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.

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Copper $1.50 Next Year?

Some things you read stop you mid-step and send you re-evaluating what makes sense to you. Early I posted that I believe the average price on commodities would be higher than they have been.

The evidence shows that companies were cannibalizing their assets to reduce costs when commodities reached their all time low in 2002 and set up a squeeze on supply that has caused on average about a 6-fold increase from the 2002 lows, which if the lows were reasonable, would be utterly unsustainable pricing, but the lows were as insane as some of the highs have been, like $50k/ton nickel.

Frank Veneroso has been promoting that investors are at enormous risk due to the excessively high price of commodities and he uses that benchmark low in 2002 to say copper increased to peak of 570% of its low, which is true and by using these numbers he calculates numbers and projects scenarios that would wipe out commodity investors. His report can be found on his web site, venerosoassociates.net.

Sprott Asset Management has been promoting that because of China and emerging markets commodities are in a super cycle like one that has never been seen before, and their material is worth reviewing, sprott.com/pdf/marketsataglance/04-2007.pdf.

Investors that listened to Mr Veneroso over the past couple years have missed tremendous gains in the commodity market, and certainly from my analysis I believe some of those gains are unsustainable, but an all out implosion of the sector as a whole?

Independent information, for example, DryShips, a shipping company shows historical graphs of what has been shipped to China.



This graph is for ore, but this kind of data is abundant on the Internet for shipping of commodities if you look at shipping companies. Indeed, shipping companies have done very well because of this utterly enormous increase in imports from China. By all accounts, China has been a sinkhole for commodities.

If I hand pick the low, as Mr Veneroso has, and contrast it to the high in terms of shipping, 7.4 m tons from December 02 to 29.5 m tons in Feb 06 is a 4-fold increase in ore imports, but that is over stating the growth of imports as is Mr Veneroso’s claim of 570% for copper. Overall, China’s demand for commodities has grown and the growth or ore is about 2.5 times what it was about 5 years ago.

Steven Saville maintains that the global boom in commodity prices is driven by inflation, not real growth, and his post, stockhouse.com/shfn/editorial.asp?edtID=19969, is worth reading. What particularly got my attention was the graph of SS CPI Adjusted Copper Price.



A strong criticism of the Veneroso report is that he uses government inflation data, data that if anyone compares to their true costs knows is a blatant lie. I have calculated that the inflation that I have experienced in my non-discretionary costs is more like 5-6% over my adult life, and something I recently read pointed out that US government data specifically excludes housing, food and energy. Veneroso’s report would be more useful in assessing where commodities actually stand if it took into consideration realistic inflation rates because there are some truths to some of the things he says.

If anything, Saville’s graph shows a downward price trend with high levels of volatility and possibly the beginning of an upward trend.

So, what is the “truth”?

Investors need to come with their own "truth" that makes sense to them based on the evidence presented to them. What seems plausible to me may not seem plausible to others. Only time will tell which “truth” was correct.

For me to come up with what seems plausible I look at a bigger picture, and I go back a hundred years and try to relate what I am seeing to what I believe to be true.

So, a hundred years ago the concept of open pit mines was utterly new and a grade of 2% copper, stellar by today’s standards, was considered low grade. Mining was predominately underground and equipment obviously antiquated. Adjusting for inflation the price of copper was actually around today’s price, and if you further adjusted it for the manipulation to understate inflation, the price of copper was actually grossly higher than today. The graph above does show that copper had been declining in price and I would suggest that to go back further you would find a much longer term decline in the price of copper.

So, technology improved and the leverage of work output improvements to each worker declined as machines continued to get bigger and better. It is analogous to computer technology. In the 90s each computer upgrade was 100s and perhaps 1000s of times better, but lately upgrades are well under 100% better.

For mining, it would not surprise me if the efficiency of workers has improved because of these bigger machines so that one person in the actual mine does in the range of 100 times the productivity of 100 years ago. A lesson from my schooling is that real wealth is created by this kind of efficiency of leveraging worker output and it enabled wages to increase, prices to decline and I suspect, at least for copper, that it hid an overall declining grade of copper being mined over the last 100 years.

