The Long Term Bull Market in Molybdenum

Molybdenum (Mo) is one of the many industrial commodities that languished in the 1985 – 2002 period. It was characterized by low prices, low or negative investment and a lack of interest by consumers except as a routine item. Additionally, much of Mo is copper byproduct, and the low copper prices caused miners to maximize moly production as much as possible.

This all came to an end in the ‘00s as steel demand growth in the developing world blew out. Moly went through much the same process as other industrial metals, with prices rising about eight times. The structural situation, however, may be even stronger than some others.

Supply / Demand

Estimates of moly supply/demand are confusing, with discrepancies between sources. However, all agree that inventories of moly have been reduced to very low levels. Previously, many of the stocks were carried by dealers; consumers and producers kept inventories just in time. The eight times price increase has made it too risky and costly for dealers to continue in this role. There may be speculative stocks held by private speculators/hedge funds etc., but in the following I assume that there will be no stock drawdown from hereon.

Usage of moly has grown 3.2% per annum over the past ten years. However it has grown 6.6% per annum over the past five. Partly this is due to strong emerging markets and infrastructure buildouts over this time period. There is reason to believe that there is a structural element to this as well.

• Moly steels are stronger and lighter. On vehicles they are a gas saver. Many observers see a higher use of alloy steels here.
• Because of strength and corrosion resistance, moly steels are also heavily used in oil/gas drilling, especially in deeper wells.
• Moly stainless substitutes somewhat for nickel stainless and currently has a significant price advantage.
• Moly is used as a catalyst in fuel refining. It is the major catalyst used in making ultra low sulfur diesel – potentially a big growth story in Europe and the USA.

For this analysis, I will also assume that potential demand will grow by 4.5% per year. Actual demand will be constrained by production.

Future moly supply hangs on new mine openings and Chinese exports. As in all mineral markets, there are a huge number of explorations going on, most of which have little chance of going forward. The mines I include here are those I think have a high probability of coming to fruition.

The Chinese situation is somewhat confused. China has effectively banned all toll roasting of moly, indicating a tight situation. There are reports that production of concentrates at state-owned mines are up, but private mines are down. I will assume that the growth in the Chinese economy will slowly reduce exports.

See the table at the top. All figures in million lbs. Mo equiv:

The take-away from this is that there can be no significant moly stockbuilds until the end of the decade. After that, if all things go well (a big if), it can resume a more normal market.

Prices

There is no way to accurately forecast moly prices. This is a situation of zero surplus stocks, but very high current prices. However in view of the above, it seems reasonable that prices will remain quite high until 2010. The 1960 – 2006 deflated average price is $14 / lb. In light of the strong fundamentals, this should probably provide a long-run floor.

Investment Possibilities

Moly metal forwards are very difficult to get. One could buy cash and hold it, but in view of the price level, that is a poor idea. If it could be traded, one would guess that there would be a hefty backwardation in moly metal.

Possible equity plays:

The best mine in the world is likely to be the reopened FCX Climax mine in Nevada. Reputable sources claim it will have an operating cost of $3.50 per lb. Unfortunately, FCX is clearly not a pure moly play, but if you were decide to go long copper or gold stocks, this would be a consideration.

General Moly (GMO). They are developing a new mine in Mount Hope Nevada and own another high grade moly claim nearby. This is one that looks like it will get done. It will take about $1 billion. Investors include the steel companies Arcelor-Mittal and POSCO (Korea). This is important because they will become dedicated consumers as well. The funds Coghill, Sprott and Citadel are also in. Production is scheduled for 2H 2010. This is a claimed low cost project – total operating cost including an onsite roaster is $7.65 / lb., and a moly price of $15 gives a claimed IRR of 25%. Grade is high for an open pit at 0.1%. One downside: some think the 2010 startup is optimistic, maybe very optimistic. http://www.generalmoly.com/gmo1dir/investors.htm

Molymines (MOL.TO). This project is backed by some of the same principals behind Fortescue Metals Group, a very successful Western Australia mining venture. This is probably a slightly higher cost project. However it is located closer to the expanding markets in Asia. Grade is 0.06%. One advantage is access to ultra cheap Aussie natgas for power. Also, there may be other economic minerals on the claim, especially iron ore. If so, there could be significant upside.

