RE:CM taking a closer look at local resources sector

With the current negative sentiments attached to the local mining sector. RE:CM - in line with its contrarian approach to investing - has started to take a closer look at certain local commodities stocks, after shying away from this sector for the most pa

Within the sector, RE:CM is paying particular attention to South African platinum stocks and currently holds Lonmin and Anglo American Platinum.

South African platinum industry returns over the past 15 years have been cyclical as the market moves between oversupplied and deficit positions.

Global demand for platinum has increased since the 1960s and 1970s, mainly because of its uses in the automotive, jewellery and industrial sectors. The autocatalyst market has grown substantially over the past 40 years. The majority of the demand for platinum still stems from the automotive sector (40%) followed by jewellery (30%) and other industrial uses (25%).

During the past five years, however, the demand for platinum slowed to a compound annual growth rate of 0.5% from a compound annual growth rate of 3.2%. The main cause is declining vehicle production in the developed world. However, emerging markets are slowly consuming more platinum and the demand for autocatalysts in these markets has grown. But emerging market demand is still relatively insignificant compared to the demand from markets such as Europe, the US and Japan. Demand for jewellery is very price sensitive as consumers substitute gold and platinum. China – and its powerful consumers – is a prominent role player in this segment and is expected to continue growing.

South Africa is a major platinum supplier and the reserve base is controlled by three major local platinum mining companies, with limited new entrants. Anglo Platinum has 50% market share and is the largest local producer, followed by Impala with 29% and Lonmin with 16%. These three companies are the only fully integrated platinum producers in Southern Africa. They control the entire process from mining, processing and refining, to sales and marketing.

The South African platinum mining industry’s output grew consistently until 2006, when supply was reduced because of safety stoppages, strikes and the steady decline of older shafts. This resulted in local platinum supply declining since 2006.

South Africa produces 80% of the world’s platinum (excluding recycling). South Africa’s market share of global platinum production has remained consistent since 1975 at between 70% and 80% (excluding recycling). The relative market share of the three largest producers has also remained stable over the last decade with over 90% share of South African production.

There doesn’t seem to be a sustainable cost advantage as market shares have remained so consistent over the past few decades. There will however be specific mines that generate better economic returns over time due to better ore bodies and leaner cost structures. It is debatable whether these advantages will remain due to different strategic mining plans undertaken by the three dominant players. Major mining companies have focused on increasing output, which is detrimental to better returns As an investor you would think that this oligopoly would focus on maximising economic profits. This is not necessarily the case. These large players have not actively reduced output to meet slowing demand – in fact, most have plans to increase output! As shareholders become more critical of returns, this situation may however change in the near future.

The three largest platinum producers are trading at their cheapest levels since 1997.The P/B value for the industry is currently at 2.2 times, compared to the long-term average of 4 times. This is almost one standard deviation below the 21-year average. If you invested in the sector during 1997 – the last time the P/B value was 2, your annualised return over the next five years would have been 38%. In 1997 the market was concerned about the emerging market meltdown and for this reason sentiment and demand forecasts became overly pessimistic. Currently the market has similar negative sentiment towards the developed world.

Currently the market is oversupplied, resulting in a lower platinum price and below normal profitability for the industry. The current oversupply of platinum should lead to industry consolidation, reduced production and higher prices. The periods of outperformance by Anglo Platinum are correlated to global platinum deficits in 1999, 2005 and again in 2007-2008.

At these current low prices platinum producers should not increase output due to payback periods of several years on new mines. This should result in constrained supply in the years to come and demand growth should slowly reduce the oversupplied position. We believe that platinum demand will recover to historic levels over the long run, as global auto sales will grow as emerging markets continue to grow and environmental restrictions are enhanced. There is currently very little incentive for new entrants to the platinum industry due to the extended payback periods, which is positive for the current producers. There hasn’t been closures or consolidation in the industry yet, and this may be the next step before the industry recovers. Time will tell.

We believe South African platinum producers provide a compelling investment opportunity at current valuations. The largest risks the industry faces is that platinum is substituted by other commodities and that autocatalysts are not used in vehicles. The current economic climate and mining issues such as the recent strikes have also resulted in negative market sentiment and reduced profitability. As often happens, bad news creates opportunities for the patient investor, and at current valuations we believe the South African platinum producers provide a compelling investment opportunity.