2008 Resource Sector Review

2008 will truly be a year that all investors, not just mining investors, will truly be happy to close the book on. What started out as a year with a lot of promise along with some obvious challenges, degenerated into one of the worst episodes for investors in living memory. No company, sector or asset class was spared in the midst of the carnage, which of course is still with us today.

The main questions on the minds of all investors at this point are: how long will it last; will it get any worse; and when will the eventual recovery take place? We will address these specific questions in more depth in our 2009 outlook piece in a couple of weeks’ time, but quite simply we are of the view that with respect to the commodity sector, most of the bad news has already been factored into the prices of commodities and resource equities.

Whilst there will be more economic news next year revealing yet more doom and gloom, we are reasonably confident that the enormous falls in value with respect to commodities and equities over recent months have pretty much factored in most of the bad news. We don’t anticipate that 2009 will be a bumper year by any means, but we believe that some degree of stability will begin to return to certain commodities next year.

Quite simply, the drastic nature of the supply cuts already implemented by major, medium and small-scale miners alike, corresponding with the sharp falls in commodity prices to well below break-even levels, means something has to give. Commodities cannot remain at these over-sold levels for an extended period of time.

But returning to the events of the past 12 months, it’s fair to say that until about a year ago, most investors, let alone resource sector investors, had never heard of ‘subprime.’ Just as likely they had also never heard of a ‘toxic mortgage’ or a Collateralised Debt Obligation (CDO). The resource sector up until a year ago was happy to simply happy to get on with the job of finding and developing new mineral deposits and trying to raise the capital to enable this to happen.

Close watchers of the resource sector, like us, were busy focusing on identifying the companies that had the best medium to long-term potential to take advantage of the decades-long China boom, which we firmly believe is still in place today. But what we didn’t appreciate at the time was the enormity of the financial tidal wave that was approaching from the United States.

Indeed, whilst we knew some turbulence lay ahead, we simply did not comprehend the extent to which financial greed and mismanagement on Wall Street could have such a profound effect on not only the resource sector, but the world economy in general. Unfortunately, our ongoing bullishness led us to maintain our positions in all stocks, when some prudent profit-taking would have in hindsight generated strong gains for Members. We will endeavour to lock in profits for members from 2009 onwards.

Towards the end of 2007 of course we saw the emergence of probably the biggest issue facing world financial markets in at least six decades: the subprime fiasco. As credit began to implode late last year, the US Federal Reserve was only too happy to dish out some monetary assistance. As we highlighted at the time, “slashing interest rates may keep Wall Street bankers happy, but it will ultimately do nothing to heal the underlying problems in the US economy.”

Our comments a year ago were particularly appropriate, considering that the ultra-low interest rates engineered by the Greenspan Fed turned out to be the root cause of the current housing and credit market woes; yet the solution being offered now is more of the same!

From the start of 2008 right through until the middle of the year, this one-dimensional policy prescription resulted in the US dollar steadily losing ground against a range of currencies commodity prices, with gold and oil hitting all-time highs during the year, oil just five months ago.

2008 also began with a continuation of a number of the key themes that have dominated the resource sector over recent years. Primarily, these involved a continuation of strong commodity pricing, tight supply conditions and strong corporate activity. We also saw resource security strengthen as an issue as commodities became more valuable than ever, with governments in South American, Asia and African looking to renegotiate royalty and ownership structures in order to get a bigger chunk of the pie.

And this is why over the past few years in particular, we have seen commodity prices trading at record levels, right across the board. Whether it has been base metals, bulk commodities, agricultural products, or energy, the resource has been scrambling to keep up with rising demand as the world’s population has increased. So it is important to bear all this in mind in the context of relatively short-term events like the current (albeit enormous) market meltdown. Whether its subprime or dot-com, the mining sector is outstandingly resilient and will bounce back.

Australia has been one of the biggest beneficiaries of the commodity boom due to our enormous reliance on commodity exports, which benefited us hugely of course during the first half of 2008, but led to a dramatic slump in the value of the Aussie dollar during the second half of the year. Despite Australia’s resource reliance, our economy has shown itself to be resilient and we are well-placed to resist the worst of the economic crisis currently engulfing North America and Europe.

