commodity bulls may be due a chinese reality c

By Christopher Brown-Humes

Published: April 3 2010 03:00 | Last updated: April 3 2010 03:00

Commodities are booming, we learned again this week, with news of a near-doubling in iron ore prices for this quarter. The same is true of mining shares.

The FTSE All-Share mining index was up 4.6 per cent in London's holiday-shortened week. The rise owed less to the news about iron ore than the raft of positive global manufacturing data on Thursday that supported the growing view that the recovery is gathering momentum and the world can avoid a double-dip recession.

But at these levels even the most ardent commodity bull has to question whether the sector is becoming overvalued. Mining stocks have tripled from their low in December 2008. Rio Tinto's shares pushed above 40 on Thursday, after hitting a nadir of 8.66 on December 5, 2008 (they are still below their 58 peak in May 2008). BHP shares at 23 are already above their summer 2008 peak of 21.96. And Xstrata shares, worth less than 3 in early March last year, are now worth 13 apiece.

The rally owes most to the fact that Chinese growth was not derailed by the recession that hit the world's other main economies. Indeed, the Chinese economy has continued growing strongly thanks to its spending on infrastructure which is very metals - and hence commodities - intensive. But what if economic recovery picks up in other parts of the world, as yesterday's US non-farm payrolls figures suggest? That could give another leg to the commodities rally. Xstrata concluded a coal deal with Japan this week at a level that was better than expected and oil also broke out of its recent trading range, hitting $85 a barrel.

There is every indication, in other words, that miners are heading for a profits bonanza. BHP calculates that every $1 rise in the annual price of iron ore adds $80m to its net profits and every $1 rise in the coking coal price adds $25m. But it is going to be harder to make profit forecasts in future because iron ore prices will no longer be negotiated on an annual basis, as they have been for the past 40 years. They will now be fixed quarterly, based on recent spot market levels. In the April-June quarter, prices will be $110-$120 a tonne, compared with the $60-a-tonne level at which the 2009-10 annual contracts were settled. If the April-June price holds for the whole year, BHP profits will rise by a whopping $4.8bn.

But that is a big if. Which brings us to the key question facing all investors in commodities in the coming months. Will Chinese demand hold at recent levels? The optimists believe China will continue to stockpile commodities, underpinning demand. The sceptics say the country's booming economy will have to be cooled by monetary tightening and that will eventually hurt demand. Interestingly, investors in the Chinese stock market appear less bullish about the country's prospects than those in other markets, given that the Shanghai Composite fell by 5 per cent in the first quarter. This cannot be ignored unless the country's stock market is completely divorced from its fundamental economic health. Another reason to doubt whether the mining rally is sustainable is that commodity price rises will feed into increased manufacturing costs and ultimately higher inflation. That will inevitably lead to higher global interest rates.

But this is not an issue in the short term. The short-term issue is that if mining profits are going to explode, how will miners spend their bonanza? Higher dividends, special dividends, share buy-backs and renewed corporate activity are all possibilities.

There certainly seems to be some unfinished business on the corporate front. At the height of the commodities boom, BHP sought to merge with Rio Tinto, Vale of Brazil attempted to buy Xstrata and Xstrata approached Lonmin. Since then Xstrata has had to abandon a plan to merge with Anglo-American. A new round of takeover activity could give a further push to share prices. But investors should also be wary about predators overpaying and regulators intervening in an industry that has already seen a great deal of concentration.