Dan is referring to the Australia’s decision to postpone for 90 days the takeover of iron ore miner Murchinson Metals LTD (MMX) by Chinese firm Sinosteel.

Australia’s natural resources are attracting considerable attention from Asia’s emerging economies. But this has set off some political alarm bells about handing control over the country’s best assets to a foreign government.

But, says Dan, junior mining companies need access to foreign capital. Without it, they’ll won’t produce iron ore anyway…

Foreign Investment in Australia, How Much is Too Much

By Dan Denning

What is the Australian Federal government’s position on Chinese investment in Australian resources?

Yesterday the Foreign Investment and Trade Board told Sinosteel to cool its heels for 90 days while the government figures out how much of Australia it will sell to foreign investors. Sinosteel, which, as you might guess, is a Chinese steel company, already owns 43.6% of iron ore junior Mid West (ASX:MIS) and was given permission earlier this year to buy all of the company.

Sinosteel also owns about 2.4% of Murchison Metals (ASX:MMX). Sinosteel applied to buy Murchison as well. It wasn’t rejected. But as you can see from the official looking note below from the Treasury, published yesterday in something called the Government Gazette, the government basically told Sinosteel to go away for 90 days while it figures out what to do.

You can’t have the benefits of foreign capital without giving up some ownership. The whole development of the Mid West region WA will depend on foreign capital and joint venture partnerships. Sinosteel is active there because all the good ore in the Pilbara has been locked up by BHP (NYSE: BHP), Rio Tinto (NYSE: RTP), and Fortescue (ASX: FMG).

If the Mid West is to emerge as an ore producer at all, it will need Chinese investment. The government probably knows this. But it’s nervous about how things will look to the public. After all, Sinosteel is owned by the Chinese government. You would have the most promising non-Pilbara ore project in the country owned lock, stock, and barrel by a foreign government.

So what’ll it be Wayne Swan? Matthew Stevens reports in today’s Australian that the government may set a 49.9% ownership ceiling on how much a foreign entity can own of an Aussie share. While mathematically pleasing because it suggests a foreign investor would not own a majority of shares in any Aussie company, in practical terms it’s not a large limitation on how much influence foreign investors would have on the locally-listed firm.

The concern is that if state-backed Chinese firms take a controlling interest in Australian mining companies, those companies will no longer be run for the benefit of shareholders, but will be used to deliver raw materials at low prices to industrial consumers in China. Is that a valid concern? If China Inc. really runs like a vertically integrated manufacturer, it probably is a valid concern.

But perhaps the Rudd government should ask Australian companies what they think. In our investigations at our small cap letter, and in Al Robinson’s research at Diggers & Drillers, we’ve talked to plenty of small mining executives who have made access to foreign investment part of their business plan. Many small Aussie miners will not get their projects off the ground without importing capital and even labour from abroad.

The government hasn’t done anything stupid yet. But give it time. It seems to be an unofficial law in human affairs that people find a way to deliberately sabotage their own success. Governments, being large institutions, are especially good at this. The U.S. government, standing unchallenged militarily at the beginning of the millennium, found precisely the way to get involved in two costly wars and simultaneously drive up the price of energy from historic lows.

Maybe nature abhors a surplus. Until recently, most human beings went through their whole life with very little margin for error. Prior to the twentieth century, most people worked growing food and scratched out a living as best they could. It wasn’t until labour-saving devices and cheap energy allowed people to move off the farm and into the city that real abundance became possible for ordinary people.

Now, 150 years into the world’s energy revolution, all that abundance and surplus is being challenged by massive demand growth in the developing world. More people want more calories, more leisure, and climate control. Australia looks like it’s in the position to ride this boom until something derails it…or until the country finds a way to shoot itself in the foot. We wonder which will come first.

But wait! Have we gone all soft in the head here at the Old Hat Factory? A reader quotes Sir John Tempelton over at our website, “Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria.” “You’re in there hard,” the reader says.

