Glencore International PLC’s multibillion-dollar merger with Xstrata PLC, Prime Minister Stephen Harper’s visit to China, where trade and other economic issues are expected to dominate the agenda: It’s a big week for commodities with large consequences for Canada and for what Paul Taylor, the chief investment officer of BMO Harris Private Banking, calls the country’s “trees and rocks and bank-based economy and equity market.”
About 50 per cent of Canada’s domestic equity market is represented by commodities, Mr. Taylor points out, so most Canadian investors have some financial stake in how these two events turn out. Not to mention the impact on some important trends analysts see taking place in commodities: consolidation in the mining sector and the rising influence of China.
1. Consolidations in the mining industry
The Glencore-Xstrata merger will produce the world’s fourth-largest mining company, which will allow the new company to “bulk up, and compete for assets with the really large other players” – BHP Billiton, Vale and Rio Tinto – says Patricia Mohr, commodity market specialist at Bank of Nova Scotia.
Mr. Taylor of BMO Harris believes conditions are favourable for a number of deals in the mining sector. First, after a “pretty meaningful selloff in commodity prices in 2011,” prices are starting to bounce back a bit, which he says could help spur players to go out and acquire. Financing is also readily available, he says, after a few years in 2008 and 2009 when it dried up.
Mr. Taylor also sees mining firms looking to buy already operating assets, to avoid bureaucracy. He cites the example of a gold firm that wants to grow: “It can take half a billion worth of capital to find a piece of property and go through the permitting process and all the regulatory hoops, and if it’s lucky, five years from now produce the first ounce of gold.” The alternative? Buy a mine that’s already permitted or producing.
Jurgen Beier, deputy leader of the mining sector for Deloitte Canada, says that the mining industry has always seen big companies grow by acquiring smaller ones. “The reality is valuations are based on the ore bodies which each of the mines own. As they deplete those ore bodies, in order to maintain their market valuations they need to replace them.” Again, a company can develop a new property – or buy one.
“The question is whether there will be more consolidation in power, in terms of more bigger companies swallowing up more smaller ones, [where]you just get these behemoths taking over the industry.”
Mr. Beier says there’s another important player in consolidation: China. “It’s competing with the BHPs and the Rio Tintos and the Vales of this world.” But rather than purchase properties, China is buying stakes in mining companies.
The effect is the same, Mr. Beier says. “The competition for resources has heated up and I think that’s driving it.”
2. The rising influence of China
If you’re wondering why mining companies look to China, Ms. Mohr says to consider this statistic: In 2011, China represented 42 per cent of world demand for the four major base metals – copper, aluminum, zinc and nickel. The United States represented 9.7 per cent.
With that kind of influence in world demand, “it’s so important that the Chinese economy continues to grow,” Ms. Mohr says.
Which is why every statistic that comes out of China, every move it makes, is so scrutinized.
When it was announced last week that the factory sector expanded slightly in January – the official PMI rose to 50.5 from 50.3 in December, beating expectations of 49.5 – analysts breathed a sigh of relief.
China began to tighten its monetary policy in late 2009, to stem rising inflation, which reached as high as 6.6 per cent, Ms. Mohr says. Inflation there came down to about 4.1 per cent in December, 2011, and China began to ease its monetary policy.
Ms. Mohr and Mr. Taylor’s banks are both predicting a soft landing for the Chinese economy in 2012 – Scotiabank is forecasting a growth rate of 8.6 per cent in 2012 and 8.9 per cent in 2013; Mr. Taylor says that this year, “maybe growth will slow to 8 per cent or slightly below that.”
Ms. Mohr says she’s seen a turnaround in sentiment about China’s economy. Late last year, she says, “a lot of hedge funds were actually shorting base metal prices, including copper, but in the first several weeks of 2012, they’ve actually started to go long again.
“I think the hedge funds are more inclined to think now that China will have a soft landing rather than a hard landing.”
Mr. Beier says that while China has a huge impact through its demand for commodities, also crucial is that it’s a source of capital. Prior to 2008, he says, if you wanted capital to build a mine or do more exploration, you would get private financing for smaller deals and institutional financing for larger ones – from banks, insurance companies or other investors.
But in 2008, when the credit crisis hit, banks and other institutions cashed in those investments to help their liquidity. And to a large extent, he says, they never came back.
The Chinese, and to a lesser extent other developing countries like India and Brazil, filled the gap, Mr. Beier says.
“So that’s the reality. If you want to develop a mine, you basically have to start working with the Chinese and those sources of capital.
Of course, Mr. Harper’s meetings with the Chinese are expected to concentrate on oil, especially exporting crude oil into China and decreasing Canada’s reliance on the United States for its oil exports.
“Having one customer [the U.S.]is not a good position for any corporation, any business, quite frankly,” says Gordon Houlden, director of the University of Alberta’s China Institute. “No matter how rich or how powerful that customer is. It’s like having one stock in your portfolio – you’re going to get a lot of volatility if you hold just one stock.”
In fact, Canada and China are meeting at an opportune time, Mr. Houlden says, sharing a “strategic alignment of circumstances.” At the time that Canada is looking for export diversification, Mr. Houlden says China is looking for diversification in imports, mostly because of its dependence on the Middle East.