October 17, 2008

October 18, 2008

The great deleveraging

By Charlie Aitken

Thursday, October 16: There has always been a necessity to characterise calamitous world events with the
word "great". The horrific loss of life in the First World War resulted in historians calling it the Great War.
Similarly, the worst global financial crisis in modern history back in the 1930s has been called the Great
Depression. More recently, US Federal Reserve chairman Ben Bernanke labelled the uncharacteristically long
period of low global bond yields and inflation in the early part of this decade as the Great Moderation.

The Great Deleveraging

However, the recent events in 2008 will inevitably been described by historians as the Great Deleveraging.
Maybe I could register it as a domain name and receive royalties every time the phrase is used on the internet,
or when comedian Vince Sorrenti is forced to include the phrase in his send-up of the significant usage of
"great" in Australian history, with the Great Barrier Reef, Great White Shark, and the Great Dividing Range, etc.

In reality, the Great Deleveraging of 2008 is really the "greatest" global margin call of all time. In some cases,
assets and trading positions of major US investment banks and hedge funds were leveraged by up to 20 times.
It is little wonder that the world financial system has ground to a halt under the threat of systemic meltdown
through counterparty risk.

Considering the absolute carnage in the global foreign exchange markets, it appears that the extent, and the
leverage of the currency-related "carry" trades has been significantly underestimated. The extraordinary 35.5%
fall in the Australian dollar in just over 10 weeks, to the recent intra-day low of US63.2¢ last week is clear proof.
(It is now around US60¢.)

In addition, it has now become very clear that the 30%-plus fall in the US dollar index over the past six years
has spawned massive global US dollar hedge trades. In this regard, with the global deleveraging and
unwinding of risk positions I have been simply amazed by the extent of the short US dollar and long commodity
trade. The stunning short covering rally in the US dollar, and the corresponding fall in the Australian dollar, has
only been exceeded by the spectacular fall in commodity prices.

Commodity meltdown

However, I am hearing from my overseas sources that the climax in the recent commodity meltdown,
particularly for industrial metals last week, was due to a new form of contagion from the deleveraging process.
My contacts confirm that the sell-off on Friday occurred as commodity traders moved their private bilateral
contracts on to commodity exchanges and clearing houses in an attempt to reduce their counterparty risk in the
deepening financial crisis.

The transfer of these opaque over-the-counter deals to physical metal exchanges has resulted in massive
volatility and a significant increase in volume. Martin Abbott, chief executive at the London Metal Exchange,
confirmed that as traders tried to reduce their risk positions, the exchange's turnover has soared by over 45%
in September compared with a year ago. As a result, the exchange has extended its forward-dated futures
contracts in copper and aluminium to 10 years from five previously, in an attempt to capture more over-the-
counter business.

The London Metal Exchange's initiatives are in response to the move by other exchanges into the over-the-
counter clearing business, and in part to capitalise on the strong backing regulators have given to the creation
of a central clearing counterparty model for the credit derivative markets. The aim is to reduce the inherent
systemic risks when credit derivatives are negotiated bilaterally between traders by having a clearing house
guarantee against default. This is an exact replica of the problems AIG faced recently.
The similarly opaque, global credit default swap market estimated at $US63 trillion, which is real leverage, has
already resulted in a US government bailout for AIG, which was simply unable to meet its risk obligations. On
reflection, the decision to allow Lehman Brothers to fail was a big mistake considering the significant
commodity positions held within the group and the risk of counterparty failure. Unfortunately, the subsequent
cascading effects on commodity prices have been all too clear.

However, considering the extent of the deleveraging process, I guess it is not surprising to hear that a
significant amount of over-the-counter trades have been operating in commodity markets. As a result, it
appears the current meltdown in base metals in particular, is a clear reflection of the unwinding of counterparty
risk as traders crystallise financial positions on to physical markets.

Consequently, a significant amount of the increase in new metal delivered into London Metal Exchange
warehouses from the unwinding of complex over-the-counter long commodity trades by hedge funds is showing
up as an increase in the exchange's official base metal inventories. I believe investors are confusing the
negative impact of this process with the perception of a cataclysmic slowdown in Chinese commodity demand.

Bulk commodities

It is also important to realise that the global financial crisis and the tightness in credit markets has not just
exclusively impacted on the base metal markets, where prices are highly visible and easily traded on London
Metal Exchange. The bulk commodity prices have also suffered.

