Dec '07/Jan '08

Outlook is hot for 2008

An interview with Donato Sferra of Pinetree Capital

By D. Sarik

Where mining, metals  and energy are concerned, 2007 has been a very good year. Many commodity prices had major runs, some achieving record highs. Investor interest in the sector remains intense and there is a flurry of speculation about what 2008 may hold. With significant shifts underway in the global marketplace and within local economies, many are wondering where things can go from here.

To help provide insight as to what may develop across the industry in 2008, CIM spoke with Donato Sferra, vice president, investments, at Pinetree Capital. Pinetree is an investment, financial advisory and merchant banking firm specializing in the small cap market, primarily in the resources sector.

2008 Outlook

CIM: At this point in time what is your overall outlook for the resources sector for 2008?

Sferra: Our call and view have not changed over the last five years, from a big picture perspective. We believe that 2008 is going to be more of the same as we saw in 2007, so it’s going to be the continued expansion of this commodity cycle.

CIM: At a macro level, what do you think the key economic factors affecting this cycle will be?

Sferra: There are a few trends that we believe will continue to support the commodity cycle: one being secular global growth. It’s being powered primarily by Asia and India and we don’t think that’s going to come to an end. Another factor is, on the supply side there has been a significant underinvestment by major mining companies over the last 10 to 15 years and that’s partly what fueled the rising commodity prices. So we have seen significant increases in demand but because of this underinvestment by mining companies, they haven’t been able to bring production of the commodity online fast enough to meet that demand.

CIM: As you mentioned, in 2007 there has been increasing demand from major emerging markets. How do you see this developing in 2008?

Sferra: The growth in Asia, and in particular China and India, is definitely going to continue unabated at very high rates. You have a major paradigm shift, for example in China, where you have an unprecedented number of people moving from an agrarian lifestyle into major industrial centres, and cities are growing exponentially. The migration of those people requires housing and everything that goes along with building a city. One example is, if you look at the U.S., they have about 20 billion tons of steel in their economy, and they have 300 million people. China only has a couple billion tons in its buildings and they have over one billion people. China needs to catch up and that demand won’t stop.

CIM: What role could softness in the U.S. economy play?

Sferra: The U.S. economy is not as important as it once was to the global demand of these commodities. The impact of a slowdown on commodities and base metals in general will be limited if global economic growth continues. We’ve looked at some numbers and one very simple example to prove that point is copper. Copper is the bell-weather metal for all other metals, and if you look at 1996, the U.S. comprised 21 per cent of copper demand and China was at about 10 per cent. As of last year, China was at 22 per cent, the U.S. was at 13 per cent, and other developing nations grouped in together doubled their demand over that period of time. So the U.S. is still important, over 10 per cent, but is becoming less important, and as long as growth in the U.S. does not slow down severely or for a prolonged period, it won’t have an impact in our opinion.

CIM: In terms of the five-year outlook that you spoke of, where do you think we are on the growth curve and when is it likely to peak?

Sferra: To see when the peak is going to come, I think you need to talk about the risks. You need to assess the seriousness of the risk and the mitigating factors. I think the three biggest risks are first, a severe and prolonged U.S. recession. To address this, the Fed has come out with a very strong statement — a 50 basis point cut. Also, Ben Bernanke, the Federal Reserve chairman, has commented that they are prepared to do what is necessary to avoid a recession. The second risk is an oil crisis. For example the end of the 1960s metals and commodity cycle that occurred in 1974 was caused by an oil crisis. With oil at the mid to high $80s level, we don’t think that’s a problem. The third risk is increasing interest rates in China. Growth there continues unabated even though the People’s Bank of China has raised rates five times this year and has raised the reserve ratio seven times. The question becomes, can inflation in China get out of hand? Currently, inflation in China is above the government’s target rate but if you exclude food items, it’s around one per cent. So the issue is can the Chinese increase food availability and production, and that’s a whole other cycle.

CIM: In 2007, there have been record highs with some commodities while others have fallen off slightly. What do you think will be hot in 2008?

Sferra: The ones we like are gold, copper, uranium and oil. The last two, which go together, are iron ore and coking coal: raw materials for steel.

CIM: With many commodities already highly priced, can investors look for continued growth in 2008?

Sferra: Our main view is to figure out which commodities are going to remain at elevated prices. As long as the price is elevated, and you have a discovery, it doesn’t matter what the price was last year.

CIM: So rather than focusing on rising prices, investors should consider that as long as prices remain elevated, these commodities can still be interesting in terms of investment potential?

Sferra: Exactly, and they provide investors with the opportunity to make above average returns if they are invested in the right company.

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