To Trade the Resources Rent Tax or Not?

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Let’s leave off with the underlying economic debate about the resource rent tax and talk about the market. It’s getting shellacked. Our colleagues Kris Sayce and Alex Cowie are finding many of the positions they’ve recommend in their publications since the March lows are declining and hitting suggested trailing stop levels. These are designed to limit your capital losses in a market like this, where the proverbial merde is hitting the policy fan.

Whatever you think about the equity of the tax, its practical effect has been to drop a giant uncertainty bomb on Australian markets in the form of political risk. If you were an international hedge fund trader parking money in Aussie stocks as a currency/commodity/yield/emerging markets/China play, you were already probably getting a bit nervous with the sovereign melt down taking place in Europe.

Falling commodity prices – copper at seven week lows, oil down three dollars over night, and Comex gold off $14 at one point – would have spooked you that China’s pricking of its real estate bubble could take the wind out of resource-related trades. And let’s not forget stocks have had a great run since the March lows of last year.

In other words, foreign capital in the Aussie market would already have been nervous. But when the government unleashes a giant uncertainty bomb on you on a Sunday afternoon, about twelve hours before markets open, you don’t really need any more reason to head for the exits.

But for a nimble trader and an investor who uses stop losses, this could turn out okay.

That is, further falls in the market would drive you out of stocks if you observe trailing stops 15-25% below the high or entry price. Resource stocks are volatile enough. This kind of news produces big moves that can trigger stops quickly. But what happens if and when the foreign hot money departs?

We’d reckon that most Aussie institutions aren’t going anywhere because they can’t. They’re in the market for better or for worse, for richer or for poorer. That means that at some point, the selling will exhaust itself. What will remain is the uncertainty over which firms will benefit or suffer the most under a resource rent tax regime.

But – and we’re only thinking out loud here – what if the share market wipe-out (which is hitting the super savings of ordinary Australians) makes the resource rent tax politically toxic for the Rudd government? What if they kill the tax or postpone it so far out in time that it’s unlikely for years? Will the lingering uncertainty act as weight on Aussie stock prices? Or would the revision or suspension of the tax trigger a quick and sudden rebound in stock prices?

If it was the latter, you might actually be able to lower your average purchase price on Aussie resource stocks. Not that the introduction of capricious uncertainty is ever good for markets. But it IS the sort of thing that makes trading profits possible. And if you’re a trader, it IS the sort of you thing you might want to think about.

One man who thought about it weeks ago was our own Murray Dawes. Murray came to mind yesterday when we’re discussing the explanation for unleashing a so much uncertainty on the market by not telegraphing a major tax that would impact a major industry and millions of investors. Was it calculated interference by a government that feels entitled to take what it wants when it wants it or just your run of the mill incompetence and ignorance of how markets work?

Take your pick! But the only people we can think of who would deliberately make a market-changing announcement capable of wiping billions off share prices the next day, and do it at the last minute, are people who are already SHORT the major stocks most likely to be affected. And the only person we know who was ALREADY short one of the biggest resource stocks in Australia was Murray, who went short said stock on April 13th.

Of course Murray didn’t know anything about the resource rent tax. As far as we know, nobody but the Henry review people and the Feds knew. But this is the funny thing about technical analysis and a little fundamental understanding of credit markets: the charts tell you what they tell you. Murray is up 14% on that short with more, perhaps, on the way.

Earlier today he sent out the update below. We’ve replaced the ticker symbol details with an XXX but otherwise left the rest of commentary unchanged:

The market is in freefall this morning with the bail out of Greece just feeding the uncertainty in Europe. After shorting XXX on the 13th of April the stock has dropped 14% in a straight line. The news of a new super profit tax has really knee capped the big miners and has caused the uptrend of the past year to be breached which signals the potential for some significant downside.

