This year however, it has resulted in the market being trounced with a number of nickel stocks down by up to 77% as in Minara (MRE) from $6.05 on 8 May to $1.41 on 11 August, Independence (IGO) down by 72% to $2.45 (closing back up to $2.80 with the buy-back), and Panoramic (PAN) down by 69% to $1.91, before recovering to $2.18. During this period, the nickel price has fallen by 34% to US$18,050/t, LME nickel stocks have fallen by 11% to 45,270t and also the A$ by 7% to US$0.876 (so the A$ nickel price is in fact down by 29% to A$20,605/t, A$9.35/lbNi).

Our last Goode News column in Paydirt’s July 2008 issue, was entitled “The commodity boom has a few more years yet” and yet commodity prices and base metal share prices have collapsed. In fact the second day of Diggers (Diggers ‘n Dealers 5 August 2008) saw one of the worst days for base metal heavyweight share prices with at one stage, BHPB down by 8%, and the new OZ Minerals (OZL) down by 13% to $1.63.

On Day One of Diggers the new OZ showed that their $1.88 current share price was only based on Century, Sepon and Prominent Hill, (ie excluding Golden Grove, Martabe, Rosebery and exploration) and yet it still plummeted on Day Two. On site on Day Two at Long-Victor, IGO stated that it thought that its realistic price in this market (Ni price etc) was in the $4.50 to $6 per share region... and yet it fell that day to a new low of $2.33/share, before closing at $2.43 per share.

What happened this year (2008) is that for the “man-in-the-street”, the resource market has transformed almost beyond recognition from a combination of sophisticated shorting, faster computer trading, new commodity funds, to some degree the sub-prime fiasco, and perceptions that the commodity boom has ended.

As for the commodity boom ending, yes China is slowing, its growth rate in July was 10.1% compared to 10.6% in June, although its copper imports actually rose from 174,000t in June to 186,000t in July, and it reported power restrictions due to a shortage of coal. China has a reputed US$5trn “war-chest” to drive its economy independent of the rest of the world. Even if the US does “fall-over” it may only reduce China to a more normal 7% to 8%pa growth, which is still significant. The copper price was reported as falling due to the stronger US$. Why should the copper price be inverse to the US$, gold sure due to alternate investment, but copper?

We can recall writing about a similar event only 4 years ago, coincidentally following a trip to China and published in our Goode News column in Paydirt’s June 2004 issue titled “The Commodity Cycle is Over ! – What Already ?....”. In which China announced a 7% target growth rate for 2004 in mid-March, which resulted in dramatic falls in commodity prices with share prices collapsing by ~30% within the following few subsequent weeks, and when it was later announced the reported growth rate was as expected still at 9.7% (to which should be added the usual ~0.5% discount).

During the past 6 months, we (ERA) have seen a number of new mega commodity hedge funds form by the big broking/banking houses and apply a long/short strategy of shorting base and precious metals. Selling on a 1 month to 3 month time-frame, rolling forward those positions and collectively backed by $xbn driving metal prices lower.

Why, because it is a market like anything else and from their viewpoint, they don’t really care whether it goes up or down as long as money is made for their investors / shareholders. They can operate on market perceptions (possibly even “fanning the flames” of rumours themselves) of the impact of the collapsing US, slowing demand, and the world (including China) grinding to a halt.

In the first month of its operation (May or June), one of the new funds stated that it was up by 20% due to shorting base metals. These funds are not producers, they are never going to deliver anything, but they appear to be producers by selling metal they do not have and intend to later buy back the position to cover the sale (though by rolling the position forward, they may never have to). It can best be described as analogous to the gold forward selling/hedging that destroyed the gold price for so many years.

This commodity short selling thrives on perceptions which could result in its ultimate periodical downfall, since for nickel the view appears to be that nickel companies can still produce at $4/lb Ni and one of the major stockbrokers has predicted that the nickel price is heading to US$6/lb. There are a few nickel sulphide orebodies that have all-in cash costs of ~A$4/lbNi due to higher grades or by-product credits such as IGO’s Long-Victor, PAN’s Savannah and Albidon’s Munali.