We have no idea what that means. But we think he means that we took a rather bullish tone in yesterday’s letter. He would be right about that.

There are still plenty of risks to the boom. Being too casual about them would be a mistake. Let’s say industrial production declines world wide as energy prices bite into globalisation. At some point, reduced industrial production leads to lower commodity prices and lower earnings for Aussie producers. Perhaps the revaluation of BHP and Rio from cyclical stocks to growth stocks gets undone if there’s a major global contraction.

We may also be overestimating the ability of Asian consumers to replace American consumers on the world stage. It’s clear it won’t be a seamless transition. But an increasing amount of Asian exports go within the Far East. Losing America as the big customer will hurt. But it will not be a deal breaker for the region’s development.

We are also trying to keep things exceedingly simple from an investment perspective. It was complexity and derivative value on financial instruments that undid so many people on Wall Street in the last ten years. By comparison, the resource industry is a breath of fresh air.

The value of projects is a function of costs and commodity prices. Companies can be held accountable for how well they execute strategies. Smart people don’t usually get involved in dumb mining projects. So following the smart people isn’t a bad start.

Are we overly euphoric? Nope. But there is a certain relief that comes when you have a clear investment strategy. Your strategy has to adapt to changing conditions. But the long-term conditions we see driving the resource boom (and the deflation of the global real estate bubble) are pretty favourable for Aussie investors.

Nothing is risk free. But Australia is on the right side of what we called “The Money Migration” a few years ago. It is the vast transfer of wealth, incomes, savings, capital, and standards of living from the West to the East. Maybe it’s overly simple as a metaphor. But for some reason-usually because it’s right in front of their face-people often miss the most obvious explanation for events.

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Source: Foreign Investment in Australia, How Much is Too Much

So, this morning, we write to you in a puddle of our own regret. We lacked foresight, and water-proof pants. We’ll try to exhibit a bit more of it as we map out where the money is today (foresight, not water-proof pants).

Foresight, of course, is a quality everybody wants and nobody has. Who couldn’t do with a little more of it? It’s one of those constants that you always need to constantly invest well…foresight, hard work, patience, a bit of luck here, some good timing there.

Meanwhile, the only news that matters in Australia today seems to be takeover-related…

Western Juniors Could Create 4th Biggest Iron Player in Australia

Here’s some foresight. Investors who jumped on the iron ore train are getting their dividends. Yesterday Murchison Metals (ASX:MMX) gave iron cousin Midwest (ASX:MIS) an all-share merger offer worth . The market loved it. Midwest leapt 12.3%. Murchison flew 8.3%.

Everybody won, except Sinosteel. The Chinese giant was closing the net around its prey, Midwest. The nerve of another prey to go and outdo it.

Together, the two iron diggers would have a market cap of AU$3.2 billion. That’s bigger than Portman (ASX:PMM), Mount Gibson (ASX:MGX) or the other second-tier contenders. It’d leapfrog the companies up to fourth place in the industry, behind Fortescue (ASX:FMG).

The structure of the deal, though, tells you a little more about the whole matter.

Sinosteel already has 19.9% of Midwest. That’s the maximum you can own without bidding.

In a direct response to the stake, Murchison has proposed a reverse-takeover. It has offered itself up as a sacrifice to the deity of iron ore. Under Australian corporations law, a reverse-takeover means the deal only needs 50% acceptance from Midwest shareholders to go through. Otherwise, a standard takeover would’ve meant a minimum of 75%.

Ergo…the two do not want to be bought. Not by China. Not at any price near what Sinosteel is offering. The Australian iron sector is combatting external consolidation with internal consolidation. Both mean share prices are going up. Here the five top juniors’ performance this year. They’ve made gains of between 21% and 65%.

Midwest’s management has recommended that shareholders accept the deal. You’ll find out in the next three months what they think of it.

