go nickel primed for price rerating

We have only written about commodities and Australian resource companies this week and it seems Beijing have been reading our notes!

I would certainly not rule out the chances of "China Inc" buying a minority stake in BHP, most likely through the discounted UK market as they did in the RIO example. Remember in RIO they paid a 20% premium to the prevailing market price for a 9% stake.

They key point about why it is unwise to dismiss this China Inc buying a stake in BHP story is because of the basic fact that BHP shares are cheap. They are the cheapest they have been this cycle to date. China Inc could justify the investment on genuine investment grounds. There is nothing wrong with re-investing surplus currency in BHP shares trading on a prospective single digit P/E while offering 30% growth. That will generate a better return than holding US treasuries.

As we have written in these notes before we would be ready to bet the house that "China Inc" will never be able to "buy" a BHP Board seat. That will just never happen, but they could buy a passive stake as an "investment". There is nothing to stop them doing that and as you can see from the RIO example if they offer the pay a high enough price for the stake they will get stock from institutional investors with short-term benchmarks.

Of course the market perception will be that "China Inc" has thrown another potential spanner in the BHP/RIO takeover works and we expect the BHP/RIO spread to narrow as it did yesterday to reflect the perception of increased deal closure risk. Remember, the risk arbitrage funds are all short BHP and long RIO. There's clearly a chance that those risk arbitrage funds start unwinding those positions and that is one of the reasons we continue to aggressively favour BHP as an investment over RIO at current prices. We believe RIO is a fine company with fine assets, but we believe the much lower risk buy at current prices is BHP.

Outside of liquidity concerns related to the BHP/RIO deal, one of the fundamental reasons we favour BHP over RIO is commodity mix. We don't particularly like the outlook for Aluminium (note the Alcoa quarterly earnings disappointment again this week), while BHP has big Oil/Gas exposure and a far more leverage to the huge coking coal settlements this week. BHP also has the entire suite of "steel making raw materials", and as we also wrote this week, we are very bullish on the global steel industry and those who supply its raw materials. BHP has solid nickel exposure while RIO currently has none. In today's note we look at the nickel market and tell you why the risks to the nickel price are all to the upside.

Nickel; primed for a re-pricing

We look at every steel making raw material ranging from coking coal ,iron ore, PCI Coal, manganese, molybdenum ,scrap and ferrochrome and we see them all trading at record highs. While some are quite illiquid markets the steel producers with real demand are buying these raw materials. Hedge funds are unable to trade these markets so this is fundamental buy side demand pushing these prices - so how can this be a bubble?

There is simply NO supply side response. We know it seems simplistic but when we see HRC prices trading at around $1000 a tonne and we see stainless steel prices rising in areas going through economic doldrums (i.e. Europe) then we just think it is time to wade into nickel producers especially as there is such limited potential for an immediate supply side response.

In recent weeks my brother Angus has been doing a lot of reading on the nickel smelting and refining industries (been a quiet few weeks) and there is some amazing detail out there that really explains to us why we can see another extreme spike up in near term nickel prices, but also why they are never coming back to $5-6 a pound longer term.

In our view the whole commodity story is about end customers just wanting surety of supply be it coking coal, nickel, or any other commodity. With prices for the end products going higher by the day you clearly do not mind paying a bit more for input costs as you want your mill producing as much steel as possible at these higher prices.

When you see that even the hardest of all global hard man negotiators like ArcelorMittal have to pay US$305 a tonne for coking coal that they only paid US$95 for last year you just know this is structural change. Why? Because they have no choice as the supply side is so tight and you can risk out-finessing yourself and having to shut mills as you cannot get the raw materials. The same is coming for nickel. People can tell you "weather and power events" led to these huge price increases in coal this year but could it also be that no mill or power station could run the risk of not getting their coal? Only 15m tonnes of the 200mtpa global seaborn coking coal was affected by QLD weather; that in itself couldn't justify a +206% contract price rise.

Nickel; micro analysis of the global market

While everybody talks about how no new US Oil refinery has been built for 30 years did you know the same is true in the nickel smelting industry?

The last time a pyro laterite nickel smelter was developed was 26 years ago. The reason you have seen a global land grab from the mining majors in the nickel sector (Inco, Lion Ore, Falconbridge, WMC etc) is that nickel production from sulphides accounts for 56% and laterites 44% of total global production, but in terms of reserves sulphides are only 28% and laterites are 72% of global reserves as shown in the graph below.