It is worth noting that in addition to the "contracted" bulk commodity purchases by the big Chinese steel mills
such as Baosteel, there are "intermediate" iron-ore and coal buyers or traders which supply the hundreds of
smaller Chinese mills by purchasing on the spot market. However, I am hearing that the credit slowdown and
the efforts of the Chinese government to tighten liquidity have severely impacted the activities of the traders,
particularly in the iron ore market.

While there is no doubt that the major mills such as Baosteel are cutting back output by as much as 10%, I
think recent reports of Chinese steel demand "falling off a cliff" are being exacerbated by the lack of buying
support in iron ore, and to a lesser extent coking coal, by the spot market traders who have found themselves
without finance. It is no secret that the Chinese government is keen to consolidate the steel industry by
eliminating the smaller players to promote a more concentrated and united steel buying consortium to
challenge the "so-called" power of the global iron ore producers. In addition, China is reportedly furious with
Vale for the mid-year increase in the Brazilian benchmark iron ore contract price.

As a result, "spot" iron prices have fallen below the current contract price for the first time in three or four years.
This very much suits the Chinese steel industry with the iron ore negotiations imminent. And after being on the
receiving end of some massive recent iron ore rises, China will be very eager to paint a very negative picture of
industry fundamentals and secure a reduction in the contract price.

In addition to the unwinding of over-the-counter trades and the credit tightness in China, there is little doubt that
the global deleveraging of risk has also resulted in the unwinding of massive short US dollar/long commodity
positions as hedge funds have been forced to liquidate currency "carry" trades to cover redemptions and losses
elsewhere. In the recent climate of panic and fear, I believe investors have sold absolutely anything of value in
desperate attempt to raise cash.

As a result, I believe a combination of the factors mentioned above, coupled with the slowdown in Chinese
economic growth, has resulted in a perfect negative storm for industrial metals and, to a certain extent, bulk
commodities in the short term.

The long-term story

I realise we all can't see past tomorrow at the moment but I want to remind you of the long-term commodity
story, which remains intact.

I am not implying that financial deleveraging is the sole driver of commodity price weakness, but I think it has
played a very important contribution. There is no doubt that an economic slowdown in China has resulted in a
reduction in demand. However, the weakness is a temporary slowdown in a strong multi-decade economic
growth cycle. But in anticipation of the resource "bears" taking some instant gratification by sending me a whole
bunch of "I told you so, Charlie" emails, it is worth making some important points. Then you can call me an
insane bull.

In light of the white-hot GDP growth of 11.9% last year, the Chinese government has initiated a series of fiscal
and monetary measures designed to significantly slow the economy and ease a dangerous build-up in
inflationary pressures, particularly in the real estate sector. The central bank has raised the bank deposit ratio
12 times and interest rates six times in an effort to slow inflation and restrict credit growth. Further, the
government has allowed the currency to appreciate by 6–7%, over and above the official revaluation, in order
to reduce the massive foreign exchange inflows and further tighten internal liquidity.

Consequently, the economy has shown clear signs of slowing. In addition, this slowing has been exacerbated
by the weakness in the global economy, the Olympic shutdown and the effects of the earthquakes. However, it
is important to put this slowdown into context with GDP growth falling from the decade high of 11.9% to
annualised growth of 10.1% in the first half of calendar 2008. Hardly doomsday.

The contribution of this growth is also very important, with the commodity-intensive fixed asset investment still
strong at 26.5% for the year to date. In addition, despite the consensus forecast of an imminent global
recession; the latest official statistics reveal China reported a record trade surplus in September. While this was
driven mainly by lower import prices, export growth is holding up well with exports by volume down by just 10%
in a very weak global economy. Interestingly, the offset was India where trade increased by 54.9% in
September from a year earlier.

Surprisingly for the China "bears", at the conclusion of the recent four-day Communist Party Congress, the
government commented that "the basic momentum of the economy remains unchanged". As a result,
considering the latent strength, the government failed to announce the expected economic stimulus. However I
believe that with two interest rate cuts recently, the economic policy has already changed to pro-growth. In
addition, with a massive $US1.8 trillion in foreign exchange reserves, China is well placed to initiate a strong
stimulus package if required.

The third-quarter GDP growth figures are expected within a few days and it would not surprise to see economic
growth slow further to under 10%. In this respect, the International Monetary Fund recently forecast the
economy to slow to 9.7% this year and 9.3% next year. I believe the important issue is the sustainability of
long-term growth and with the recent fall in inflation it appears the government will engineer a soft landing.

