Wednesday, November 21, 2007

Is Zinc Deleveraging?

An article, Shanghai Exchange More Than Doubles Zinc Price Limits, describes how the margins for zinc contract have been increased and how price controls have been relaxed, if my understanding of the article is correct.

To enter a contract you needed 5% down, but that changed on November 19th to 9% down and it is increasing to 14% on November 22. That is almost three times the margin requirement and three times the amount of money down.

The price control limited the change in any single day to 6% and that has been raised to 13%.

The changes to margin are enormous.

Frank Veneroso has maintained that metal prices increased beyond reasonable levels partly due to hedge funds buying metals without ever planning to take possession of metal. With a 5% margin requirement, they could tie up 20 times the deposit on any commodity trade. Increasing the margin dropped the leverage to 11 times and the final increase drops the leverage to 7 times. Essentially traders now require about 3 times the money to enter a contract. If hedge funds are indeed responsible for the huge increases in price, that leveraging has got to fall apart pretty quickly with such enormous increases to the margin.

Zinc exports from China increased by 47% during the first 10 months of this year, which really doesn't say much unless you have an idea of how much of the world zinc market they produce and how much they export. Data from the US Geological survey suggests that China produced about 25% of the world production, about 3 times what the US produces. This certainly suggests China is a big enough producers of zinc to be dramatically influencing the price down with such huge increases in exports.

The price declines will result in enormous downward pressure on zinc stocks I've previously followed.

When I looked at Zinifex in July the P/E was around 8.6. The metal values per ton of their Rosebury mine that they were mining was about $610/ton, but the reserves for future mining were a higher grade at about $800/ton. Having a higher grade coming up, and not an outrageous P/E to start gave Zinifex room for downward pressure from prices. The downward pressure on zinc prices have been enormous, however, at today's prices that higher grade reserve still has metal values of over $650/ton. The Century mine also had higher grade in reserves to be mined. Costs are in Australian dollars. The higher grades to be mined are protective, however, zinc prices have come down enough to be cautious with this one now.

I didn't care much for Tamberlane, Breakwater or Acadian. Tamberlane only had one deposit out of the 34 that had very nice revenue potential and that would only last 1-2 years and the other deposits were questionable. Breakwater's best mine had metal values of about $410/ton and those are now below $300/ton. The metal values in El Toqui are down to about $230/ton. El Mochito's values are down to about $275/ton and Myra Falls about $320/ton. Myra Falls is showing $1.10 per pound cash costs last quarter. With zinc below that the mine doesn't look very good at all. Toqui has $0.76 cash costs per payable zinc sold. The costs appear to have gone up enormously, from $0.39 per pound payable in 2005. There has been share dilution to bring the fully diluted count from about 395 million to 461 million. Acadian estimates 8 million pounds of zinc and 3.5 million pounds of lead. The costs are estimated to be $12 million. They estimated $13 million of revenue, but the price declines of just the past days brings that down to $12.3 million. At best that might give just under a penny per share for full year production. It might even run at a loss.

Hudbay minerals looked to be valued at about 2-3x the valuation of Blue Note when I looked at them together. Today Hudbay's earning look to me like they are heading to the 50c/share for a full year range, and that won't show up on the next quarter, but Q1 2008 would have earnings in the 10-13c/share range based on today's metal prices and exchange rates. Q4 already has some better metal prices rounded into the quarter. I saw some serious reasons to see earnings declines when I reported on this stock and they have shown up and further declines will likely happen.

Blue Note's metal values are down to about $315/ton. They have have not met 2007 production goals, and there has been more dilution. Production costs are supposed to be in the $66 million range. The gross revenue potential is still in the $190-200 million per year, but that up to 4c/share earning potential in a quarter is mostly likely gone. The numbers still look like it has the potential for 1-2c eps for their first full quarter of production, but the first full quarter of production is not likely until 2008 due to problems getting the zinc circuit functioning.

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