At the end of the day, recessions and economic crises eventually do end and the world will continue to grow. The world’s expanding population needs to be housed and fed, all at a time when commodities are becoming increasingly scarce and more costly to find and develop. Therefore, our medium to longer-term prognosis for the resource sector continues to remain unashamedly bullish.

Let’s now review the performance of the various commodity groups and our relevant stock selections over the past 12 months.

Bulk Commodities
Iron ore, coking coal and thermal coal began the year as the star performers of the resource sector, recording huge contract price increases early in the New Year on the back of surging Asian demand. Prices surged even further during the year on the spot market, as demand was so strong for immediate-delivery product that buyers were prepared to pay a premium to get hold of product straight away.

Australian iron ore producers benefited enormously, as we are strategically located just a few days’ sailing time from China, so can service Asian markets much faster than our biggest rivals, the Brazilians.

However, prices fell dramatically during the second half of 2008 as the economic crisis took hold in Asia, which is where a large proportion of the world’s steel industry is based. Spot iron ore prices, which at one stage traded at double the underlying contract price, fell to below US$50 a tonne, less than half the contract price. Not only that, but many Chinese steel mills have either refused to take contracted product, or been prevented from doing so by the withdrawal of lines of credit by their financiers.

Many iron ore and coal companies have felt the dual impact of both slumping demand and plunging prices, but fortunately our portfolio exposure is essentially restricted to the lesser-risk sector heavyweights, Rio Tinto (RIO) and BHP Billiton (BHP). Both companies are industry stayers and will be around long after the iron ore fad has passed most investors by.

Our pure bulk commodity exposures comprise three coal plays: Macarthur Coal (MCC), Cockatoo Coal (COK) and Bandanna Energy (BND); and one iron play, Territory Resources (TTY). Both Macarthur and Territory, as producing companies, saw far more volatility in their respective share prices than did Cockatoo and Bandanna, as advanced resource plays.

Macarthur and Territory suffered from extreme commodity price volatility during the year, as well as corporate issues. In the case of Macarthur there was a buy-in and rumoured takeover by several off-take partners that failed to materialise, whilst in the case of Territory the company suffered from dubious investment decisions made by its former Chairman. Both stocks nevertheless retain their fundamental attractions and leverage to an eventual rebound in bulk commodity prices.

Cockatoo Coal and Bandanna Energy are both emerging Queensland coal players that made great strides during 2008 with regard to their respective projects. Both companies transacted major corporate deals during the year and boast large resource positions and strong industry backing, factors that are not currently reflected in their respective share prices. They are the coal companies of the next decade.

Base Metals
The base metals group (comprising copper, nickel and zinc) was probably the worst performer of 2008, being directly impacted by the worldwide economic slowdown, particularly in Asia and the USA. In fact, base metals failed to generate any positive momentum throughout the year, declining steadily and then more rapidly in price as the year progressed.

Base metals hit their peak in prior years, as they were the commodity class that first responded to the commodity boom. Accordingly, whilst other commodity classes were rallying to record highs and enjoying substantial price spikes during 2008, base metals drifted lower.

The underperformance of base metals this year can largely be attributed to the fact that London Metal Exchange (LME) inventories were beginning to increase at the end of 2007, an indication that base metal demand use in the steel industry was beginning to ease somewhat. Whereas iron ore and coking coal demand hit record levels during 2008, the use of zinc and nickel in the steel rust-proofing and stainless-steel-making processes respectively, fell as the year progressed.

Copper’s demand and price deterioration has been more closely aligned, like that of crude oil, with the downturn in global economic growth. As housing and vehicle construction (copper’s two major uses) has fallen dramatically, so too has consumption of copper.

Aside from the sector heavyweights mentioned earlier, our portfolio base metal exposures comprise a variety of smaller, emerging companies. Let’s review each of them on the basis of metal type.

