Sunday, November 04, 2007

Currency Contrast of Commodity Prices

I am Canadian and as such when I look at commodity prices I convert to Canadian dollars. Earlier in the year the conversion meant adding as much as 19% onto the US quoted price yet today it means take 7% off.

The change in currency valuation is enormous for the base metal industry. If you look at the mining industry from a world perspective, there are some mines in the US, and for those mines wages have effectively declined as the US dollar has lost value in comparison to other currencies. The US has gone from a high of 1.1875 on Feb. 7 of this year to a low of 0.9323 this past week. At its height earlier in the year the US dollar was “worth” 27% more relative to the Canadian dollar. A $30/hour US wage on Feb 7th was $35.62 Canadian and at the low, this week, it is $27.97 Canadian. Canadian wages have done the opposite. A $30/hour Canadian wage at the height of the US dollar was $25.26 US and now it is $32.18 US.

For US based mining companies wages are fairly fixed relative to the US quoted commodity price. Their might be union contracts that give them an increase, but when you do your back of the napkin calculation on a company using commodity prices you do not need to correct for costs due to currency changes for mines located in the US. That cannot be said for mines located in the rest of the world.

Given that the US dollar has lost ground with almost all other currencies, when the “costs” are converted to US dollars the increases will be staggering, as the wage conversion calculation above shows. I suspect many investors are not going to be prepared for what this does to the value of their investments. The full effect of these increased costs are not going to show up in the third quarter financial reports, although some will. For the third quarter the US dollar averaged around 1.05. As of this week it has declined a further 12%. Only a portion of those wage changes will show up in the next series of quarterly reports. Expect to see costs up in that 12% range for 4th quarter results being reported next January to March.

The margins, or earnings, on base metal stocks are affected by both the costs, which are in the currency of the country and the commodity prices, which are quoted in US dollars. The workers may not have gotten wages, but once the costs are converted to US dollars, they are simply up dramatically relative to the US dollar in most countries. This is not good for investors, especially investors in commodity stocks with high P/Es. In general, I suspect that chances are if a base metal stock has a P/E over about 6-12 right now, depending on other strengths/weakness of the company, it is going to correct downwards in the next year, indeed, if the LME warehouse stock levels continue to rise this estimate may be conservative because of metal price declines due to increasing supply.

The one year copper spot price shows three almost equal peaks in the spot price of about $3.70 US, in April, July and October. In Canadian dollars those “peaks” are about $4.25, $3.85 and $3.60. Today in Canadian the US price of $3.40 is about $3.16 Canadian. In Canadian dollars the price of copper was about 35% higher at its peak. In an earlier blog I looked at the Bingham Canyon mine. About 2/3rds of the revenue when straight to earnings for the period I looked at it. Because this mine is located in the US it is not going to see enormous wage increases, although it will probably see large energy costs increasing. However, this mine will still have exceptionally healthy earnings, although the margin may decline a little. This mine has lots of room that if it saw a 35% hair cut on revenues it is still highly profitable, with probably 40-50% of revenue making it to earnings. Contrast that to a mine with say 20% of revenue with strong prices going to earnings. At 35% hair cut in commodity prices means that the mine is now losing money.

I dislike nickel immensely, and here’s why. Nickel prices peaked in April at around $24/lb US. In Canadian that would be around $27.50, and there is a lot of nickel being mined in Canada. On Friday nickel closed at $14.35 US, which is now about $13.40 Canadian. Nickel peaked at a price over 100% higher. The good thing about nickel is the peak was a short-term spike and that utterly unsustainable price only got averaged into earnings for a very short period. The very, very bad thing about nickel is that a number of nickel stocks have priced in an earnings expectation based on a much higher nickel price than is realistic. The current price is already a strong nickel price and a wise investor would be evaluating their investment at $10-12/lb nickel. I believe to have priced a nickel stock with a high P/E with the outrageous nickel price of $21.65/lb, or $25 Canadian, as investors in FNX mining did in the first quarter will prove to be economic suicide.