http://www1.molymines.com/default.aspx?id=1&category=1&Ddte=1&DGrd=1

Adanek (AUA.TO). A smaller producer. This should be the 1^st new moly project online.

http://www.adanacmoly.com/index.php

Thomson Creek (TC). This company operates the Thomson Creek mine in Idaho and another in BC. It has a PE of 16, P/B of 4.3. They also have a Mo roaster in PA, which also does toll work. This would seem to have lower risk since it is already in operation. However, production at both mines has been below expectations.

http://www.thompsoncreekmetals.com/s/Home.asp

The Trade

General Moly (GMO) seems the pick of the litter here. Molymines (MOL.TO) also looks good, especially in view of the track record of the principals.

For those who want to be market neutral, hedging new ventures is difficult. The betas of GMO and MOL.TO are statistically unreliable. In reality this is going to be quite nonlinear. In a major economic meltdown, these stocks could go to near zero, while a 10% correction might mean nothing for the long term. To partially hedge, I am buying XME puts, strike at 10% under the market.

Update on the copper trade

I have a trade on long PCU/short comex copper (dec 07 at this point). As I mention in the sidebar, I've hedged most of my equities with various instruments, short S&P500 futures being the easiest. I hope to keep this position on for a very long time. Let's see how it has done since the start of the credit crunch:

.................PCU.....Comex.....Dec SPZ7
July 15......112.5........3.66..........1558
Nov 15......107...........3.08..........1456
% change...-5%........-16%...........-7%
Note: PCU is dividend adjusted

So the trade has done quite well. Even unhedged, it would have made 11%, pretty good on a relative value trade. And if you hedged it that goes up to 18%!

So what to do here? I'm in a bit of a quandary: on one hand I believe that the trade will pay many times that over the next few years. Copper the metal is still way overpriced, and we are just starting to see the beginnings of new supply brought on by the price rise. Also, PCU is still a very profitable company, and is lower cost than most of its competition. OTOH, instinct tells me to take profits on a big gain like this. So I'm taking the chicken s*** way out - I'm taking a little off. Hope to put it back on if the whole stock market tanks big time.

LINQ

Last week I mentioned that I had bought LINQ Resources, an Aussie commodity investment fund. This fund invests in mostly late stage exploration and development, rather than operating mines. Many of its investments are more of a private equity type rather than stock market plays. It has a somewhat higher risk portfolio than the big cap mining companies. I think it is worth the risk:

1. It's selling for 10% - 15% below NAV. This is the good think about buying closed end funds.

2. A hedge fund that specializes in buying discounted funds like this and eliminating the discount through activism has bought a large position. This fund has an excellent record, and I expect it will be successful.

3. I'm not sure the management of the company is too savvy financially, but they do seem to know their mining. I'm hoping that the infusion of financial expertise from the hedge fund owner will lead to a better company.

3. The company still has a substantial cash position. I've noticed that private equity companies tend to go up after they manage to invest their funds.

Sorry....

I wasn't able to post last week. Family issues. However there are a couple of things worth noting. First, I'm taking off a little more of the levered loan trade. This was an extremely large position that is now only a large one. Also, the discount on the closed end funds that I bought has narrowed significantly. I still expect this to do better, but it's not the gift it was a month or so ago.

Also, I have a new commodity equity trade, an Australian investment company called LINQ Resources (Yahoo symbol: LRF.AX). Hopefully, I'll be able to post a full analysis of it later in the week.

Take off the oil trade

The oil trade (long oil equities, short crude futures) was the first trade I posted when this blog started in Nov. 2006. link It's time to book the (very substantial) profits. Here's why:

1. The crude market has moved from a big carry to a big backwardation. Remember, a major rational of the trade was to collect the carry in crude. The current term structure is telling you that current oil prices are not driven by spec demand, but by real oil consumption.

2. If oil goes into blowout phase, the equities will not follow as hard. Equities are a long term investment, and will more or less follow the long term forward crude price. I doubt that Dec 2011 futures will blow out.

3. The downstream parts of the oil industry are starting to soften. There is a lot of refinery capacity being built around the world, and much of the output will come to the US. I also expect that coal and natgas prices will continue soft.

If you want to have continuing oil exposure, it's best to play the highly levered companies. I would recommend something like Canadian Oil Sands. This has a high breakeven oil price, but would generate huge profits in a blowout. Note that this is a pure spec on the crude price - not the kind of commodity/equity relative value that we mostly do here.