Our zinc exposures comprise CBH Resources (CBH), Jabiru Metals (JML) and Terramin Australia (TZN). Not surprisingly, they have been severely impacted from an operational and share price perspective by the fact that zinc has been the worst-performing of the base metals. CBH has had to batten down the hatches as its established Endeavour zinc operation at Cobar in NSW, announcing production cuts and job lay-offs.

Meanwhile, Jabiru and Terramin have commissioned new zinc operations in Western Australia and South Australia respectively during 2008 at just the worst time from a price perspective, putting their operations under pressure right from the word go. Nevertheless, all three companies form medium to long-term holdings within our base metal portfolio.

Our nickel exposures comprise Heron Resources (HRR) and Rusina Mining (RML). Heron has continued to benefit from having two of the world’s largest mining houses, BHP and Vale, on its register, so whilst times are tough as far as development of its two emerging Western Australian laterite projects are concerned, the company will benefit from a strong cash position and the dynamic tension of having two goliaths as shareholders.

Meanwhile, RML has continued to make progress during 2008 with respect to all three of its nickel development options in The Philippines and remains a great longer-term nickel play. We also bid farewell to our most successful nickel exposure, Jubilee Mines during the year, following the takeover by Xstrata at $23 a share.

Our copper exposures comprise Discovery Metals (DML), Copper Strike (CSE), Zambezi Resources (ZRL) and Indophil Resources (IRN). We retain faith in all four copper companies as they all possess projects with long-term appeal.

Discovery has made great strides during 2008 with an encouraging pre-feasibility study on its emerging Maun copper project in Botswana; ZRL has continued with appraisal work on its various high-quality copper projects in Zambia, although cash reserves are currently an issue; CSE recently completed an encouraging feasibility study on its Einasleigh project in Queensland; and Indophil Resources has undergone a topsy-turvy year full of on-and-off corporate interest from various parties with respect to its Tampakan project stake in The Philippines, although shareholders are still waiting for confirmation of the latest approach.

Crude Oil
The oil price famously surged to a record high of US$147 a barrel just after the halfway mark of the year, with strong expectations that if the economic status quo had remained, we would have been looking at a price of US$200 a barrel by now.

As prices rose to fresh highs during the year, the calls were deafening from developed nations everywhere, in particular the US, for OPEC to open up the taps and make more crude available. High oil prices resulted in riots, demonstrations, escalating costs and general hardship for both private consumers and industry.

Alas, the price of oil plummeted during the second half of 2008 as the world economy dramatically slowed. Nevertheless, we retain the view that we held at the start of the year, which is that an oil price of at least US$75 a barrel is required to guarantee future oil supply. Essentially today’s lower oil prices are a threat to tomorrow’s production levels. The fields of the future will be much costlier to find and develop than the fields that now provide the bulk of the world’s oil. So higher oil prices are inevitable.

Our larger portfolio producers, Woodside Petroleum (WPL), Oil Search (OSH), Australian Worldwide Energy (AWE) and Arrow Energy (AOE), all benefited from the surging oil price during the first half of the year, whilst correspondingly seeing their fortunes tumble during the second-half as prices reversed. Both AWE and AOE were busy on the corporate side during 2008, with sizeable corporate deals to help grow their respective asset and revenue bases. All four of our larger producers remain key portfolio holdings. Caltex (CTX) on the other hand has had a tough time of it, suffering from both the rise and subsequent fall in the price of crude this year.

Interestingly, our smaller producers retain their key attraction, which is growth. Our smaller portfolio exposures comprise Carnarvon Petroleum (CVN), Incremental Petroleum (IPM), Salinas Energy (SAE) and Oilex (OEX). The first three are established smaller producers that are able to expand their production bases at a time when many of the international oil sector heavyweights struggle with static output and declining reserves. More then ever, the sector’s big guns will be eyeing-off acquisition opportunities in the current downturn to bolster their flagging growth levels.

On the exploration/development front, Oilex (OEX) made great strides as it progressed steadily towards first production from fields in India, Oman and Indonesia, during late-2008/early 2009. Like most junior companies however, the company’s appalling share price performance failed to reflect these fantastic achievements. The company continues to represent a stand-out growth opportunity.

