The Profitable Marriage of Two Soaring Resource Companies

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The huge run-up in commodity prices between January and mid-March has been a welcome boost for listed producers in the falling Aussie equities market. Oil, sugar, coal, gold, wheat… all these things have gained voraciously. Australian companies drilling, harvesting and mining them have weathered the storm of equity-selling better than other stocks.

Meanwhile, listed financials have gone from shaky to shaken.

That’s no coincidence. The fear surrounding banks sparked a stampede of financial capital. A lot of it has charged into the commodities sector. The tide of money flowing out of financials is gushing your way.

There are Always Good Resource Stocks…

But tangible assets…and resource companies…are a truly diverse bunch. They come in a variety of shapes, sizes, weights and uses. That diversity ensures there will always be something making gains. Commodity buyers always want more of something than there is available. That’s the beauty of resource investing. You have access to a constant stream of good investment ideas. It’s like a whole separate investment universe.

Unconvinced?

Well, the market was flat for all of February. But Alumina (ASX:AWC) was up 23% because Chinese aluminium demand sprouted wings. In the first half of March, the market was down 4.5%. But iron ore junior Midwest (ASX:MIS) had an explosive 20% gain thanks to a takeover offer.

Tangible assets are in a long-term bull market. Even when the whole share market is floundering… somebody, somewhere is making money in the resource sector. But in their haste for obvious profits, speculators can miss good opportunities.

There are two specific opportunities in particular we’re looking at. These come from two sectors of the Australian resource market that speculators haven’t blown up. Separately, they’re great companies. But together they combine two of the most profitable aspects of the resource boom, with synergies to boot.

We don’t expect this opportunity to stay at the price it is today, though. Money moves towards quality, and this pick is of a high standard. With that in mind, let’s quickly recap the exodus from financials to resources.

Funds Look for Inflation Safety in Commodities

Apart from the fact that resource stocks are in a historic bull-market, a lot of this buying motivation comes from inflation. Commodities tend to outperform other asset classes in an inflationary environment. Speculators are using the resource market as a shield against rising prices.

This is evident in Exchange Traded Funds (ETFs), which track the prices of the commodities they hold.

The Goldman Sachs Oil ETF has added around 22% since last year’s calendar came off the wall. The PowerShares DB Agricultural Fund is up 18%. StreetTRACKS gold ETF (NYSE:GLD) is up 16%.

Here’s an interesting one… the Powershares DB Base Metal Fund (AMEX:DBB). It’s up 13% over the last three months, despite most metals taking a breather.

These high commodity prices are pulling headline companies up with them. Global miner Xstrata (LON:XTA), for example, is up 7% for the year in London, despite the London market being down 13%.

Speculators have definitely moved into the hard asset market. But now that they’re here… what will they do next?

The Factors of Speculation

Different speculators hold different positions on the market’s direction. You could easily identify dozens of difference factors, all of which have the potential to drive the price of oil, wheat, or copper up and down. That leads to a lot of uncertainty, and a lot of people buying and selling.

But there are a few factors that matter more than the others. Here’s a short list of what the speculators are looking at, and what they mean for commodities in general.

  1. Profit-taking from commodity gains


This one is unavoidable. Given that commodities are in an uptrend, every now and then speculators will choose to realise their gains. It will mean tangible assets occasionally take a break from the main uptrend.

  1. Gloomy economic news from the US


A global recession would certainly cause demand for commodities to fall somewhat. It’s one reason traders have to sell commodities. We don’t agree that it will kill the boom. But there will be times when some commodity holders lose their nerve and sell.

  1. Investors’ continuing need for an inflation shield


Given that the Federal Reserve slashed both headline rates by 75 points less than two weeks ago, there’s still plenty of reason to think people will buy commodities to protect themselves from inflating prices. Low interest rates mean cheaper credit. An easy money supply always leads to inflation in the long term. And you can bet that central banks will continue to heave money at falling financial markets to slow the rot. That’s inflationary.

  1. Direction of the US dollar


The US dollar will probably head downwards in the long-term, but at the moment it could move either way. The dollar was so depressed before the Fed cut rates that it actually rebounded. This, we feel, is a temporary break against the norm. And when the dollar moves down, commodities quoted in dollars become more valuable nominally. Traders will buy commodities as a hedge against a falling dollar.

  1. All types of market participants are willing to bet on the long-term commodity trend


Not just traders and investors, but consumers of commodities – like Chinese steel mills – will be keen to jump into the market and pile on inventories while piling is cheap. When commodity prices fall, there will be dip-buyers keen to make a thrifty purchase.

Looking at that list, it’s not hard to see why the price of grain futures or an oil ETF could fluctuate. Traders and hedge funds have a lot to think about. Those factors won’t all take precedence at the same time, of course. This adds to commodity volatility.

Predicting exactly when each will be most prominent is impossible. Don’t bother trying. Instead, read on. There are two corners of the resource market that have excellent potential for gains… and speculators haven’t taken advantage of them yet.

Junior Explorers

Explorers have lagged the overall commodity trend this year. While commodity prices have charged ahead, followed by producers, fearful investors have been loathe to give small explorers the same attention. The Small-Cap index on the ASX is down 17% this year. Investors have scorned small caps. In the process they’ve dropped good mining companies.

That means, quite simply, that explorers are un- touched by speculation.

