commodity-linked exchange traded funds (ETFs) and index swaps so far in 2013. That compares with more than $20bn in net inflows during 2012, suggesting investors are finally capitulating to the idea that the commodity supercycle may have come to an end. The FTSE 350 Mining Index is down 22 per cent year on year while the more speculative Aim Mining Index is off by more than a third.
The question investors must ask now is: have prices reached a bottom?
We don't think they have. A bruising 2012 for many miners proved to be a mere precursor of more to come in 2013 as commodity prices continued to slide, further squeezing profit margins in an industry that was already struggling to cope with soaring costs. We expect these trends to continue into 2014, albeit at a reduced pace, despite the best efforts of miners to slash spending on new projects and cut operating costs.
True, we're closer to the bottom than we were at this point last year - but it's difficult to see what could save the sector in the next 12 months. Chinese economic growth is not expected to return to its previous sky-high levels next year; if anything, growth there could slow down slightly in the coming months as a result of tightening credit conditions, real estate cooling mechanisms, and the gradual switch to a service-based economy from an investment-led one. Tapering by the US Federal Reserve is also widely expected to begin in 2014; historically, tightening of monetary policy is bad news for riskier assets such as commodities.
For the most part, though, supply has now caught up with - or exceeded - demand for many industrial commodities. Mining has always been a cyclical business and the long lead times required to bring new mines into production regularly cause supply to overshoot (or undershoot) the demand curve. Very few mines currently in operation are being shut down and there are many new ones still being built, so without phenomenal growth in China miners will continue to struggle against a flat (or softly rising) global demand curve for commodities.
Still cyclical, but not so super
What should investors still interested in mining equities do? Although there appears to be value on offer in the sector, we don't suggest backing up the truck just yet. For the next year or two at least, mining companies will continue slashing exploration, curtailing development, and high-grading their deposits in response to low metal prices and high production costs. As geologist and newsletter writer Brent Cook puts it: "These cosmetic changes add nothing to the companies' future growth and leave investors wondering, 'Why bother at all?'."
His answer is simple. "We know that economic discoveries are not keeping up with current metal production, and producers are painting themselves into a corner. This will ultimately lead to a severe shortage of new economic deposits, valid exploration projects, competent junior explorers and, eventually, a rush back into the sector…". So perhaps the question we really need to ask is when will demand outstrip supply again, resulting in a rush back into the sector? Not in 2014 is our answer, and probably not in 2015, either.
In the meantime, rid yourself of the vast majority of junior exploration companies, especially those that are undercapitalised. Many of them are having trouble raising money and we expect several will go bankrupt or delist in the coming year. Avoid project developers with low-grade, high-capital expenditure deposits, as banks rarely ever lend to junior mining companies anymore. And only hold on to shares in mining companies with deposits big enough to attract a major mining company in the next few years, or low-cost mining operations in safe jurisdictions with plans to expand production.
Names we would consider holding on to or buying include Rambler Metals & Mining (RMM), Petra Diamonds (PDL), Randgold (RRS) and Central Asia Metals (CAML).
