ZINC (Horsehead) Investment Thesis

Horsehead Holding Corp (ZINC) is a company that recently came to my attention. ZINC is a metal waste recycler with a turbulent recent past, and it appears to be one of the few zinc pure plays for an investor looking to bet on zinc prices.

Horsehead's 3 primary lines of business are:

1. Collecting EAF dust - it carts off EAF dust (a zinc-rich waste byproduct) from steel mini mlls for a fee. It claims to be the largest EAF dust recycler in the United States. Mini mills today can either sell their EAF dust waste to recyclers like Horsehead or pay landfills to bury it under the ground.
   
   
2. Recycling zinc bearing waste (primarily EAF dust) and converting it into commodity Zinc oxide and PW zinc metal, which it then sells at prices that track the market price of zinc. It claims to be the largest zinc-bearing waste recycler in the United States.
   
   
3. Recycling nickel bearing waste (including NiCd) batteries and converting it into Nickel based products for sale in the market. Nickel is a commodity and the prices Horsehead commands roughly track nickel prices.

The Zinc recycling business accounts for 75% of its revenue and appears to be management's primary focus. In its zinc recycling business, the company buys EAF dust (a waste byproduct of steel manufacturing in mills that use Electric Arc Furnaces aka "mini-mills") and zinc secondaries (other forms of waste that has zinc), and refines them into zinc which it then sells. The bulk of its feedstock is EAF dust, which is collected from Nucor and other "mini-mill" steel manufacturers, and processed as follows:


Conversion Stage 1: The company's Palmerton, Rockwood, and Calumet facilties primarily use Waelz Kiln technology (the technology has been known since the late 1800s, and has been in commercial use since the 1970s) preprocessing EAF dust to produce CZO (55-65% zinc content).

Conversion Stage 2: The CZO is then shipped to the Palmerton facility which uses natural gas to heat it to burn off impurities, leaving behind zinc calcine (65-70% zinc content). The zinc calcine granules are then shipped to the Monaca plant as feedstock and/or sold to other facilities around the world.

Conversion Stage 3: The Monaca plant then refines this feedstock into the finished products: zinc oxide and zinc metal. The Monaca plant can also take in other types of feedstock: (a) CZO (they have installed washing facilities to allow it to receive CZO directly and wash off chlorine impurities), or (b) zinc secondaries (other types of zinc containing waste). The plant also uses metallurgical coke, natural gas and electricity in its operations, and its electricity is solely provided by an onsite 110 megawatt coal-fired power plant that uses Power River Basin coal. The coal contracts appear to be renewed every 1-2 years. The Monaca electrothermic zinc smelter and refinery has a 175,000 ton per year smelting capacity (zinc containing equivalent?), and is able to produce:

- PW metal 88,000 tons per year

- Zinc Oxide 90,000 tons per year

- SSHG Metal 15,000 tons per year

- Zinc Dust 5,900 tons per year

The Monaca plant is scheduled to be replaced by a new refinery in Rutherford County, North Carolina in Q3 2013. The new plant is intended to lower the cost of production by approximately 35%, and to comply with new environmental regulations. (As opposed to its Monaca plant, which will require capital investments to become compliant).


The economics of the business
and its ecological niche in the business ecosystem

While it is tempting to say that Horsehead exists in a mutually beneficial symbiotry with steel mini-mills, this would not be entirely accurate. Why? Because the benefical relationship is one way, and not a "closed loop".

The mini-mills benefit by having lower EAF waste disposal costs, because they can pay Horsehead less than what they pay landfills to take their EAF dust. (in terms of total costs - for example that impute the potentially higher risk of breaching environmental regulations when using landfills). If competition comes in the future, it is entirely possible that Horsehead has to pay the mini-mills for their EAF dust.

However, the minimills do not depend on the zinc metal that Horsehead produces. While they do require zinc for processes such as galvanizing steel, they can and will source for zinc metal from the open market. In selling its zinc metal, Horsehead competes in an open commodity market, and is a price-taker.