However, due to rising costs, labour, materials, consumables etc, the break-even C1 cash cost (including smelting) for nickel appears to probably be closer to US$6/lb. At which level most of Kambalda would probably close and BHPB would have to virtually shut down its nickel division because it could no longer offset the high MgO ratios of its Mt Keith ore. As for the nickel laterites,with the rising sulphur prices, MRE (which is already laying off staff) would probably have to close.

The industry recognised Resources & Technology Marketing Services (RM) July 2008 comprehensive “Review of the World Nickel Industry” publication, estimated that nickel pig-iron is uneconomic below US$10/lbNi. RM have forecast that the nickel price should remain in the range of US$8/lb to US$13/lbNi between 2008 and 2012, with the average appearing to be in the US$9/lb to US$10.50/lb vicinity and volatility occurring between the expected US$13/lb high and US$8/lb low. We (ERA) are using US$9/lb for our long-term forecasting, although US$10/lb appears to be more realistic.

RM also stated that “the production scheduled to come on stream over the period 2008 to 2012 should be sufficient to meet demand”, although any delays “could result in further market tightness, and associated increases in the nickel price”. Vale have already stated that they are reviewing the feasibility of one of their long-term projects. Certainly at Diggers, the audience had a shock when Xstrata (responding to a question) stated that the expected capex for Koniambo was now US$3.85bn.

As for the share prices, what has happened is that sophisticated covered short sales are taking place. The process was described in the SDIA Conference (partly sponsored by the ASX) in May 2008, and as one speaker commented “how do you think your super fund gets its extra 0.5% to 1% annual performance ?”.

The following purely hypothetical transaction that takes place is that a large broker (apparently often with international connections) approaches an insto (Insto A) that has a sizeable holding in a company (Company A) that it does not intend to sell, and offers it the ability to earn 0.5% to 1%pa on its holding by making it “available” should it be required. The broker then offers a facility, say 0.5m shares in Company A to another insto (Insto B) should it require it.

Insto B then sells say 2m shares in Company A when the market opens on Day 1, and only manages to buy back 1.7m shares during the day, so it is 0.3m shares “short”. The broker notifies Insto A that it needs to borrow 0.3m Company A shares overnight and from an ASX viewpoint, the buys and the sells match.

The sale in Company A by Insto B was not reported as a short sale, because it has effectively been a covered sale. The next day (Day 2), the 0.3m balance can be purchased and the borrowed shares returned. By completing the transaction within 3 days, no change in ownership appears to have occurred. However, it should also be recognised that Insto B could sell another 2m shares on the opening on Day 2.

It is very difficult to regulate this practice as it is unofficial/ unrecognisable short selling because the buying and selling is “matched” from an ASX viewpoint by the end of the day. To put it into perspective, in one day in May 2008, 30.5million trades occurred on the ASX or about 1,400 per second for 6 hours. On the LSE, trades average ~4,200 per sec. Basically computers are trading with each other with the mega and large trades now broken up to a maximum size of 20,000 per trade which has been determined by quants as resulting in the most representative price over a period.

So how to stop it, most probably either through buy-backs (by stocks that are cashed up) putting floors under their share prices and scaring the shorts into covering their positions to probably ~10c above the stated floor prices, by takeovers, or possibly instos building up a major position in a stock and supporting it. IGO announced a buy-back of 10% of its stock from Friday 8 August at an unspecified support level, which resulted in its share price rising by about 20%.

As for the market recovering, we (ERA) once overlaid 15 years of the gold price (and gold share market) on top of itself which resulted in an accuracy (of about 80% or 12 times) in which gold rose at the end of August / beginning of September. So hopefully the resource market (or at least gold) should be on its way to recovery as you read this issue of Paydirt.

Disclosure and Disclaimer: This article has been written by Keith Goode, the Managing Director of Eagle Research Advisory Pty Ltd, (an independent research company) who is an Authorised Representative with Taylor Collison Ltd, and with his associates, may hold interests in some of the stocks mentioned in this article. The opinions expressed in this article should not be taken as investment advice, but are based on observations by the author. The author does not warrant the accuracy or completeness of any information and is not liable for any loss or damage suffered through any reliance on its contents.