We have already taken phase 1 profits at $42 and I think we should take phase 2 profits while the market is so weak. We will still have 1/3 of the position on to ride this downtrend if it continues, but with such a good win in such a short time frame I think it would be greedy to not cash in some chips now.

Technically XXX has broken the February low that I mentioned last week and I wouldn’t be surprised if we saw a false break of this level in the short term. Also the Point of control of a distribution from August to October last year is $37.85 which should provide some support to the price in the near term. Therefore I wouldn’t be surprised to see a bounce from here. Who knows, we may get the chance to re-enter a full short position in the stock if we see a bounce.

Later this week we’ll try and give you a video insight into what he was seeing two weeks ago that led him to the trade. But based on the spring in his step this morning, there’s at least one trader in our shop who sees these sorts of markets as tremendous opportunities to capture profits from uncertainty, whether it emanates from Athens or Canberra.

Your editor is less sanguine about trading these markets. We’re more interested in a long-term wealth building plan. That’s why we’ve taken over the helm of the Australian Wealth Gameplan. Regardless of what you think of the policies, its clear government is having a big effect on the economy and the stock market.

Our view is that your best offense/defence against an uncertain world is to gain a measure of financial independence. That doesn’t mean money has to become the only objective or most important thing in your life. But financial independence does give you some personal freedom too.

–Right now, to be fair, not losing money seems to be the primary objective in a market filled with major risks. If you can preserve your capital now, you can do something with it later, like buy stocks when they’re cheap again. But you can’t do it if you lose your money now.

All of this artificially induced uncertainty in the market comes at a bad time anyway. The S&P 500 fell 2.4% in New York overnight. It’s still up 5.2% for the year and 73% from its March lows. But the worry is again the debt. Rather than bombard you with numbers, check out the chart below, courtesy of the venerable New York Times:

It’s appropriate that this devilish image looks like both a pentagon, or, if you invert it, a pentagram. It shows you why Spain is suddenly the new Greece, but spicier. Spain’s debt is much larger than Greece’s debt, and the Spanish own almost one-third of Portugal’s debt, which has lately been under pressure from the ratings agencies.

It makes you wonder if prosperity is really prosperity when it’s purchased with borrowed money. It also makes you wonder if there’s enough money or confidence in the world for the European Union to guarantee the solvency of various member governments. Hmmn.

Finally, Wayne Swan has said, by way of defending the new resource rent tax that, “Our resources belong to all Australians and Australians do deserve a fair share.” Thus is revealed the face of the entitlement mentality at the highest levels of government and bureaucracy. And it was done unselfconsciously and proudly.

It’s a fair enough debate about who benefits the most from Aussie resources. But keep in mind that nobody has to open a mine at all. Businesses do it to make a profit. And without a profit you can’t have a tax.

If you believe that Australian resources are so valuable that miners will extract them no matter what the tax rates and the Chinese will buy them no matter what the price, then the best thing to do would be to just leave them all in the ground and let them grow even more valuable over time. If you leave scarcity enough time to do its work, you’ll have the most valuable unmined resources in the world in a few decades (give or take).

But as with many things in life, it all turns on how you define value. If it’s romance, a kiss is only a kiss if you share it. It economics, value is only determined when there’s an exchange between two parties. One demonstrates what he’s willing to pay for a good or service and another demonstrates what he’s willing to sell it for. The price indicates the value both parties place. But the value is only revealed when an exchange takes place.

In that context, Aussie resources are worthless unless private sector enterprise raises shareholder capital to find them, extract them economically, and sell them at a profit to interested parties. They may belong to everybody in Swan’s world, but they will profit no one if Australia becomes the most highly-taxed mining industry in the world. Fifty seven percent of zero is zero.

And if you’re a policy maker counting on the sheer abundance of resource wealth (coal, iron ore, mineral sands) to guarantee that someone is going to produce them so you can tax them, you may want to consider two other handy ideas from the real world markets and economics: comparative advantage and substitution.