The economics of the business are that it is a price taker in a commodity market, and to maintain its position, it needs to maintain a low or have the lowest cost of production. Its profit potential is largely dependent on exogenous factors, namely it is the spread between the cost of EAF dust and the market price of zinc, minus its commodity intensive cost of production. Changes in relative commodity prices could destroy its business model/ecological niche. For example, if the cost of zinc falls and the cost of energy used in recycling rises relative to the cost of energy used in mining, the business of recycling EAF dust could become untenable.




Competitive forces and competitive position

Horsehead's exists in a symbiotry of commensalism with mini-mills in the United States. It's competitive position in the ecosystem, and the existence of its ecological niche, is dependent on: (1) it being able to secure EAF dust from mini-mills by making it cheaper for the mills to send it to them as opposed to the landfills/other recyclers, (2) it being able to produce zinc at the low end of the zinc cost curve compared to mined zinc and other recycled zinc. In the latter, the factors of production in recycling and mining can be a key consideration - for example, if recycling technologies require far less energy than mining, then recycling can have a strong cost advantage in times of high energy prices.

Apart from these horizontal competitors, Horsehead also has to secure its place in the ecosystem from the threat of vertical integration. In other words, why don't the mills process the EAF dust themselves? A mini-mill looking to reduce its cost of operations may choose to run its own EAF dust recycling facility to make some money to offset steel production costs. There are a couple of reasons why they may find it  uneconomical to do so. For example:

• Horsehead may have a vastly superior proprietary recycling technology protected by patents or trade secrets, which competitors are unable to work around. This appears to be unlikely, since Horsehead has not said that they have a technological ace up their sleeve.
  
  
• There may be economies of scale in recycling, such that a central recycler can achieve much lower costs of production than an individual mini-mill. This is probable, given that nature of industrial processes and the fragmented nature of steel production (i.e. no dominant mini-mills with >40-50% market share that can achieve greater zinc recycling cost efficiency than any 3rd party zinc recycler like Horsehead)
  
  
• The ability to quickly start and stop production (a key advantage that mini-mills have over integrated blast-furnace steel mills) is incompatible with recycling processes. For example, recycling processes may require continuous operation or face costly shut-down / start-up procedures.

Nonethless, a mini-mill operator looking to increase its share of the value chain could decide to get into the EAF dust recycling, or use the threat of this to squeeze the profits out of Horsehead by charging Horsehead for its EAF dust.


Sustainability of the competitive position and the ecological niche (Parameters of an investment thesis)

Given the economics of the business, the key to Horsehead sustaining its earnings stream are likely to be:

1. The ability to preserve the ecological niche of recycling EAF dust into zinc. This requires that:
   
   (a) That steel manufacturing using EAF continues to be in vogue; only Electric Arc Furnace mini mills produce EAF dust, which is Horsehead's primary raw material / feedstock.
   
   (b) The "best" zinc recycling technology must allow for economies of scale, and steel manufacturing in the North American geography continues to be fragmented;  i.e. steel mills need to find it more cost effective to have their EAF dust recycled by Horsehead than doing it themselves.
   
   (c) That a new high-value use for raw EAF dust does not appear (for example, as a form of fertilizer for a genetically engineered vegetable able to extract nutrients from  EAF dust)
   
   
2. Having the lowest-cost position compared to other horizontal competitors (zinc miners+smelters and zinc recyclers):
   
   (a) Through the use of the best technology, and possibly denying others access to the best technology
   
   and/or
   
   (b) By having the structural factors in place to allow lowest cost operations, which others cannot match. For example, lowest cost factor inputs into the refining process (such as energy costs), factory sites next to, or structurally well linked to minimills (e.g. dedicated and hard to replicate rail lines).

Quantitative analysis - Current and projected future cost of production
(Does the company have a lowest-cost position?)

Given that the cost of production is such a key factor in sustaining Horsehead's earnings stream, let us have a look at Horsehead's numbers, to get a "back of envelope' feel for their costs of production relative to other zinc recyclers and miners. It's likely that we don't have the calculation correct down to the penny, but that shouldn't materially affect our analysis since we are trying to figure if they have an "order of magnitude" cost advantage over their competitors.