In my May 30th post on FNX I pointed out many problems with investing in this company, and in the shorter term the price has gone higher than the roughly $35/share it was at then. But, short-term hype and speculation is not true valuation and this is the type of investment susceptible a wake-up-one-morning to 40-50% haircut. Going back to first quarter, earnings were $30 million (extrapolate to $120 million full year expectation) with an average price of $21.65 and an exchange rate of 1.17. Guidance was that earnings are supposed to decline by $9 million per $1 decline in nickel price, so expect $66 million decline from the contraction of nickel price. A 10% change in exchange will kill another $12.7 million in earnings, so expect another $32 million decline from exchange, or $98 million. That leaves about $22 million for full year earnings, or $5.5 million per quarter. Factoring in the roughly 70% increase in production expected, that would give about $9 million per quarter, or earnings of $36 million per year. Assuming share count has not increase, which is full year earnings of about $0.42/share, outrageously low for a $37 commodity stock. The earnings have gone 36c the first quarter, 40c the second quarter and 15c this past quarter, yet this quarter had record output. Earnings were 24c/share in Q3 the year before. Output increased by 50%, yet instead of a 50% increase in earnings to 36c, earning were 15c, an expectation decline of 58%. The average exchange rate was 1.04 for quarter 3. Now it is 0.93. That 15c/quarter extrapolated to a full year is 60c, but factor in that further currency decline and expect to see next quarter earnings of 10-12c.

Anyone doing a peer valuation of their nickel stock relative to FNX is seriously misleading himself or herself.
I expected the US dollar to decline relative to the Canadian dollar, but never in my wildest dreams would I have predicted 0.9323 this fast. I suspect there is not an analyst report out there that has factored in the drastic loss of revenues, or alternative drastic cost increases, due to the strong changes in valuation of the US dollar.

I don’t have time to look at the degree of change in other commodity prices right now, but my prediction is 100% US companies will perform better relative to companies with operations in other countries because they will only be dealing with how commodity prices affect their bottom line where as other companies will have the huge challenges of how the drastic decline in the US dollar affects either costs or revenues, depending on what currency they do their reporting in.


twelvethoughts said...

Hi Deborah,

Great to have you back. The dollar's drop has been spectacular it hit US$1.10 to CDN$1.00 which was pretty impressive. Next time I head north for poutine I'll have to bring gold.

Have you been following BN and Roca? BN diluted their shares, Roca had just bumped $4.00 before retreating due to the hectic week. Sold all my positions in both, fortuitously the BN ones before dilution, because of fears of selling like we had in August. I won't be returning to BN.

Don't know if you saw this story that was on Mish Shedlock's blog. "$36.5M owed to Yukon government unpaid on schedule"
but this is absolutely sickening.

"Naturally, we would have wanted our money back when we expected it to get back, but you know, the paper we bought was the highest-rated investment paper one could buy," deputy finance minister David Hrycan told CBC News on Tuesday.

Any finance minister in such a position has to know that "AAA" and what the ratings agencies say can mean nothing. Orange Country had "AAA", Enron, there are so many its inexcusable for a finance minister to try to avoid responsibility. Resignations are in order.

Homeowners who bought into the bubble and lose their homes I don't have much compassion for. When $36.5m goes missing in a province of 31,000 I cannot express the sympathy I have for the residents who, through no fault of their own, just got their pockets picked.

Deborah said...


I was very drawn to watching dollar change. It was like every day I would look at it and gasp, almost falling out my chair at how shocking it was.

I have followed Blue Note and Roca. I am more concerned for Blue Note over the falling US dollar because the price of zinc is now about $1.16 Canadian compared to a high of about $1.80 Canadian earlier in the year. In US the range was around $1.60 something as the high and it is still over $1.20 US. The currency change is enormous. Roca is going to be hit by currency as well, but there hasn't be a decline in moly price yet.

Funny, or not so funny you mention Mish's post about the Yukon government. I just finished a post on it and then read your comment.

Seriously, it should be required that our elected officials have two years of university calculus.

One of the things that I am grateful for is that I started to become aware that the markets were in serious trouble about a year ago, and that there were people involved in doing things that most likely will cause a lot of hardship for many innocent bystanders. I think the worst is to come.

The two things that I came to a conclusion that were in serious trouble were pension funds, and I think the ultimate hit they are going to take is going to be severe, and banks. I have encouraged my friends to sell out of their banking stocks. The US banks are being hit big time and I think the Canadian banks will follow.

The world has a serious credit bubble and idiots have created about $350 trillion in derivatives, putting everyone at risk from these things unwinding.