Zinc and copper are in a similar situation, low commodity prices over the last few years have put off investments, limiting future supply growth, while demand kept slowly growing. Consequently, a big supply gap is expected to open sometime over the next decade. However, a likely recession or global economic slowdown, as we are in the late part of the short term cycle, would severely hit commodity markets and zinc miners.
The best investment approach one can take in such a situation is to go through each potential investment, make earnings models, estimate the miner’s strength and survival potential in a bad environment and find good management.
One of the sectors I understand pretty well is the zinc sector. Some of you may remember how I was pretty bullish on Nevsun Resources (NSU) in the past, which is a zinc related investment.
I’ve been very bullish on zinc when the price was lowerm two to three years ago. It has all the same characteristics as other base metals; cyclic supply and demand that is relatively easy to forecast with huge and fast market sentiment changes due to the short term investors’ orientation.
If there is no immediate boom potential in a mining sector, it usually gets shunned, the first sales create a self-reinforcing cycle that negatively reflects on all related equities. However, that can only go up to a point. Having first a helicopter view on the sector and consequently a bottom up view on the investment opportunities helps in finding value at the bottom, if there will be any, and taking advantage of the next positive sentiment boom, which always comes. In this article, I’ll share my zinc knowledge, systematize it, hopefully find some stocks to follow and take advantage of the low prices when the right time comes. A big warning before we start: you have to expect huge volatility with zinc miners and therefore possible trading with a margin of safety.
Zinc as a metal
The major application for zinc is corrosion-resistant zinc plating of iron (hot-dip galvanizing). Other applications are in electrical batteries, small non-structural castings, and alloys such as brass.
Investing in zinc – supply, demand and price
Zinc has a strong correlation with the global economy, especially economic development in China. More growth equals to more building, more requirement for steel and consequently for zinc. Further, if there will be increased demand for zinc batteries, demand for zinc might pent up even more. At the end, for investing purposes, it all boils down to:
Demand and supply
Other risks (jurisdiction)
Financing and debt
Management integrity and quality
Margin of safety and value
One can find irrationality in the above, so let’s see whether there is irrationality in the zinc sector.
Zinc prices tripled over the last two decades due to increased demand from China, like it has been the case for most commodities. Also, a high degree of volatility is common. Zinc reached a high of $1.6 last year while it reached a low of $0.61 a few years ago.
Past prices don’t mean that much, we have to see what are the minimum prices related to production costs, supply and demand. Current prices are still high, and relatively stable. However, prices of zinc mining stocks have plummeted.
The bad performance is because markets always project what is ahead. Both Dalio and Klarman have been warning us about a slowdown in 2019/2020. A global economic slowdown will inevitably hit zinc prices and consequently stock prices. However, investing in zinc is about seeing what is beyond 2020 and then correctly timing it. A margin of safety in the form of long term value is something that always helps.
Let’s first see about the short- and long-term outlook.
Short term outlook for zinc
A good way to check the fundamentals of a base metal is to look at the inventories with the London Metal Exchange. There is more zinc around the world within the so called ‘hidden inventories’, but the LME gives a good indication of the general trend and situation. Hidden inventories usually move in sync with LME warehouse levels.
It is very interesting how the cycle works; at the end of the previous cycle in 2007, inventories were very low, as those were in 2000. Low inventories, high prices, lead to heavy investments, that in combination with declining demand due to recessions, creates high levels of inventories that take a while to be consumed.
The above chart shows how we are again at the end of the zinc cycle.
The International Lead and Zinc Study Group (ILZSG) forecasts that zinc supply will grow 6.4% in 2019 while demand is expected to grow only 1%, but they still expect a deficit of 74,000 tons which is much less than the deficit of 322,000 tons in 2018. Mines ramping up in 2019 are Vedanta’s (VEDL) Gamsberg operation in South Africa, MMG’s Dugald River mine, New Century Resource’s Hellyer tailings project, with output to in rise in Cuba, Kazakhstan, Peru, South Africa, Turkey, and the United States.
ILZSG’s report tells me that if there is any kind of slowdown, supply might quickly exceed demand. This would lead to rising inventories and lower zinc prices.
As it was the case from 1999 to 2003 and 2008 to 2015. This means miners might be looking at a few bad years, if not more, depending on global economic growth. The key is to buy value at the point of maximum pessimism.
In general, I would say there is a big investing opportunity once every decade; 2016, 2007, 1994, and there are a few small opportunities two times a decade, 2014, 2011, 2009, 1997, 1991. Such volatility, long periods of low prices and oversupply, high correlation to the economy and all that goes along with a risky sector like mining is, puts off many investors. A contrarian attitude is key and the easiest way to have such a behavior is to have a margin of safety, preferably in the form of cash and cash flows.
The long term outlook
The long-term outlook is not a linear one, but definitely a growth one. The zinc market will grow alongside economic growth and might have a boost thanks to batteries and increased galvanization, that usually increases as economies develop.
Also, things might be different for zinc when the next recession comes. Due to low prices, that put off investments, there might be a structural deficit ahead. This means that even with a recession, demand might outstrip supply because there simply aren’t enough projects out there. Same story as with copper, where a structural deficit is expected to emerge in the next decade.
It also depends on what kind of a recession will we see next, one with India and China still growing or one with big issues there? For investing purposes, it is really important to time this well. For us investors, whether the supply gap open in 2020 or in 2023 makes a big difference.
Time to look at the details.
Cost curve, prices, expectations
When it comes to costs and prices, the marginal producer is usually the one that sets the price. As the price depends on the marginal producer, it results in high volatility if there is oversupply or high demand. However, 97% of miners are cash flow neutral or positive with zinc at $1 per pound. In 2016, with oversupply, prices quickly went to $0.6 where only 75% of producers have positive cash flows.
When you add the sustaining costs, still 85% of the population is profitable at zinc $1, that again means many can sustain production at lower prices. So, if we hit a downturn, one can really expect zinc prices to go below $0.8, but not much lower as I don’t believe such an equilibrium could last for longer.
Therefore, my calculation for a margin of safety zinc price is $0.8 per pound. The key is to find stocks that offer value even with such a low price. If you find something like that, whatever happens with the market, you will be fine. Also, one should always keep the debt in mind, something usually not included in the reported mining costs.
Another thing to keep in mind is that there aren’t many pure zinc miners, so there is another possibility to take advantage of irrationality, but you have to also analyze all the other operations a miner has, which is a lot of work. For example, Teck’s investor presentation deck has 178 slides.
Which one is a buy? Well, give me some time to go through the complete list, make earnings models, estimate intrinsic values through cycles, look at all other potential risks and see about the investing risk and reward. Then, we will see what stocks to cover and possibly invest when there is an opportunity to invest with a margin of safety. I am willing to even wait 10 years to do that but you never know given the market’s volatility.