Revenue and Operating Cost	Zinc recycling and smelting	Nickel recycling and smelting	EAF Dust Removal
Revenue	$270.7m (Zinc metal: $171.2m; Zinc oxide: $96.6m)	$47.7m	$39.4m
Operating Cost-Total (Excl overheads, interest and depreciation)	$267.3m	$33.5m	$24.0m
Operating Cost-Feedstock costs - 19% of total operating cost	$50.8m (73% of raw material was EAF dust, which is "free"; 27% is zinc secondaries which is this cost)	-	-
Operating Cost-Conversion costs - 81% of total operating cost	$216.5m  (cost of coke, natural gas, electricity for other sites, and coal-generated electricity for Monaca, maintenance costs, labor costs, diesel fuel for freight etc)	-	-
No. of short tons produced / processed (i.e.  for which revenue was received) (2000 pounds = 1 short ton)	126,720 on a zinc contained basis (raw tonnage: 136,661)	raw tonnage: 27,000 tons	raw tonnage: 532,000 tons
Operating cost per produced / processed pound (C1 cash cost)	$1.05 per zinc contained pound	-	-
Operating Feedstock (zinc secondaries) cost	$0.20 per zinc contained pound	-	-
Operating Feedstock (EAF dust) cost	$0.00 per zinc contained pound("free" - mini mills pay to have it trucked away)	-	-
Operating Conversion cost	$0.85 per zinc contained pound	-	-

Horsehead is in the process of building a new (SX-EW solvent extraction electrowinning technology) zinc refining plant in Rutherford County, North Carolina to replace its Monaca PA facility. Let's assume that when this plant goes live in Q3 2013, it will be achieve the cost efficiencies that management is likely hoping for:

(1) Feedstock costs will be zero; either because they will be able to use EAF dust as the sole feedstock, or because they are able to recover lead and silver in the EAF dust to offset the cost of zinc secondaries).

(2) a 35% reduction in per-unit conversion costs, with possibly even lower per unit costs as volume goes up, since a portion of the conversion costs are fixed. Let's also be optimistic and say that this 35% per-unit cost reduction applies across both the pre-Rutherford plant production steps that feed into the Rutherford plan and the conversion at Rutherford/Monaca (today,  CZO and Zinc Calcine are produced and fed to the Monaca plant; in future it may be Waelz Oxide and Galvanizer skimmings that are fed into the Rutherford plant).

In this best case scenario, the C1 cost of production would then be $0.55 per zinc-equivalent pound on a factory exit gate FOB basis.


Comparison with Zinc production cost across the industry

The cost of zinc mining and production varies across the world. Zinc production costs are a combination of mining and smelting costs. The final cost of zinc production is complicated as it depends on many factors. This presentation from Nyrstar gives a good overview of the cost components. For example, mining costs vary depending on the byproducts and credits that a mine can get. Zinc ores are often extracted together with Lead bearing ore, so the cost of zinc mining could in some cases be considered negative if lead ore sales cover the costs of mining. Smelting costs also differ for the ores produced by each mine, because each mine's ores are in different forms and purity. The cost to transport ores to smelters and the cost of energy for the energy intensive smelting process are also variables. For example, an impure ore that has a low zinc content will cost more to transport on a zinc-contained basis. But if a cheap source of power is available nearby, a smelter can be built that will have lower smelting costs, which could negate the cost of transporting the low grade ore. Complicating the matter is the fact that energy costs are becoming increasingly globalized (for technological and structural reasons - there are fewer cases where proximity to a source of fuel confers an energy cost advantage).

Companies such as Brook Hunt research and publish reports on estimated mining and smelting cost curves. That information is available from these research firms as a paid service. Nonetheless, there are some publicly available data points that allow us to estimate Horsehead's cost position in relation to its competitors:

• One of the world lowest cost zinc mines is the Vendanta Resources operated Rampura Agucha mine in India. [Ref: Vedanta C1 mining costs ].  According to information provided by Vendanta, their 2010 C1 mining cash cost is $300 per ton (approx $0.15 per zinc contained pound), and the mining industry 50th percentile is $900 per ton, and the 75th percentile is $1,267 per ton.