Not much happening...

...this week. Once again, a lot of vol., but not much actual movement. We've seen this for about a month now, and I suspect we will see a fair bit more.

The market reminds me a lot of the period after the 1987 crash. In both cases we had extreme worry/fear on Wall Street, but good market valuation. I find a really good fear index is the performance of the financial sector stocks. If they are going down, wall streeters fear for their own jobs (rightly so) . As most people know, most of the decline in the S&P 500 is due to the financial sector. I doubt this will go away any time soon. It's not just a question of unknown losses from subprime and LBO paper. The big profit drivers for the street, debt packaging and M&A, are down for the count. I bet volumes will be a quarter of what they were (might even be zero for awhile). Gloomy stuff.

Now you might say "So what? That's just the street, not the real world." Well, the wall streeters are the salesmen for the market. If the salesmen are demoralized, it's unlikely that we will get much interest from the buyers. I know it sounds cynical, but we need people with a vested interest in a bull market talking it up and selling it.

OTOH, the market has real value. Click on the chart for the current state of the Fed Model. See previous posts for an explanation of what this is. We are certainly in the value portion of the spectrum. Another thing: the US dollar is finally beginning to fall against the Asian exporters. This will be highly beneficial for big cap multinat's, esp. GE, BA, and a lot of our commodity favorites.


The result of all this will probably be more of the same. I'm hoping that we get a real capitulation by the longs. This would probably happen if some of rumored losses among the big houses turn out to be real. In the meantime, just wait it out. I'm still hedged with S&P futures. I also wrote a few S&P calls (Sep) to play the enormous time decay right now.

I took off the cocoa position. The new crop looks quite good. I still like the market longer term, but it may have to wait another year.

Railroads

OK, I've been promising a post on US railroads for three weeks. Here it is.

The US is running out of transportation capacity. Most of you who live on the coasts already know about this in your daily lives, but it is occurring in freight as well. There's a lot of reasons why:
-Most importantly, the change in the automobile from a family vehicle to a personal one.
-Movement of the population from the heartland to the coasts
-Continued economic and population growth

"America runs by truck" as the slogan goes, but trucks are slowing down. According to the stats I could find, they have fallen by about 5% in the last few years. In the past this would have been rectified by building more roads. This is no longer possible: skyrocketing costs, eco-opposition, and the near end of eminent domain have closed this out. As far as freight expansion of the airlines - don't even ask.

Rail is the one mode that still has significant excess capacity. I know - you are going to tell me about the rail traffic jams of a few years ago. Those are history. The fact is that the US railroad business was very poorly run after the mergers of the 90s. Even on the long-haul western RRs, speeds were less than 25 mph. This has now changed. Speeds are up; dwell times are down. Remember, trackage is the limiting factor in US RR capacity. An increase from 25 to 35 is 40%.

This has gone along with a general improvement in RR management and Boards. I believe that this is the reason Buffet, Chris Hohn, Ican and such have gone in. The change is industry-wide - even pathetic losers like Amtrak are doing better. The most important result of this is that they are using their duopolies (two RRs in the east; two in the west) for shareholder return, not competition for growth.

Along with the improvements in mgnt. and capacity, commodity trends have favored RRs. Two of their biggest customers are agriculturals and coal. Both of these have had increases in volume, with more to come. The growth in ethanol has led to high revenue tank cars being substituted for hoppers. Intermodal (trailer piggybacks) will also rise with increasing road congestion.

But the biggest trend will be in an increase in RR margins because of operating leverage. Remember, this is a very high fixed cost industry. For example, BNI's operating margin (net) has gone from about 15% to 22% in the last few years. It's hard to disentangle operating margin from pricing power - to a certain extent they feed on each other since a duopoly can reduce unneeded capacity.

OK, what to buy? Realistically, you can probably buy the whole ector. I chose one western (BNI) and one eastern (CSX). A buy-side analyst I read and respect claims NSC as the cheapest, but I deferred. Of course the risk in BNI is that you wake up one morning and find Buffet has reduced his position. I judge this to be unlikely since the position is getting too large to exit. There is no RR ETF.

This position is unhedged. I expect to keep it for a very long time, and I don't want to bet that the stock market goes down over the next five years.