So what? You’d be right to interrupt us here. What does it matter if they’re pure and untainted? Who cares? Being pure and untainted doesn’t necessarily mean juniors will go up in share price.

Well… for one, it does leave them open to the upside of speculative buying, without the downside of speculative selling. They haven’t been a target for hedge funds yet… but they easily could be, if inflation causes another mass rush into resources.

More importantly… their general prospects are good today because of consolidation. Bigger players in the resource industry have a lot of reasons to acquire explorers. As costs rise and new mines become harder to find and develop, bigger players will look more and more to junior explorers with existing tenements.

Midwest, as we mentioned earlier, is up 20% this year thanks to Chinese interest. We’re still mad keen on iron juniors.

There will come a time when these little miners are all the rage. That may be sooner than you expect; coal small cap White Energy (ASX:WEC) got a 28% boost from a mystery buyer just this week. The tide may be turning.

For now, junior miners are cheap and largely speculation-free. And some of them will be targets for acquisitions, giving their share prices good premiums.

Mining Services

There are two reasons why we like mining services this month. Neither reason requires much explanation.

Firstly, pick-and-shovel sellers are still making money. It’s a profitable industry. But their share prices have fallen this year. Three Diggers and Drillers picks operate in the services industry. They’re all down for the year, making them even better opportunities. It’s a good indication hedge funds haven’t heaped speculation on mining services yet.

Secondly… we mentioned that the commodities themselves have been a major target for hedge funds.

Mining service providers don’t trade in any kind of commodity, so they’re not directly related to the volatility you’re seeing in prices. Any trader can buy up the price of copper because it’s widely traded on big exchanges. But have you ever seen a Diamond Drilling ETF?

That could be one of the reasons mining service providers haven’t taken off this year; they aren’t linked directly to commodities. But in the long term, we think they’re relatively cheap.

The one we most like recently made a new addition to its business that gives it more earnings power than ever before. That addition has quite a lot to do with a dusty, white substance with two useful properties… allow us to explain…

The Powder that Creates and Destroys

Ammonium nitrate is like a stick of dynamite floating in a bowl of vegetable soup. It’s explosive and nutritious at the same time. These two special qualities give the companies we’re looking at a big edge.

That’s ammonium nitrate in the picture below. At room temperature, this is how it often looks. Puffy and white… kind of like Rice Bubbles. But please don’t eat it.

Why?

Putting the BOOM in Mining Boom

Source: www.epsilonfert.com

It tends to make other substances explode violently. Especially flammable materials – oil, straw, or the paper.

For example… if you were to pour a bunch of ammonium nitrate onto The Herald Sun or The Australian you’d risk seriously destabilising the chemical structure of your daily news… syndicating it into nearby airspace at an initial velocity of 5.27 kilometres per second. That’s 15 times the speed of sound.

There’s no doubt about it. When this stuff detonates, you can’t miss it. It actually doesn’t even need to come into contact with the right material. Enough heat or pressure will do the trick. It’s been known to blow at heats of around 160ºC.

This immense explosive capacity makes ammonium nitrate immensely valuable, particularly in Australia. Miners use the vast majority of ammonium nitrate production here to blow up rocks.

Often the most valuable minerals are hundreds of metres underground. There are tonnes of dirt between you and the goods. You can sweat and strain to dig it all up… or you can make all that earth go away with one nice, clean, devastating explosion.

Then there’s the other use… fertiliser.

Fertilisers can be either organic or chemical. Ammonium nitrate is the latter. Fertiliser-grade ammonium nitrate typically has less nitrogen than explosivegrade, because the nitrogen is what makes it such a potent destructive force. For safety reasons, fertiliser makers use a diluted version.

But nitrogen is also what makes ammonium nitrate so nourishing for plant life. Plants need nitrogen to help them capture energy from the sun. Crops absorb the element from ammonium nitrate as soon as the two make physical contact. Then they can grow and flourish.

Ammonium nitrate has properties that both create and destroy. Right now, that versatility is giving you the chance to snare two overlooked Aussie mining bull markets in the one stock: agriculture services and mining services.

A Marriage of Ammonia… and Earnings

The two firms we’re looking at have a common input in ammonium nitrate. This, obviously, is what brought them together. They stand to gain cost advantages in sharing ammonium nitrate production. Spreading fixed costs over a larger production base will dilute expenses for the combined company. That leaves more profit for you, if you buy shares now.

But each stands to gain a lot more than that. They’re both good businesses with excellent prospects ahead. Diversifying operations will reduce risk for each player.

Together, the group will have revenues of around AU$3.5 billion, making it one of the 30 largest companies in Australia. With these renewed resources, international expansion beckons. Incitec will have the opportunity to create operations in the booming South American agricultural market.

But on top of that… neither of the two companies have much to do with volatile commodity prices. Fertiliser futures aren’t traded for profit in New York, or anywhere else. There’s no such thing as an “Explosion” ETF. Speculators haven’t made this stock a risky proposition.

Al Robinson
for The Daily Reckoning Australia

[Editor’s Note: Unfortunately we can’t reveal the name of the company Al is following here, it wouldn’t be fair to Diggers and Drillers subscribers. But you can find out what this company is instantly by simply taking out a trial subscription to Diggers and Drillers. We’ll send you the latest issue via e-mail instantly.]

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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