• Xstrata provide the overall C1 operating cost for their zinc mines, covering both extraction (mining) and conversion (smelting) costs.  [Ref: Xstrata C1 zinc mining costs].  In 2010, they report an average cost of $0.31 per zinc contained pound, and they claim that they are among the lowest cost producers.

Back-of-envelope comparisons of this nature are imprecise, but the data does give us a sense that on a factory gate FOB basis, Horsehead is not one of the lowest cost producers of zinc. Having said that, Horsehead does have the benefit of being sited in the United States. The United States imports >70% of its zinc, so the cost of transportation is a cost that Horsehead's products do not have to incur. Let's see how much the transportation premium is.

• Based on recent data, the cost of ocean freight is approximately $0.02 per ton-mile, and the cost of rail freight is approximately $0.03 per ton mile. [ Ref: BTS study ]. The relative fuel-energy efficiency of the different modes of transport bears out this relative cost structure. [ Ref: Center for Climate and Energy Solutions ]
  
• Given that the earth's circumference is around 24,000 miles, and the breadth of the continental United States is around 2,000 miles, the furthest distance imported zinc would need to  travel is likely to be 12,000 ocean miles and 1,000 rail miles. This translates into an import transportation cost of $270 per ton, or very roughly $0.14 per refined zinc contained pound (assuming high purity zinc product) ].

Which suggests that for United States customers (such as the Nucor mini-mills), Horsehead's cost position is roughly the same as a foreign producer whose FOB cost at the smelter exit gate is $0.55 - $0.14 = $0.41 per zinc contained pound. This suggests that Horsehead's cost position is comparatively advantageous. However it is a qualitative assessment whether you feel this puts Horsehead among the lowest cost producers.


This comparison does have a margin of error. Here's a couple of ways the comparison may be off base:

• Zinc mining and production is an energy intensive one, so our cost comparison must be made against 2010 costs for the industry as a whole, so that we use the same energy cost basis.  (We must compare 2010 costs against 2010 cost curves, because energy prices change year by year.) That way our comparison will show the relative cost of production arising from the cost elements which are specific to each player (For example, comparing a 2010 cost of production with a 2007 cost of production would be misleading because the cost of carbon-based energy was different). What could trip up our comparison is if players like Xstrata have longer running energy supply contracts which expire in 2012, so their reported 2010 costs are actually based on energy prices from a few years back.
  
  
• In future, new mines may open up which change the cost curve; for example, a new mother lode of easy to extract high purity zinc ore may be found. The probability though is that all the low hanging fruit have already been picked, and that new mines will cost more than existing mines to operate.
  
  
• The reported C1 operating costs for mined zinc includes credits (and "profits" from recoveries of lead and other elements in the zinc ore). So we may not be looking at an apples-to-apples comparison. In reality, the cost of producing any metal (such as zinc) will vary on how much other metals are present in the ore which can also be sold. If the type of ore extracted at a mine changes over time (e.g. different strata of ore at different seams), then the cost of producing zinc at the mine will change over time.

Summary
Broadly we arrive at the following conclusions:

1. Horsehead is not the lowest cost recycler/producer of zinc, even though its cost position is advantageous. Our back of envelope cost numbers (even with the projected cost reduction) suggest that on a smelter exit gate FOB basis, the recycling process is more expensive than the 25th percentile of  most zinc mining (extraction + smelting) costs. The question is: will this continue to be the case in future? This is a qualitative assessment that you need to make, and you may want to consider factors like:
   
   (a) Fundamental shifts in mining cost curves: For example, are today's low cost mines going to be exhausted in the next few years and replaced by higher cost mines?
   
   (b) Sensitivity of mining (extraction) cost curves to energy prices. As another example, if mine-ore extraction costs are very energy intensive, then ZINC could have a cost advantage when energy prices go up because the price of EAF dust is likely to be less energy dependent. (It is effectively free to Horesehead today) (This presupposes that mine-ore smelting and recycling conversion processes are roughly equally energy intensive; if recycling conversion is more energy intensive than mine-ore smelting, then rising energy prices may raise Horsehead's costs of production more than it does for zinc mines)
   
   Betting on the transportation cost advantage relative to foreign producers is a bet that:
   
   (c) There will not be a low cost zinc mine appearing in the United States, otherwise that zinc source could be cheaper than Horsehead; and/or
   
   (d) Transportation costs are not going to experience a sustained drop. If transportation costs go up, then Horsehead's competitive position will improve considerably.
   
