Bit of a read but well worth the 5 minutesWhy an Energy Crunch...

Bit of a read but well worth the 5 minutes

Why an Energy Crunch Could Lead to Booming Profits in "Solid Electricity"

Inside this Issue
The Leading Edge of the Energy Storm: How soaring Australian coal prices are making aluminium expensive to smelt in South Africa.

Following the Pilbara Pattern: A Perth-based company that plans to make it big in bauxite.

There are lots of reasons why a small company share can go up in price quickly. Usually it's an innovative new product, a new market, or, in some cases, a sudden change in the market value of a good, product, or service.

Take bananas a few years ago. One day you could walk into a store and buy them cheap. A few cyclones in Queensland later, and banana prices were through the roof. For most share investors, this wasn't an opportunity. It just made bananas and banana bread more expensive.

But in other markets - especially resource and energy markets - a sudden change in the availability of basic resources can change everything. A commodity can go from abundant to scarce relatively quickly. Its price can go from cheap to expensive quickly as well. Naturally, the share prices of companies that produce volatile commodities can change quickly too. We're counting on that this month.


The Leading Edge of the Energy Storm

The high cost of energy - especially coal and oil - is directly impacting resource production in two countries: South Africa and China. As energy prices grind higher - or even hold where they are - this will force the production of certain base metals to lower-cost countries. It will also change the supply-demand dynamic for these base metals, creating new investment opportunities in the process. A good example is South Africa.

You have no doubt read about the power crisis in South Africa. South Africa has a booming resource economy like Australia's. It's driven by gold, palladium, platinum, coal, diamonds and other resources.

The trouble is, South Africa's economy is growing faster than its electrical industry. Contrary to all the gloomy reports, we found the place pretty positive when we visited in late February (mostly Johannesburg). Like any fast growing country starting from widespread poverty, you're going to have a lot of chaos, crime and uncertainty.

But one of the few things you want to be able to count on is the power. You flick a light switch, the lights go on. That's so basic that you and I take it for granted. Not so in South Africa. The folks who run South Africa's only large power company told the government years ago that it would have to invest more in power to keep up with the economy's growth. The government didn't listen.

The result is what you have today: rolling blackouts and "load shedding" by the power provider. Demand for power has grown much faster than the available supply. This is not make-believe land. When demand exceeds supply something has to give, and in South Africa, that means power must be cut to someone.


Energy-Intensive Industrial Users on the Chopping Block

The government's first response to the power crisis was to cut supply to the places that used the most of it, namely the suburban business parks where most of Johannesburg's business community has relocated in the last yen years. That makes sense. You can only cut power to people who are using it. But cutting power during the middle of the business day unexpectedly is not exactly good for business, or for people's state of mind.

The government decided to look at industrial users of power. And once it did that, it wasn't going to be long before South Africa realised - like China is now realising - that there is one particular industrial process that uses much more energy than any other: aluminium.


Why Aluminium is called "Solid Electricity"

Source: International Aluminium Institute

You make aluminium in several steps. First, you have to refine bauxite ore into alumina. Then, you turn alumina into aluminium by adding generous amounts of electricity in an established process. I won't go into the details. But the basic ingredients are what we want to focus on: bauxite and energy.

Bauxite is plentiful. You can find it all over the world. Australia happens to have plenty of the stuff. But it is not alone.


Australia is the Saudi Arabia of Bauxite




World Bauxite Mine Production, Reserves, and Reserve Base

Because of its large bauxite reserves, Australia is also one of the world's largest aluminium producers, as you can see from the chart. But because bauxite has been cheap for so long, other countries that use a lot of aluminium decided to increase production in the last few years. After all, it's cheaper to make aluminium if you have the raw materials than import it. So that's what China and South Africa began doing.


China is Aluminium's Largest Producer




China, as you know, has been using a lot of everything. China's economy grew at double digit rates in the last quarter. Aluminium is a key commodity for commercial and residential real estate activity. It's a lot like copper in that respect. When an economy expands, demand for aluminium increases.

To meet that demand, China has increased its production of aluminium, importing bauxite from Indonesia as well as mining its own. In the first three months of 2007, China increased its aluminium production by a whopping 40%. China's ability to produce aluminium is expected to grow by 15% this year, according to the Australian Bureau of Agricultural and Resource Economics (ABARE).

We're not so sure. Why?

Bauxite is cheap and plentiful. Energy is not. China and South Africa have strained power grids. But more importantly, electric power generation in both countries comes from expensive coal.


Asia Depends on Coal

Hydro-electric power is much more common in North America, Europe, and Latin America than it is in Asia and Africa. Africa does have some large hydro-electric dams, but they are on large rivers, and South Africa's power mostly comes from coal.

Coal prices in Newcastle, New South Wales have been rising in the last month as world demand grows and supply bottlenecks tighten. The rising cost of coal, not to mention the awful environmental side effects are beginning to add up for countries like China and South Africa. What it means - in practical terms - is that it's getting too expensive to make aluminium in countries that don't have cheap energy.