The Bingham Canyon mine started mining a 2% grade and the grade they now mine is less than 1/3rd of that. Some minerals are far more abundant, like aluminium, so over all grade declines would not be as significant, and for me, that is the most plausible reason aluminium has not seen the same degree of ramp up on price. It is my guess based on what I know about the world.

Today’s machines have reached limits of technology. You can’t build a 30-story wood frame building because the tensile strength of the wood will not allow it, as are the limits of today’s machines. There may yet be technological improvements, but they will be much slower coming and they will never give the kind of leveraged improvements of the past.

Living in BC, my truth points to a very strong other source of leverage of earnings for mining companies as the gains in technology declined – the export of jobs to countries employing slave labour wages. In BC in the 80s mines closed and were no longer economically sustainable. The move of the mining industry to countries with lower wages allowed the continued overall decline in commodity prices. Mines with good grades in North America were sustainable, but this trend wiped out lower grade mines.

The move of highly leverage productivity jobs to other countries empowered workers and workers have demanded and gone on strike for better wages and working conditions in these other countries, so the wage gap has declined and the options to export jobs to lower paying countries has dried up.

So, basically not a single economy of scale to reduce prices exists anymore, not increased leverage of output due to technology, not export of jobs to cheaper countries and to top it off, declining grade of mined ores can not longer hide behind these effects. I believe many analysts are missing the decline of grade in their analysis when they come up with something like $1- to $1.50 copper as a long-term price.

And then there is yet another point to take note of, the over burdening level of US debt and spending that is killing the US currency. Commodity prices are quoted in US dollars and there has been an enormous decline in the US dollar with respect to other countries, for example, Canada, Australia, Russia, Chile, and China.

Canada vs US


Australia vs US


Russia vs US


Chili vs US

China vs US (2 yr)


The US dollar has not declined with respect to all countries, but in terms of the world market, the US commodity price quote has not increased to the same degree if the prices were quoted in other currencies.

So as I see it, there are four driving forces for increased commodity prices:

• Inflation


• Wage demands in excess of inflation


• Declining grade which leads to increased costs


• A declining US currency

Considering these factors, I simply cannot see a long-term copper price being less than about $2, and costs for producing commodities will exceed the rate of inflation overall. Indeed, a real risk to investors is declining margins due to increasing costs.

However, an estimate of a long-term price isn’t a statement of belief that prices will never go below the price. Clearly, in 2002 prices were below a long-term sustainable price, as they are currently most likely above a long-term sustainable price.

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Bingham Canyon Mine – The World’s Largest Copper Mine

Mining has a rich history and the Bingham Canyon mine has one of the richest histories. Operating since 1906, it is the world’s first open pit mining operation and it showed the world how to mine low-grade minerals profitably.

In 1906 there was a 9000 ft mountain. The mine is now ¾ of a mile deep.

In the late 1800s a man named Daniel Jackling first got the idea that perhaps copper could be mined from the surface if the operation was big enough. Old time miners in the region thought he was crazy to even consider trying to mine such a low grade, which was a mere 2% or about 38 lbs/ton. Today that grade, about $120/ton at today’s prices, would be considered very good by open pit copper mining standards. The original goal was to mine 2000 tons per day, which a quick calculation suggests about a 25 million pound per year when operations started in 1906. It wasn’t long before the Bingham Canyon mine was the only mining operation in the region.

In 2006 the grade mined was 0.63% copper, 0.057% molybdenum, with 0.49 g/ton gold and 3.5 g/ton silver. At today’s prices that’s $90/ton metal values. In 2006 Bingham mined concentrates that contained about 580 million pounds of copper, 37 million pounds of molybdenum, 523,000 oz gold, and 4.2 million oz silver, about 17% US copper production. The smelter was shut for 63 days so only about 90% of the concentrate was refined.

Bingham Canyon mine claims to be the world’s biggest mine, as does Escondida in Chili. Who’s telling the truth? Escondida currently has the largest production in the world, about 2.8 billion pounds per year, 8.1% of the world’s copper production, and its production is more than 100 times Bingham 1906 initial production. Started in 1990 at 6-700 million pounds per year, Escondida has not produced the most copper in the world, that title belongs to Bingham Canyon.