   
   
2. The viability of the ecological niche that Horsehead occupies (EAF dust recycling) depends on:
   
   (a) the future direction steel demand and steel manufacturing take in North America. This is another qualitative assessment that needs to be made; and/or
   
   (b) the propensity of mini-mills wanting to capture more the profits in the value chain. and deciding or threatening to vertically integrate
   
   
   
3. The company's future earnings stream largely depends on the price of zinc. This is one of the key variables that an investor needs to project. ZINC is a reasonably good investment vehicle if you have an opinion on the future price of zinc, as it is one of the few zinc pure-plays around. However, its moderate-cost position detracts from its investment merits somewhat, as does its relatively weak balance sheet. The company may not have the financial staying power to ride out a depression in zinc prices / rise in energy prices without shareholder dilutive capital raises.

Please leave a comment or drop me an email if you have any thoughts you'd like to share.

[ Update 11 Jan 2011: Thanks to an anonymous reader who informs that the Monaca power plant has been idled. Horsehead now buys its power for the Monaca plant from First Energy (FE). ]

[ Update 4 Feb 2012: For clarity, I have edited some of the cost comparison paragraphs. Thanks to Jacob Benedict for his feedback. ]

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References:
1 ton/short ton = 2,000 pounds
1 tonne/metric ton = 2,204 pounds

Overview of Zinc Smelting and cost and profit components of zinc smelting:
http://www.nyrstar.com/investors/en/Nyr_Documents/English/zincleadsmelting.pdf

Cost curves for Zinc Mining and Smelting in 2010:
http://www.latiza.com/archivos_publicar/presentacionesconferencia_2011/Zinc%20Market%20Outlook%20-%20Lima%208%20July%202011.pdf
http://www.nyrstar.com/investors/en/Nyr_Documents/English/2011-05-12ab.pdf

Combined cost curve (mining + smelting) c 2010:
http://files.shareholder.com/downloads/HBM/0x0x446391/255a8364-6605-4296-9612-973ad9b59140/Hudbay_BMOPresentation_Feb24_FINAL.pdf

Definition of C1, C2, C3 mining costs: (Cash operating cost, C1 + depreciation and amortization, C2 + interest and indirect costs) (Industry standard nomenclature)
http://www.gfms.co.uk/brochures/precious_metals_costs_service.pdf
http://vp134.alertir.com/afw/files/press/boliden/Kokkola-2008-3_Industry%20trends_LE2.pdf
http://moneyterms.co.uk/cash_cost_mining/
http://www.nortongoldfields.com.au/PDF/ASX20April11_%20Quarterly%20Report_March%202011.pdf

Mining industry survey
http://www.pwc.com/en_GX/gx/mining/pdf/mine-2011-game-has-changed.pdf

Other EAF dust recycling companies:
http://www.globalsteeldust.com/steel_dust_recycling
http://steeldust.com/

Waelz Kiln technology:
http://www.valo-res.com/pdf/WaelzKilnDescription-EN.pdf

Overview of the Global Steel Industry:
http://www.dbresearch.de/PROD/DBR_INTERNET_EN-PROD/PROD0000000000231889/Presentation%3A+Global+steel+market+-+the+present+and+the+future.pdf

Transportation: Average Freight Revenue per ton mile:
http://www.bts.gov/publications/national_transportation_statistics/html/table_03_21.html

Transportation: Energy efficiency (BTU) per ton mile:
http://www.c2es.org/technology/factsheet/FreightTransportation
http://en.wikipedia.org/wiki/Fuel_efficiency_in_transportation

Analyzing oil companies - The economics of the energy, commodity and materials business, and valuation traps

One school of thought is that investing in commodity-processing/resource-owning companies, such as oil majors like XOM, RDS, BP and CVX, and pulp and paper companies like Votorantim Celulose e Papel (NYSE ADR: VCP), is a good way to preserve wealth during periods of elevated inflation. The underlying hypothesis is that the price of commodities will rise in line with the general price level, allowing them to grow their profits in line with inflation.