In a recent report, ABARE says that, "the electricity intensive nature of aluminium production, and the fact that most electricity in China is generated from coal fired power stations, means that expansions to aluminium smelting capacity can, indirectly, have adverse environmental impacts."

"To address this issue, the Chinese Government has indicated its desire to limit the production and export of aluminium. In late 2006, the Chinese Government imposed regulations on the size, capital investment requirements and environmental standards of new smelters, and also increased the tax on exports of aluminium metal to 15 per cent (from 5 per cent)".

It's not a difficult conclusion to reach: increased power costs (and shortages) in China and South Africa will lead to lower aluminium production. There is still probably going to be a surplus this year. But the futures market is already pricing in increases later this year and early next year.

That would be a change from aluminium's recent performance. Of all the base metals it's been the big laggard. There was good reason for this, too. Bauxite is easy to mine and easy to find. Energy was cheap. Turning bauxite into alumina and alumina into aluminium was not a high- margin business.


Emerging Sources of Electrical Power in 2008

But now that the energy part of the equation has changed, a shift is taking place in the global aluminium market. Aluminium production will move away from China and towards places where energy is cheaper. In fact, it's already happening.


Aluminium has lagged base metals until now

Source: Bloomberg

Many countries in the oil-rich Persian Gulf are building aluminium smelters. Did you see last year that Dubai planned to build the world's largest aluminium smelter ever?

It's a US$5 billion project with the aim of producing a smelter that can generate 700,000 tonnes per year. It is not alone.

Saudi Arabia has plans for a US$3.8 billion smelter. Oman has plans for a US$2.2 billion smelter. Qatar has plans too.

Saudi Arabia has also said it has plans for a US$7 billion "mine-to- metal" project that includes bauxite mining, refining and aluminium smelting. It calls this the "third pillar" of its oil and petrochemical strategy.

It's an attempt at economic diversification that does not include loaning billions of dollars to struggling American financial institutions. You can argue about whether or not it makes sense for the Gulf States to become aluminium producers. But you can't argue that they have the energy to do it. China and South Africa can't say the same.

What do the Gulf States lack? To make aluminium you need bauxite, electricity and the capital to build a smelter.

Capital? Check (the Aussie firm Worley Parsons (ASX:WOR) got a AU$300 million contract to do work on the Saudi smelter). Electricity? Check (plenty of oil and gas, for now.) Bauxite? Hmmn.

Well there's plenty of that in Guinea and Australia, isn't there?

Rio Tinto (ASX:RIO) is supremely placed to profit from all this, especially because of the Alcan acquisition. BHP Billiton (ASX:BHP)... not so much.

But if we are right and the rising cost of energy forces a shift in global aluminium production away from China and toward the Middle East...what is the best way to profit from this?

But if we are right and the rising cost of energy forces a shift in global aluminium production away from China and toward the Middle East...what is the best way to profit from this?

Bauxite? Alcoa (NYSE:AA)? Or infrastructure firms building smelters in the ME? Or all three?

The answer to that question can be found in what happened with Australia's iron ore business. For many years it was dominated by just a handful of companies, mostly BHP and Rio Tinto.

Then, a few visionary entrepreneurs saw the changes coming (that China would be a big customer for years). You know the rest of the story. Chinese, Japanese and Korean steel companies are inking deals with anyone who can produce iron ore, from Rio Tinto and BHP all the way down to much, much smaller producers.

One of the best performing stocks on the ASX last year was Murchison Metals (ASX:MMX), a small producer in the Mid-West (not the Pilbara). And Fortescue Metals (ASX:FMG), which hasn't actually produced any iron ore at all, did even better:

"Major players such as Fortescue Metals Group (up 460 per cent in 2007), Murchison Metals (up 182 per cent) and Mount Gibson Mining (ASX:MGX) (up 215 per cent) are expected to benefit from higher contract iron ore prices to be negotiated later this year," according to the Herald Sun.

These are exactly the kinds of gains we're after as small cap investors. We think that aluminium prices are going to rise in the next two years and take bauxite with them. Short of buying Rio or the large US company Alcoa, you could do worse than find a small Aussie company poised to rise from a sudden increase in aluminium prices. We believe we've found just the share to do the job.


Following the Pilbara Pattern

The path to Australia's first big bauxite fortune will look a lot like the path Andrew Forrest trod in iron ore. Forrest - who according to Forbes magazine is Australia's richest man - realised he didn't need to compete with BHP and Rio Tinto. Just becoming Australia's third biggest producer of iron ore would be enough to make him a very rich man.

He was right. Incredibly, Forrest's company Fortescue Metals (ASX:FMG) has yet to ship any actual ore to China. But the inherent sense of the business proposition - and rising iron ore prices - have propelled the stock to amazing heights anyway.

Incidentally, while Warren Buffett took the crown as the World's richest man this year (net worth of US$72 billion), India had four men in the top ten. Russia had 87 billionaires on the Forbes list. Russia's richest man, Oleg Deripaska, is the world's ninthrichest. He made his money in Russian aluminium, not in Russian oil.

The company we're tipping this month went public in 2006.