Uranium
Uranium prices retraced sharply during 2008 following last year’s enormous price spike, driven by heavy speculation in what is realistically a thinly traded, easily-manipulated market. Like many commodities however, uranium had overshot on the downside, which is reflected in the fact that prices seem to have stabilised and have actually been rising steadily over recent months.

One of the biggest developments in the sector in decades was the announcement by the new Western Australian government that it was lifting the long-standing uranium mining ban. The state is home to enormous uranium reserves, which now have some prospect of commercial exploitation.

Nevertheless, whilst the news was greeted with an initial flurry, the reality is that any potential development is still up to a decade away. This is symptomatic of the key supply-side issues that continue to exist in the uranium sector. The situation got worse during 2008, with two of the world’s biggest producers, Cameco and Uranium One, along with a host of smaller players, announcing supply cut-backs.

Our portfolio uranium exposures, Paladin Energy (PDN), Extract Resources (EXT), Bannerman Resources (BMN) and Marathon Resources (MTN), generally performed solidly during 2008 with some disappointments along the way, although there was little positive reflection in the various companies’ share price performances.

In the case of Paladin, the company finally managed to achieve budgeted production from its flagship Langer Heinrich operation in Namibia, whilst also making solid development progress on its number two project, its Kayalekera development in Malawi. It remains an essential energy stock in any portfolio.

Both of our other emerging Namibian uranium plays, Extract and Bannerman, managed strong finishes to the year with respect to their share prices, as a result of good news on the project front. Extract continued to generate strong exploration news that attracted neighbour Rio Tinto onto its share register, whilst Bannerman settled an outstanding tenement dispute, announced a new CEO and finally generated some positive momentum. Namibia remains perhaps the world’s number one uranium destination so both EXT and BMN are essential holds in our portfolio.

Marathon Resources was able to close the book on what was an ugly year with some positive news, with the South Australian government allowing the Mt Gee site clean-up to get underway. The company can finally get back on the ground in 2009 in a constructive way.

Precious Metals
Precious metals prices, comprising gold, silver and platinum, all enjoyed stellar price performances during the early part of 2008, as they joined the commodity price party being enjoyed by the rest of the sector. Gold hit a record high of US$1,031/oz in March, with the other precious metals following suit.

The story changed dramatically however once the credit crisis firmly took hold, with the price of platinum slumping dramatically on the back of slumping vehicle demand. Platinum’s price strength is more closely tied to its underlying industrial use than say gold, with silver probably somewhere in the middle. As a result, the performance of the various three precious metals has varied considerably over the second half of 2008.

Three years ago, in October 2006, we published an article saying that gold would be the next great investment bubble. We still believe that to be the case. Bull markets don’t build overnight, and the gold bull has been brewing for years. It has been gold’s price performance over recent months, rather than its spike to record levels in the first quarter of 2008, which has drawn most attention.

There is effectively a silent gold rush taking place all around the world. Investors who understand gold’s role as an international currency are selling their surplus paper dollars and buying the yellow metal. This has led to unprecedented demand for bullion and coin dealers everywhere are struggling to meet this demand.

Physical demand for gold from investors and lease rates for gold lending have risen to virtually record levels, indicating strong demand for the yellow metal as a store of wealth at a time of enormous investor unease.

Not surprisingly, our portfolio precious metal exposures demonstrated varying price performances during the year. Our gold portfolio comprises a range of companies from established larger players to mid-cap companies, and finally smaller/emerging producers.

At the bigger end of the market, Lihir Gold (LGL) and Newmont Mining (NEM), despite some operational hiccups and operating cost issues during the year, retain their position of strength due to their strong reserves bases and project pipeline.

Our small-mid-cap producers comprise Resolute Mining (RSG), Sino Gold (SGX), Dominion Mining (DOM), IAMGOLD (TSX: IMG) and Dioro Exploration (DIO). From an operational perspective these companies performed solidly during the year, with SGX ramping up production from China, Dominion generating more low-cost gold from South Australia, Resolute finalising a capital raising to develop its new project in Mali, and IAMGOLD embarking upon several corporate acquisitions. Dioro was the only exception, struggling somewhat at its South Kal operation in Western Australia.