However as with all investments, it is crucial not to overpay for a stream of earnings or you will end up with negative real returns. We'll look at one way of analyzing and valuing a commodity-processor/resource-owning company's earnings quality. We'll also see why in some cases we are better off buying commodities directly.

The economics of Commodity producing businesses

- they are price takers

Because their products are seen as commodities, customers have no particular reason to pay significantly more for a product from one company over another. In many cases, it is also relatively easy for customers to switch suppliers. This means that commodity sellers are price takers who cannot sell their product for more than the market-clearing price. The implication is that:

1. The strongest company is the one with the lowest cost of production and cash reserves. One of the worst things that can happen to a commodity company is if the market price for the commodity drops below its cost of production, making it lose money every day it stays in business. (While hedging can ameliorate this, it is only a short term solution) So well-funded companies with the lowest cost of production will have the most sustainable competitive position; if prices drop, the lowest cost company will be able to run with the lowest losses until all other competitors go broke and withdraw capacity from the market, allowing prices to rise to a profitable level.
   
   
2. They are vulnerable to price-irrational competitors. A competitor that decides to sell product below cost could drive the company out of business. This is a particular risk in "essential commodity industries, as governments may run loss-making state-owned competitors for political reasons. This is also a risk if the industry requires large amounts of fixed capital to operate, because ailing competitors may resort to flooding the market with product just to cover some part of their fixed costs (ie. manufacture as much as possible, as long as variable production costs are covered).

Durability of competitive position

- Factors affecting Earnings stream quality

Because they are price takers with an undifferentiated product, they have a durable earnings stream only when (a) the environment minimizes chances of prices falling below their operating costs, and (b) in the event that occurs, they are the best positioned to weather the down period until prices recover.

Industry reports and published financial statements can give you an indication of which companies are the most competitive, and have low production costs. The leading companies typically achieve their competitive position by (1) having economies of scale, (2) acquiring commodity reserves with lowest costs of production, and (3) applying operational efficiency and technology to minimize production and overhead costs. Unless there are disruptive events, it is likely that the leading companies will retain their competitive positions over the short term. However, the long-term durability of their earnings stream depends on 2 principal factors:

(1) The probability of price-irrational competitors emerging (such as government funded competitors). This depends on:

1. the geo-political environment: For commodities that are considered strategic assets, there is always the possibility that interventionist governments may setup state-funded not-for-profit competitiors. States with resource reserves are especially good candidates for this. The probability of this happening is balanced by the existance of trade barriers and trade agreements which can prevent dumping of commodities into foreign markets.
   
   
2. the cost structure of existing competitors. Competitors that are heavily in-debt and/or have high overheads may flood the market with product, just to cover some part of their fixed overhead costs/debt servicing. They can price product below true (fixed+variable) costs over the short run, just to meet cash flow needs.

(2) the probability that an upstart competitor can achieve lower costs of production. This depends on:

1. The components of the cost of production. For example, the bulk of the cost of steel production lies in the cost of energy needed to run furnaces. So a competitor could achieve lower costs of production if it managed to find a cheaper source of power, for example by erecting a new dam for cheap hydroelectric power. You would need to analyze the probability of this happening to estimate the earnings quality of a commodity company. Likewise a pulp and paper company's costs could predominatly be in forestry costs, so a competitor who could open up cheap forestry landbanks (because of climate change or changes in government rules) could gain a competitive edge.
   
   
2. Commodity re-cyclablity. Recyclable commodities like gold present the possiblity of a recycler finding a way (through technology, or finding an untapped source or cheap recycled gold) to produce re-cycled commodity at a lower price than extracting it out of the ground. For example in the gold market, it is conceivable that gold prices can fall below the cost of production of even the lowest cost miner, because there is a huge supply of gold which is already in the hands of consumers. Because gold is indestructible, there is always the possiblity that existing consumers may flood the market with their gold, and depress the market price of gold below it cost of extraction from the ground.
   