Aussie resource customers like China can find substitute suppliers, which they are already doing in Africa. Aussie-listed enterprises can substitute Aussie projects with political uncertainty for foreign projects with political uncertainty, but a more transparent and lower tax burden. International investors can substitute Australia as a destination for capital and replace it with Indonesia, Brazil, or Guinea.

That is not to say Australia has suddenly become third-world soviet republic (if you can still use those terms these days). But it is to say that when you raise prices on a project – and introducing a resource rent tax changes the plans and economics and profitability of many mines – you cause people to seek substitutes and alternatives. When, for the purposes of looting big profits, you change the rules midstream, you also change the conditions that created those profits. If it had tried, the government could not have come up with a better way to sabotage its own prosperity.

There IS a good argument about whether Australia’s main comparative advantage in the global economy – low-value added resource extraction – can produce diversified national wealth. But that’s not the issue the government has tackled with its strategy (and it IS a huge issue that deserves a real public argument).

Instead, the government has revealed that it believes it’s entitled to change the rules on mining taxes because it knows better how to spend wealth even if it has no idea how to create it. Also implied is the moral superiority of government to the market. Also implied is that the people making policy think they are smarter and thus entitled to chose for the rest of us how to redistribute wealth created by the private sector.

But now we are drifting to a bigger debate. We’ll close with the simple idea that a normal return in the bond market – 5.7% according to the Henry Review – is normal because the government confiscates its revenue with the threat of imprisonment. Bond investors correctly surmise that all things being equal, governments will always be able to pay interest on their bonds because taxpayers don’t want to go to jail.

But is 5.7% a “normal” return for someone who undertakes to go into the bush and find an economic concentration of metals or minerals, raise the money to build a mine, build the mine, dig up the resource with expensive capital equipment and scarce human capital, and sell it before more producers come in and bring down the price?

For that kind of uncertainty with so many variables, wouldn’t you demand a higher rate of return in order to make it worth your while at all to take the risk? And if the reward for your risk taking was the theft of your profits, would you even bother to take the risk at all? We’re about to find out.

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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Comments

  1. Seriously though, are you joking about which miner Murray is talking about? Blind Freddy could figure out which one you are talking about. None of the others trade even near $40 (although RIO will in good time).

    Reply
  2. The building industry usually uses 20% – 25% profit on any major project. They too have very large capital inputs at the start of any project. Anybody worked out what the mining companies manage to shovel (pardon the pun) away from theirs?

    When a truck driver at a mine starts getting paid as little as a nurse or police officer, or concreter, or prison officer …….. then I will know the mines are starting to feel the pinch.

    Enjoyed the ride on the stock market today, don’t know who sold out this morning (wasn’t me, perhaps it was the WA premier). Even made money on the Rio shares i bought yesterday. Evidently the exodus from the market was more of an opportunist comment that an actual eventuality.

    smallcap
    May 5, 2010
    Reply
  3. I really don’t think that the word “think” applies to what Uncle Kevin does. He basically plays to the news bite and announces things. From the number of people who have left his department and the known temper tantrums, I think that he is micromanaging person who really does not take advice before he acts.

    The major problem with this new tax has been the surprise announcement but that is exactly what has been happening with other things that he has cancelled by a fax sent after the closing.

    I saw an article along the lines of some think that he lacks a “core of competence” and that is my belief

    Reply
  4. …why is it that when greeks behave “greek” they’re misbehavin’ while when germans behave “german” they…ain’t……germans seem more hardworking than greeks, maybe germans got nothing better to do…notice the whitehouse in washington?…looks kind of greek….the euro is a “one size fits all” cloth cut by bankers to suit an idealized generic european type…well, it’ll need to be of a greater elasticity to cover all of the eurozones expanded borderlines…afterall…variety has a price and often, only when it’s gone do we realize the cost…

    Reply
  5. Welcome to “Kevin’s Kingdom” ;-)

    Now when is the next election to be held?

    Reply

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