The commodity see-saw

Guy Antoine
Investment Analyst
B Sc (Hons) Cum Laude, CFA

In our 2Q2013 commentary we explained how our research indicated that resource companies were
being undervalued by the market. The undervaluation was especially material when compared to
industrial companies on a relative basis. This article expands on our research on the resources landscape,
explaining some of the thinking behind our portfolio’s exposure to resources.

Exhibit 1 shows the profitability of diversified mining companies in their respective commodity divisions. The bars
show the percentage gap between 2013 profit margins compared with the 13 year average levels of profitability per
commodity division.

Exhibit 1: % gap between 2013 EBIT margins

and average commodity margins 1

15
10
5
0
% gap

-5
-10
-15
-20
-25
Iron Ore

Copper

Manganese

Thermal coal

Platinum

Aluminium

Coking Coal

Nickel

source: Ubs, 01 June 2014

This chart reminds one of a see-saw tipping in favour of iron ore, lofting its margins high into the air. Childhood memories
will remind you that all it takes is a little shift in weight, perhaps a small nudge from the other side, and the balance is shifted.
Iron ore would come crashing down, while the opposing base and precious metals are lifted to normalised profits (at least)
once again.

It is striking to observe that in 7 of the 8 commodities shown above, margins are below normal levels of profitability, with
most of them being significantly below. The only metal enjoying substantial profitability is iron ore. Mining companies would
have been suffering from a cyclical recession if not for this commodity. This is underlined by the fact that in 2013, according
to UBS, more than 70% of ‘diversified’ mining company profits were generated by iron ore alone. This is compared with
normal levels of around 20% before the global financial crisis of 2008.

Imagine the market balance between supply and demand like an elastic band fixed between two points, like on a catapult.
When it is most stretched, the potential energy to snap back to its neutral position is greatest. Two ‘stretched’ commodities
with high, but opposite, potential energy are iron ore and platinum.

1
Average commodity margins run from 2001 to 2013. Companies include: Anglo, BHPBilliton, Glencore, ARM, Exxaro, Kumba, and Assore.

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Competitive dynamics predict that when above-normal profit margins persist, this situation attracts investment as investors
are drawn to the promise of high returns. If barriers to entry are low, the super-normal period is brief as new capacity is
quickly added, flooding the market with new supply.

In the case of iron ore, barriers to entry should be relatively low compared to other commodities like platinum. Iron
ore deposits are abundant and spread across many continents. Despite the abundance of iron ore, projects have taken
considerable time to be delivered to market. For example Anglo American’s Minas Rio project was first acquired in 2007
and is only expected to deliver first ore at the end of this year – over 7 years later. Bulk commodities are typically large scale,
and require significant capital investment. Often further investment is required in associated infrastructure in order to move
the high volumes of material. For example Minas Rio requires the development of the mine itself, a 525km slurry pipeline to
transport ore to the Brazilian coast and the construction of a port for shipment. Clearly these large commitments are not
likely to be cancelled mid-stream even though Chinese demand (the driver of global demand) appears to be moderating.
The combination of increasing supply with moderating demand growth could well put further downward pressure on iron
ore prices.

In stark contrast, platinum is rare and concentrated in South Africa and Zimbabwe. Exhibit 2 shows the relative abundance
of known discoveries of various commodities as measured by years of reserve life. Geological reserves are portions of
ore bodies that can be extracted today at an economically viable cost. By dividing these reserves into the current annual
production rate, one gets the approximate number of years left of supply. At the end of 2012 the world had 45 years of
iron reserves and 29 years of platinum. This assumes no new reserves are discovered, constant annual production, and no
change in the economic environment.

Exhibit 2: Global reserve life-of-mine in 2012

100
90
80
70
60
years

50
40
30
20
10
0
Aluminium

Coal

Iron Ore

Copper

Nickel

Platinum

Gold

Zinc

source: Ubs

It is more likely that new iron ore deposits will be discovered than new platinum deposits. Based on elemental abundance in
the earth’s crust, iron is roughly 11 billion times more abundant than platinum, while platinum is slightly more rare than gold.
This context suggests that over the long-term, the platinum reserve life limits are likely to be far lower than those for iron ore.

Most iron ore deposits can be exploited near-surface, compared with almost the entire world’s known platinum reserves
that lie hundreds of metres below surface. The newest shafts in Rustenburg are being sunk to 2km deep, requiring extreme
and expensive engineering.

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In 2014 it is estimated that iron ore supply will expand by 10%2. Year to date mined platinum supply will be at least 13% lower
than the already low 2013 base3. This contrasting picture suggests that the expected economic forces of reversion are taking
place. We can expect margins to normalise lower for iron ore and higher for platinum. The commodity see-saw appears to
be moving. For the 6 months year-to-date iron ore prices are down 31% while platinum prices are up 9% and palladium up
18%; suggesting the inevitable reversal is underway.

Competitive forces predict that when an industry experiences persistent sub-par profits, high cost supply is shut down.
Weak players leave the market, restoring supply to an appropriate level commensurate with demand. If barriers to exit are
low, this rebalancing can be rapid. In the case of South African platinum, the rebalancing has been slow, suggesting there are
high barriers to exit (the top 3 producers have been burning cash since 2012). One example was Anglo American Platinum’s
original intent to close its Rustenburg operations, affecting 14 thousand jobs. Under social and political pressure Angloplats
ultimately agreed to keep some mines operating, and reduced the actual number of retrenchments to around 3.3 thousand.

Twenty two weeks of strikes has removed significant supply from the market in a short space of time. So far an estimated
1.05 million ounces of platinum has reportedly been the shortfall as a result of strike action in 2014; more than Lonmin’s
entire annual production. Curiously the platinum price has only advanced 2% since the onset of the strikes (23 January).
Compare this to 2007 where the price moved 20%4 in response to 3 months of reduced supply. This was mainly due to
Eskom’s power crisis and subsequent load-shedding. The current price benevolence suggests that consumers of metal have
or had substantial stockpiles that need to be worked through before the market can rebalance. Industry experts disagree on
the size of these stockpiles and consequently the exact timing of the rebalancing.

As investors we cannot time the market exactly, but we can estimate intrinsic value. In our opinion, too much value has been
ascribed to the iron ore market in the recent past, and too little value to the platinum industry. As a result, we have limited
look-through exposure to iron ore and significant exposure to platinum group metals in our client portfolios. Some of our
platinum exposure has been taken through exchange traded funds5 because in the short term strikes will negatively impact
some platinum companies’ ability to capitalise on higher prices.

Element’s portfolios are well positioned to benefit from the laws of competitive dynamics and the eventual rebalancing of
commodity markets when they occur.

2
UBS 16 May 2014 seaborne iron ore forecast.
3
Barclays Capital 3 June 2014 platinum supply forecast; 2013 SA mine production was still 21% below peak levels achieved in 2006.
4
Price move taken from 1 November 2007 to 31 January 2008. This 3 month period was characterised by 23 incidences of load shedding.
5
With the recent launch of both platinum and palladium ETFs on the JSE, an investor can replicate almost 90% of the mining company’s price basket
(combined with the gold ETF).

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