   
3. Probability of changes in the company's competitive sphere. The "competitive sphere" is the range of competitors who can serve the customers that the company is serving, and it varies according to the nature of the commodity. For example, a perishable commodity like fresh milk has a local competitive sphere (as long as customers aren't open to ESL milk or UHT milk which can be supplied from thousands of miles away e.g. by Fonterra in New Zealand). Competitive spheres can change with technology. For example, natural gas used to be a local product which could only be transported along a pipeline to nearby consumers. However, with technology advances and the build up of LNG processing facilities worldwide, natural gas can now be converted into LNG and shipped anywhere across the world, making its competitive sphere a global one. The lowest cost producer in a particular region might find itself displaced from the lowest cost position when compared with producers across the globe.
   
   
4. The Company's ability to keep acquiring lowest cost reserves. Resource owning companies constantly need to find new resource reserves to replenish reserves depleted by production. Otherwise the company will be operating in run-off mode, and will cease operations once its existing resource reserves are depleted. If the company is unable to find reserves with low extraction costs, or a competitor finds a motherlode of easy to extract reserves, then its future competitive position and earnings quality will deteriorate.
   

Valuing commodity/resource companies

- buying commodities, instead of resource companies, may be a lower risk way for investors to preserve wealth

To a long term owner looking at a company as an income producing asset, the valuation of any company is based on the present value of the expected stream of earnings which the owners can take out of the company. (We exclude earnings which need to be retained in the company, since they are needed to keep the goose alive to continue laying its golden eggs)

To arrive at a risk-weighted estimate for the future earnings stream, we need to combine all of the following:

1. the earnings that will flow from its current commodity reserves
   
   
2. the risks to those earnings, arising from changes to its competitive position (costs relative to its competitors) and the likelihood of non-economic competitors
   
   
3. the ability of the company to continue adding to its resource reserves without changing its costs of production relative to its competitors

In the short run the company's earnings will likely grow in line with inflation (assuming it also drives commodity price rises), because the company's costs of production (reserve extraction costs and reserve acquisition costs) are based on yesterday's prices while revenue is based on today's inflated commodity prices.

However over the long run, the ability of resource companies to grow earnings in line with inflation is not a sure thing. In fact, their earnings behavior over the long term is likely to be no different from the average of a basket of companies across industries. Why? Because (a) as inflation sets in, their cost of acquiring reserves and the costs of extraction will also likely go up, and (b) like all companies, they face competitive risks to their earnings. And as we have seen, as commodity producers they can face more earnings risks than non-commodity producers.

So if you are looking to preserve the value of your wealth during inflationary periods, you may be better off investing directly in commodities, if you hold the view that commodity prices will rise in line with inflation. (which is the same premise in the "invest in resource companies" hypothesis)

Valuation traps and mistakes

- particular to commodity/resource companies

One mistake is to value a company by extrapolating its future earning stream from its recent earnings history. Commodity prices tend to be cyclical in nature, because of the oscillating boom-bust feedback loop that develops; increasing production causes prices to drop, which causes production capacity to be withdrawn, which causes prices to go up, and so on. These cycles can span many years, so you need to look at the 10-year earnings history (or longer) to get a feel for the company's earning power.

For resource-owning companies, this approach also ignores the fact that the company's reserves are not infinite and will run out at some point. Management will continue acquiring new resource reserves to keep the company viable as a going concern, and the new reserves' cost of production will determine the company's earnings quality down the road. For example, an oil company with low-cost reserves may have a high quality earnings stream today. But if it cannot replenish its reserves with equally low cost resources, it will gradually slip into a weaker competitive position and become more vulnerable to losses in future. This should reduce the valuation placed on the company.

Another valuation mistake is to take the enterprise value of a commodity company as = the amount of commodity reserves they have, multipled by the prevailing commodity price. (i.e. valuing the company in run-off mode, where the company will cease operations once its existing reserves are depleted). The problem with this approach is that it assumes that it is possible to extract and sell the entire reserves all at once. In practice annual production capacity is limited, so if you want to value the company as a run-off company, you need to base your value calculation on the NPV of each year's production, until all reserves are depleted. (It is not uncommon for resource companies to have only 10-20 years of resource reserves if production rates are maintained.) You may be surprised that the NPV value expressed as a PE ratio can be in the low single digits.