The problem is how you turn laterites that grade only 1-2% nickel into finished 98% grading nickel matte. At the moment most nickel laterite players capture between 20-30% of the value chain (linked to the LME nickel price) and the smelters keep the rest. This is the complete opposite to copper where smelters only keep around 20% of the end value.

Why are there so few nickel smelters to process laterite ores?

You have to remember that back in the late 1990's there were huge expectations of massive new stainless steel mills being built all over the Asia but when the Asian currency crisis came through in 1997 most of those projects were cancelled. At the same time there was also a huge expectation in nickel markets at the time about hydro smelting (pressure acid leach) which was supposed to change the nickel industry forever and bring on millions of tonnes of low cost smelting capacity using nickel laterite ores.

Ten years down the track pyro smelting has been dogged with technical difficulties and never really got moving like people thought and here we are with a chronic shortage of nickel smelters being built all around the world. The best known example of hydro technology has been at Goro in New Caledonia that CVRD own and has been the subject of cost over runs, local unrest and huge cost blowouts amongst other things. Brook Hunt predicts that 60% of new nickel smelting planned around the world to come on in coming years is via this hydro technology and given Goro's technical problems there is no way all this planned production will come on and work to planned production levels.

Pyro Laterite smelters account for only 30% of planned new smelter supply. Pyro laterite smelters have one key disadvantage and that is the amount of moisture you have to get out of the laterite ores. The moisture level is usually been 15-30% and combined with low grade feed (usually 1-2% nickel) means that the energy usage of these pyro laterite smelters is enormous and therefore the capex on these pyro laterite smelters is huge as you have to make them big to be cost efficient.

Compare the fact that you need to put between around 15 times more feed material through a pyro laterite smelter than a traditional sulphide smelter and you can see why there had been a land grab in the global nickel sector with Inco, Falconbridge, Jubilee, Lion Ore and multiple mid cap players all falling victim to M&A as they chase high grade massive sulphide players.

Ferro Nickel/ Nickel pig iron - Call it what you want - Is it economic with coking coal at US$305 a tonne?

Much was made of the production of nickel pig iron by the Chinese when the nickel price got to around $20 a pound last year and how that eventually led to killing the rally in the nickel market. When talking about ferro nickel(pig iron) the market never talks about the enormous quantities of nickel laterite, coke, and pure iron that are needed to produce a tonne of ferronickel.

Most of the low grade ores the Chinese used to produce it came across from Indonesia and the Philippines last time but there are now enormous rail and port bottlenecks in China and the problem now is how you move these huge quantities of material around especially given so many of the mills are so far inland in China?

As record high benchmark coal prices this week have shown, the coking coal market is extremely tight. Therefore the price of its by-product 'coke' is also becoming more expensive. You need 4mt of coke to produce 1mt of nickel pig iron and thus not only are the quantities of coke you need to move around enormous but increasing cost of this coke has made production of this ferronickel uneconomical.

To add to this, electricity tariffs have also gone up in China and power supply to many areas of China remains "uncertain" to say the least and these rising energy costs are just another blow to the ferro nickel producers.

I believe that these ferro nickel players are not going to be nearly the issue they were 12 months ago and that is why I believe the nickel price is going back to the old high of US$20 a pound (currently US$13.22lb).

Costs blowing out - Hard to bring on new production

Ravensthorpe and Goro seem to be the poster boys for cost blowouts in the nickel industry and I actually believe that these huge cost blowouts are probably scaring off people starting any new large scale projects. In the copper smelting game you process a 20-35% grading copper concentrate whole nickel laterite smelters are processing 1-2% nickel ore meaning you need to feed 10-20x more ore through which means your whole plant has to be on a far larger scale.

Cost blowouts in Xstrata nickel projects. The chart below is from Xstrata in November 2006 -Clearly Goro/Ravensthorpe a lot higher now.

Nickel Production Costs - For example, the chart below shows Xstrata's estimated costs of bringing on new nickel production in 2015. Note a huge scale project producing 240/-tonnes of nickel would still only produce at US$8 per pound and the capex would probably be $10bn which knocks most people out of the running.

Consensus forecasts remain below cost of getting it out of ground - Most analysts are using long term nickel prices that are below long term costs of getting the stuff out of the ground.