There is no doubt that the Chinese economy has slowed due to a variety of issues, including the slowing global
economy. However, the Chinese economy is still growing at faster than 10% a year despite the bulk of the
developed world being close to, or in a recession. As a result, I believe the multi-decade Chinese urbanisation
growth story remains firmly intact, driven predominately by internal demand, which remains independent of
economic cycles. In this respect BHP and Rio, while cautious in the short term, both expect China to sustain at
least 8% annual growth for the next two decades. I agree.

Supply constraints just got worse

In addition, the global credit crisis will serve to exacerbate the long-term commodity supply constraints. There is
no doubt that major brownfield expansions will be significantly delayed and marginal greenfield projects will be
scrapped as spot prices fall below the marginal cost of new production.

In this respect, Alcoa management's comments at the recent third-quarter result are particularly interesting:
"Given the sharp decline in metal prices … we are stopping all non-critical capital projects, and making targeted
reductions to match market conditions, and are adjusting our manufacturing capacity to meet demand." While
Alcoa's key markets are not China, it appears management is significantly reducing capital expenditure and
shutting uneconomic capacity.

As a result, the consensus forecasts of big supply surpluses in base metals will prove wide of the mark as
mining companies delay new projects and marginal production is closed or significantly reduced.

Doomsday scenario

Commodity markets, particularly base metals, have been directly impacted by the unwinding of financial
leverage. In addition, in the short term there is no doubt that Chinese economic growth and commodity demand
has slowed, but I believe investors are confusing the meltdown in commodities with a cataclysmic fall in
Chinese growth. As a result, I think global resource share prices are factoring in the prospect of a doomsday
outcome.

Last week (see BHP Billiton: Pricing for Doomsday) I attempted to backsolve the extent to which the BHP
share price was factoring in a doomsday, or even worse, an Armageddon scenario. The doomsday scenario
implied a price target of $28.97, while the Armageddon outcome predicted a share price of $23.18.At the height
of fear and panic it is interesting to observe the price for BHP (around $26.00) is around the midpoint of both
scenarios.

As a result, I have now run the doomsday model on our universe of resource companies. In the doomsday
scenario, I ran the model on a worst-case price scenario. My worst case prices are those where I believe the
marginal producer will make a cash return, but not necessarily a capital return. For reference I have also run a
spot and long-term scenario. The chart below shows the premium or discount of the current price to each
scenario.

The key takeaway is that the majority of stocks we cover in resources are now trading at a discount to even the
worst-case scenario, suggesting value opportunities emerging across the sector. The gold sector, notably
Avoca, Newcrest and Sino Gold have held up well, arguably being priced on the futures curve rather than my
selected scenarios. The cheapest stocks on this screen are Apex, Roc Oil, and Independence Group.
In addition, some resources have fallen so far, that they are close to cash backing. The chart below represents
the cash balance as a percentage of market cap. The stocks showing negative are net debt and therefore
become irrelevant for this analysis.

The top-ranking stocks are Independence Group – impacted by falling nickel price, but with cash now 55% of
market cap, the nickel operations, and the share in the Tropicana project are being priced at $137 million.
Gindalbie – impacted by fears that iron ore prices and funding arrangements are at risk, but with cash at 44%
of market cap, the iron ore projects are being priced at $130 million. Australian Worldwide Exploration –
impacted by falling oil price, but has mounting cash but is also trading at 40% of net present value at spot
prices.

I would suggest that the stocks with operations in the lowest cash cost quartile, and with no need for additional
funding, are the safest in the current environment and include Australian Worldwide Exploration, BHP,
Fortescue, Newcrest and Western Areas. I include Fortescue, because I don't believe it has a funding issue. Of
these stocks, AWE came up favourably on both screens above, and Western Areas is trading at a 46%
discount to my worst-case scenario. AWE and Western Areas appear grossly cheap.

Despite the change in consensus sentiment, in no way am I stepping back from my positive long-term view for
commodities and resource stocks. I believe the sharp pullback represents a major mid-cycle correction in a
long-term bull market. Despite the fear, panic and doomsday mentality, I believe the current environment is an
unprecedented opportunity for investors to buy high-quality, long-duration assets at multi-decade lows. Warren
Buffett has recently stated that this is the best buying environment since 1973-74. If you don't believe me, listen
to him and put some cash to work in quality resource stocks. The bottom in credit is also the bottom in
commodities; however I continue to expect extreme short-term volatility in commodity equities as they make a
bottom and world markets swing between optimism about liquidity being pumped and pessimism about near-
term data. We are certainly in "bipolar markets", but there is value to be found.

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