Our emerging gold players retain all of their upside potential. These companies comprise BMA Gold (BMO), Catalpa Resources (CAH), Mundo Minerals (MUN), Integra Mining (IGR), Centamin Egypt (CNT) and Andean Resources (AND).

Mundo endured some commissioning hiccups with its new gold operation in Brazil, Catalpa seems at long last to be making some real headway on its Western Australia project and Integra continues to generate exciting results from its Western Australian drilling programme. BMA Gold has proposed a merger with a South African gold play, Andean’s Argentine gold project gets more attractive by the day and Centamin is on track for first gold production in Egypt in early 2009.

Lion Selection (LST) completed a successful share buy-back and capital return to shareholders whilst we also introduced Gold Bullion Securities (GOLD) to Members for the first time, offering investors direct exposure to physical gold through an Exchange Traded Fund (ETF) without the hassles of storage, etc. Importantly, all GOLD holdings are backed by the physical metal.

Our other precious metal exposures comprise Platinum Australia (PLA) and Coeur D’Alene (CXC), enjoyed contrasting operational performances during 2008. Whilst the share price performances of both companies were disappointing, Platinum Australia successfully commissioned its first production operation, its low-cost Smokey Hills project in South Africa, during the year. Meanwhile, Coeur struggled with production and cost issues. Nevertheless, both companies remain long-term holds within our portfolio.

Diamonds
Diamond demand and prices held up fairly well during the year, but were impacted by the economic slowdown over recent months. De Beers up until October was confident that diamond demand would hold out against the tide, but as a luxury good demand has dried up as consumer wealth has been destroyed.

This impacted upon our two portfolio diamond stocks, Vaaldiam Resources (TSX: VAA) and North Australian Diamonds (NAD). Vaaldiam, after an extremely difficult year, has temporarily placed both its Brazilian diamond mines on care and maintenance until conditions improve. But the news is more promising on the NAD front, with mining stalwart Joseph Gutnick appointed as the company’s new CEO and also assisting with a major capital raising to fund a feasibility study on the Merlin project.

Heavyweights
There was a large amount of corporate activity involving our sector heavyweights during the year, culminating in the unsuccessful bid by BHP Billiton (BHP) for Rio Tinto (RIO), accompanied on the international scene by the unsuccessful overtures by Brazil’s Vale for Xstrata (XTA), and the offer and then subsequent withdrawal by Xstrata for Lonmin.

Whilst the larger, diversified companies were able to better weather the downturn in the resource sector, all have still been hit hard in share price-terms by the crisis. More than ever, debt levels have been closely scrutinised by the market, with Rio Tinto and Xstrata suffering the most due to their high levels of gearing.

Exploration
Our pure exploration plays comprise Argo Exploration (AXT), Hannans Reward (HNR), Azure Minerals (AZS), Pioneer Nickel (PIO), Falcon Minerals (FCN) and Image Resources (IMA).

Fortunately, despite the pounding that junior companies have received in the current market environment, all our exploration juniors maintain their key exploration attractions and most importantly are either cashed-up and/or have the capacity to generate additional funding.

Disappointments
The appointment of Administrators to both View Resources (VRE) and CopperCo (CUO) was overwhelmingly the most disappointing aspect from our point of view. Rising operating costs impacted the fortunes of both companies. We are nevertheless hopeful that deals can be put together to get both companies re-listed.

Overwhelmingly, 2008 was a year that all investors will be extremely happy to see the back of, as we look ahead to at least some degree of stability returning to markets and commodities in 2009.

We will be publishing a regular report next week, followed by our 2009 outlook piece in a fortnight’s time.

We wish all Members a Happy and Safe Christmas and a far more prosperous New Year.

Signing off for 2008, we take this opportunity to thank you for your support of the Mining & Resources Report in its third year.

Best Wishes,

Fat Prophets