Similar to the fact that thermal coal producers now tell you it now costs $50-60 a tonne to get it out of the ground costs are clearly going up in terms of the cost of getting nickel out of the ground. There is a severe shortage of high grade sulphide ores around the world as well as a clear shortage of smelters to process nickel ore. When you see the enormous capital cost of bringing on huge new nickel smelters in whatever form they may be you can see that the days of getting nickel out of the ground for $3-5 are behind us. I think the long term higher costs of mining and processing nickel are the main reason we are so upbeat on nickel.

Chinese Growing Stainless Steel production

We note Chinese giant Jinchuan announced this week it plans to start production of high quality austenitic stainless production in 2011 producing 400,000 tonnes per annum. This just adds to the growth of stainless steel production that Xstrata points out in the chart below. However, in my view I just cannot see how nickel supply growth can possibly keep up with stainless steel production growth which means nickel prices are going up.

Stainless Steel prices in Europe also appear to have bottomed; Minimum and Maximum Prices for European and Chinese Stainless Steel shown below

Posco recently said it will raise prices of its stainless steel products by as much as 23 % after costs increased for materials including ferrochrome and nickel. The price of 300-series stainless steel hot-rolled products will gain by 400,000 won ($404) per metric ton, or 11 %, to 4.05 million won starting April 14. Posco is selling 300 series stainless for around US$4000 a tonne which is up strongly.

Consolidation in the Sector

There has been no more M&A activity in any sector than in the global nickel sector in the last 4 or 5 years. In the last 4-5 years we have seen Falconbridge swallowed by Xstrata for US$24b, Inco taken over by CVRD for $19bn and Lion Ore taken by Norilsk for US$7bn after a bidding war with Xstrata that eventually led to the stock being taken out at a 100% premium to the pre bid price and down here we saw Jubilee Mines get taken over for US$3bn cash.

With the capital cost of major projects blowing out all around the world clearly the ability of small nickel players to affect the demand supply imbalance is minimal in my view. With debt markets shut for many small cap companies I struggle to see how some micro cap stock is going to bring on any 100/-tonne nickel in the middle of deepest, darkest Africa and bring it on line on time and on budget.

I struggle to see which of these 6 major nickel producers is going to be an irrational price taker of nickel. There is no need to be.

2007 Nickel Production - very concentrated space.

Some very smart people are buying nickel related stocks right now (Glencore the largest nickel trader in the world continue to creep in Minara), there is strong speculation about Arcelor Mittal buying the Finland Government's 40% stake in Outokumpu and if old Lakshmi is buying stainless steel assets now, then he clearly does not think stainless steel prices are going down and that makes me bullish on nickel prices as well. I also still see Jinchuan from China taking equity in mid cap nickel stocks to secure off takes as they seem desperate to maintain their own smelting production. These are just 3 small examples which make us very interested in the nickel stocks.

You saw what happened to coking coal markets when you saw huge rains in Australia and power issues in South Africa, what if there are ever abnormal issues in Sudbury in Canada or over in Russia? The nickel spot price reaction would be enormous.

Russian's playing games on the LME?

Our LME trading sources tell me that the guy trying to buy Norilsk, Rusal billionaire Oleg Deripaska has been putting large whacks of Nickel inventory on the LME to keep a lid on the nickel price during the whole process of trying to buy the 25% of Norilsk he is attempting to buy. It does make sense as he is a large metals trader even though Rusal does not produce nickel at the moment we are sure he would have no trouble playing around in 30-40/tones of nickel.

Here is the chart of nickel inventories in the LME. Remember the time to buy nickel in the past few years has been when inventories were at their peak as a lot of it was game playing by Posco (which backfired spectacularly).

Note that LME inventories just started rising when Rusal first announced plans to buy the 25% stake in Norilsk in November last year.

Inventories are in orange, nickel price in white

What's left of the Australian nickel sector is cheap. The market is too bearish on nickel and it will be the last steel making raw material to be re-rated. Buy nickel stocks while they are still discounting the past. Minara (MRE), Western Areas (WSA), Mincor (MCR), Sally Malay (SMY), Poseidon (POS) and BHP are the way to play this theme.

Nickel leverage is just another reason not to sell BHP shares to "China Inc" at the lowest P/E this cycle. BHP remains a strong fundamental and trading buy.

Go Australia.


Charlie Aitken
Director
Head of Institutional Dealing
Southern Cross Equities