Saturday, January 28, 2006

Base Metal Commodities versus Insiders...Why the Conflict? (corrected)

I came across a terrific article in The Stalwart on backwardation and the base metals. In backwardation, the further out you go in time in futures contracts, the lower the price.

People attribute this to the current low state of inventories, a corollary of high demand. Backwardation suggests that there are supply insufficiencies in the corresponding (physical) spot market.

The Stalwart suggest that though commodity markets remain in backwardation, the shift upward in longer dated commodity deliveries’ prices suggests perhaps some permanency in higher prices.

Here's another example of the bravado in the copper market currently. This fellow had forecast a range of $1.60-$2.00 with a weakening economy, but guess what... he is letting the market's euphoria dictate his price.

Yet, when I look at the base metal producers, almost no insider seems to believe in his stock.

For example, in Freeport-McMoran Copper (FCX) return on capital now exceeds 50% versus a 5 year average of about 6%. Enterpirse Value to EBIT is merely 6.3 times. Yet management seems to be selling stock hand over fist, with sales of over $47 million in the last three months.

Phelps Dodge (PD) has a recent ROIC of 21% versus a 5 year average of about 2% and an EV/EBIT of about 11.7 times. Management here also seems to be eager to sell stock with sales of $1.7 million in the last 3 months.

A particular article that The Stalwart has highlighted comes from the Australasian Investment Review. In it, it suggests that “base metal prices are now so far above traditional methods of valuation that commodity analysts have thrown away the rule book, continuingly upgrading forecasts in simple acts of exasperation.”

Backwardation has been de rigeur thinking for some time. As the AIR points out the frustration of the exercise : “The western world spent 2005 actively de-stocking its inventories. This is a standard response to high spot prices, provided you believe high spot prices have a limited shelf life. Relief has not been forthcoming, however - prices are only higher.”

The article also highlights the emergence of commodity hedge funds as important new actors on the scene. “Now there is a new breed of hedge funds (probably as a direct response to higher prices) establishing large long positions across the metal spectrum. There is also an explosion of interest in commodity index funds, such as the GSCI (Goldman Sachs Commodity Index), which is now estimated to be holding some US$65-80 billion in funds. The second largest, The Dow Jones AIG Index, is holding $15-20 billion.”
“The Australian broker, Macquarie reports current expectations are that investment in commodity index funds could rise by up to US$40 billion to around US$120 billion by the end of this year.”

Commodity markets offer easy and rapid trading, low margin requirements, no need to deal with physical inventory, etc. However, as any of us who have observed the commodity scene recognize, there are very large risks when one deals with very large contracts with small amounts of margin.

“But we also believe it would be extremely dangerous to presume that flows into commodities index investments will always be positive; indeed, our strong inclination is that they will not be" says broker Weres. “Depending on scale, such a reversal could result in a price correction either in line with, or below, the levels justified by supply/demand fundamentals.”

If, as, and when the tide turns, the premium of current metals prices versus fundamental levels will quickly be lost, and it’s a long way back to traditional, fundamental price levels. It seems a little bit like measuring eyeballs back in the Internet heights.

Are we witnessing new era thinking in metals prices? Is the emergence of hedge funds as a significant force in the commodity trading arena leading to imbalances? Why are insiders in the metal producers actively dumping their holdings?

Though the companies seem to fit the value lovers bill as to valuation, free cash flow, and high returns, where is the sustainability? A few questions to ponder.

1 Comments:

At 5:28 PM, Anonymous Joseph Weisenthal said...

Thanks for the link, though I believe you've got it backwards. Backwardation is normal, since naturally one would not commit to paying more in the future than you'd have to pay to buy it today. The fact that the charts are starting to flatten is unnatural, and indicates overenthusiasm. Hence, it's logical that insiders have been dispensing shares.

That being said, I hadn't known that there was significant insider selling, so thank you for bringing that to my attention. Just another piece in the puzzle.

 

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