To put into perspective how much mining has happened at Bingham Canyon over the last 100 years when Daniel Jackling first built his mine there was a 9000 ft high mountain and now there is a hole ¾ of a mile deep and 2.5 miles across the top, 500 miles of roads in the pit and it has produced over 17 billion pounds of copper.

Bingham Canyon mine uses some of the most equipment today. The shovel weighs 2.5 million pounds and pick up 98 tons with a single scoop. The trucks carry between 255 and 350 tons of rock.

The trucks and shovel look small until you look at the tires.

The mine has been highly profitable and been described as “the richest hole on the Earth.” It is operated by Kenncott Utah Copper, which is owned by Rio Tinto. Of the $7.4 billion in profits that Rio Tinto had in 2006, about $1.8 billion came from Kenncott Utah Copper.

The life of the mine is currently projected until 2017 with reserves of 0.54% copper, 0.043% molybdenum, 0.32 g/ton gold and 2.59 g/ton silver, or about 18% less metal values per ton mined in 2006. The declining reserve grades does mean that profitability will decline and Bingham Canyon Mine’s centennial year (2006) may also go down as its most profitable year in its history. Future considerations after the open pit operations come to an end is to consider the economics of under ground mining for metal resource that can not be reached through open pit operations.

To evaluate if Bingham Canyon mine is a good investment, investors need to check out Rio Tinto. It trades in the ADR under the ticker RTP.

Rio Tinto has a market cap of $113 billion. Sales in 2006 were $25.4 billion and earnings were $7.338 billion, or about 6.5% of the market cap. Reinvestment for capital projects in 2006 was $3.9 billion, with $1.1 billion of that financed through increasing debt.

The copper group made 49% of the 2006 earnings, with Bingham and a 30% ownership of Escondida being the two largest contributors to the copper revenues. Escondida has a life-of-mine that should go 25-30 years. Depending on the grade an economic feasibility to switching to under ground mining, Bingham’s revenue stream may need to be replaced in the next decade and Rio Tinto has interests in 4 world-class undeveloped projects in the works to start in 4-10 years that will meet that objective:

• 100% ownership of La Gradja in Peru.
• 9.95% increasing to 19.9% interest in Oyu Tolgoi (Turquoise Hill), in Mongolia.
• 19.8% interest in Pepple in Alaska.
• 55% interest of Resolution Copper, 2 km deep.

Rio Tinto has a diverse holding of properties, diamonds, alumina, aluminum, coal, iron, uranium, and titanium in many countries in the world. Reports are in US currency. To quote from Rio Tinto’s 2007 outlook published in February:

Since January 2003 strong appreciation against the US dollar has been seen in the Brazilian Real (61%), Australian dollar (37%) and the Canadian dollar (32%). This in turn has increased mining production costs as denominated in US currency.

US currency has declined further since that report, further putting upward pressure on production costs as they are reported in US currency. This puts downward pressure on earnings.

Furthermore, commodity prices were very strong in 2006, and with strong prices there is more risk for price declines. With a company as big as Rio Tinto mines are constantly coming to the end of their mine life, so there is a constant need for replacement projects to maintain operations, never mind increasing operations. Rio Tinto’s $3.9 billion in capital projects demonstrates that they are focused on ensuring a strong production profile.

A problem for Rio Tinto that a small company does not have is that it is so big, any meaningful production growth can be offset by declines in price because relative meaningful increases in production relative to their size affects the supply to the point it can push prices down. For example increasing Rio Tinto’s copper production by 10%, say around 200 million pounds, and that would increase world supply by about 0.5%. A small company’s existing production might only be 100 million pounds, so that increase would triple their production, or increase by 200%. Rio Tinto’s relative increased production is so small, so it gives little protection from downward price risks compared to the small company. The downward prices risks would be enormous if Rio Tinto tried to double their production.

There is no question that Rio Tinto is an amazing company with exceptional management that pays attention to not diluting the share count, but with strong commodity prices investors have not properly considered what happens to their investment if commodity prices decline. It simply isn’t wise to price a big commodity company above a P/E of about 12.

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