Alchemy

Because I am trying to be a bit cautious about what is going on with China and energy, I have limited myself from taking too many new positions. I only want to add stocks that are unconnected, or better yet positively correlated, to it.

My two main areas of addition the last few weeks have been gold stocks and a basket of chemical manufacturers.

Gold Stocks

While I have no idea what gold is going to do, I do know that when gold miner sentiment gets very bad, the miners tend to rally. Even if it turns out to be short-lived, it is good for a trade.

Meanwhile when I look at the gold miners, they appear to me to be one of the cheapest sectors of the market.

While I’ve taken positions in Torex Gold, Jaguar Mining, Superior Gold, Wesdome (again) and Fiore Gold, I want to take another name, Argonaut Gold, as our example.

I pick Argonaut because of their milk-toast factor. There is not a more bland miner out there. Argonaut has some very boring, very low grade assets in Mexico and they are now building a large, low grade, high capex mine that is having cost over-runs in Canada.

But here’s the thing. Even Argonaut has been able to generate loads of cash of late. About $100 million of free cash flow (ex-development of the new mine) over the last 12 months.

The stock trades at ~5.5x free cash flow (ex-mine development). The mine they are building (Magino) will increase production by about 50% and lower costs for the corporate whole by 2023.

Now I have not bought Argonaut. I am a little worried about cost over-runs at Magino. They need many of the same inputs that appear to me to be in short supply. Costs are already over their 15% buffer.

But it illustrates the value. If gold doesn’t collapse (which it might, I mean who really knows) these miners appear extremely cheap and unloved.

Chemicals Trade

This is a basket trade for now, until I have fully researched these names and have a better sense of the biggest beneficiary. I added back a name that I owned a few months ago – Chemtrade Logistics. I have also added Olin Corp and Westlake Chemical. I might add Methanex.

While we are inundated with commentary telling us the worst of supply chain issues are behind us, I am less sure that these forecasts will turn out to be correct across the board.

Take for instance this news that came out of China a few hours ago.

Steel production had been curtailed through September. Production was supposed to come back beginning in October. Now they are asking for at least some production to be cut through March. This strikes me as odd if you believe the energy crisis will be over in a month.

This is good news for steel producers. If I wasn’t already nervously long Stelco and Algoma I would consider buying some steel stocks right now.

Steel and aluminum seem likely beneficiaries of China electricity cuts. But there are also some chemicals that require a lot of electricity to make. For example, note the process to make chlorine:

There are three key ingredients to make elemental chlorine; salt, electricity and water. From these three ingredients, we get elemental chlorine (Cl2), caustic (often sodium hydroxide or NaOH) and hydrogen (H2). As these three products are highly reactive, technologies have been developed to keep them apart.

Electricity is central to the process. Not surprisingly, Chinese production of caustic soda is being curtailed.

Current tight supply conditions in Asia’s liquid caustic soda may continue in the near term, as recent curtailed output in China has had ripple effects across the wider regional market.

The article goes on to say that the curtailments will continue until December at least.

Due to China’s dual control policy as well as a shortage of national energy reserves, market participants expect curbs on output to remain in place as the country heads into the winter season in December.

And remember, it is not just China. Europe is having the same problems with energy. Caustic soda prices there are going up as well.

Producers had for the most part targeted double- to triple-digit increases for Q4 compared to Q3, reflecting tight availability in the European market combined with strong global demand for caustic soda. However, in the face of large energy cost increases in September caustic soda producers have independently raised their price targets for the quarter.

KEM ONE announced an increase of 200/dmt beginning from 1 October due to erosion of margins caused by high electricity costs, according to an email to customers on 23 September.

Other producers have raised their targets from between + 100-125/dmt at the beginning of discussions to + 140-170/dmt as of the second week of October, according to sources.

The following was from KeyBank last week:

If you take a look at producers like Westlake, they should reap a windfall – at least for a while.

Westlake’s trailing 12-month FCF is $1.44 billion. The stock has an EV of $14 billion here. So 10x FCF. But that FCF is heavily weighted to the most recent quarter. They did $653 million of FCF last quarter.

Annualized that would be $2.6 billion and we are at 5x FCF. And prices are still rising, so that FCF could look even better in Q4.

Of course, these are stocks to not overstay your welcome on. If you look at Westlake, over the last 5 years FCF has averaged about $800 million. So they trade at 17x FCF on that average. Which still isn’t crazy – especially in this market.

But much like the shipping stocks there will be a windfall and then supply will come back. And the stock prices will probably fall when that happens.

I’m just not sure when that will be. It could be soon – I mean this blog thinks Europe is in the catbird seat being short natgas right now. So what do I know? If this comes to pass I am going to have to scramble out of these positions sooner than later.

But just case everyone is wrong about everyone being wrong, they seem like a nice hedge on a more troublesome scenario playing out.