You’ll also find out exactly how desperate China is to get its paws on our iron. The ball’s in your court, Sinosteel. The company will most likely withdraw, and reassess. Perhaps it’s content to pay huge spot and contract prices for iron in Asia. Or perhaps it’d like to own the next best producer after Fortescue.

St George Accepts Westpac Bid…Almost

A much bigger takeover is slowly plodding towards the finishing line. St George (ASX:SGB) signed a scheme of agreement with Westpac yesterday. It had prudence enough, though, to add some fine print to the contract. We’ll do a deal you, Westpac. As long as your shares stop dropping

So far, Westpac’s bid is 10% smaller than when it came into the world. The stock is at a year-low. If the fall that began last week in the All Ordinaries accelerates, Westpac’s shares may continue to erode. Maybe the finishing line is a little further away than we thought.

Two takeovers are evolving parallel to each other. There’s the iron story in the hard-asset market, and the banking story in the financial sector. Both are mergers, involving shares only. No cash. Analysts tell us that the prices are good. Yet the parties involved have reacted entirely differently.

Midwest said “Yes” and left it that. St George said “Maybe. Just don’t let your share price fall.”

Sadly, Westpac doesn’t have a lot of control over that. And those two reactions might reflect the underlying businesses, we reckon. Iron ore miners are willing to jump on the front foot. They’re merging to create more scale in a growing industry. Banks are on the back foot. They’re merging as a defense against falling earnings margins.

Westpac’s interest margin has fallen from 2.6% in 2003 to 2.25% last year. It won’t have improved since the last report, filed in November. Bankers aren’t making as much as they used to. That’s the bottom line. There are better companies to invest in.

Al Robinson
The Daily Reckoning Australia

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Source: The Fourth Biggest Iron Player in Australia

–The Fed is trying to soften the blow of falling asset prices by making it possible for homeowners to refinance into longer-term loans at lower rates, and then ride out the bear market in housing and credit. In other words, the Fed has kicked the dollar to the curb. It’s on its own now.

–That doesn’t mean the dollar won’t really from time to time. As a proxy for economic growth, there will be times in the coming years, let’s call them false dawns, where the U.S. economy appears to be emerging from the slump, or is at least growing faster than Europe’s sluggish economy. But the long-term trend for the dollar index is lower highs and lower lows. For gold and oil, it’s just the opposite, higher highs and higher lows.

–Speaking of highs and lows, our friend Dr. Joanne Nova at GoldNerds.com read our note yesterday about the challenges of deep-water drilling. But drilling deep is a challenge anywhere, even on land.

–”Here’s another perspective on the difficulty of drilling Brazil’s new oil field a full 10km below the surface,” Joanne writes. “Did you know the deepest hole ever dug reached down to 12km, but it took 19 years to get there? The Soviets started planning the Kola Superdeep Borehole in 1962 and began drilling in 1970 reaching the record depth in 1989.

–”They initially aimed to reach 15km, but were forced to give up a few years after they set the record. Things were too hot, too strange, and too expensive. And this was not a hole designed to produce anything except interesting scientific papers. Twelve kilometers down, the rocks were under so much heat and pressure they behaved more like plastic than rock. The hole apparently kept flowing closed whenever they had to replace a drill bit. Makes production hard if the hole keeps disappearing.”

–Yes it does.

–Incidentally, Australia’s deepest on-shore drilling effort doesn’t have anything to do with oil, gas, or mining. It is energy related though. Geothermal hopeful Geodynamics (ASX:GDY) finished drilling its Habanero 3 well in early February to a depth of 4,221 metres.

–Even if you don’t get all the way through the Earth’s crust at that depth, it’s still pretty hot down there, which is the whole point. Geodynamics hopes to be operating Australia’s first commercial geothermal electric generating plant by the end of this year, with a capacity of 50 megawatts per year.

–We know a bit about the project and the share because we tipped it in the Australian Small Cap Investigator. The credit crunch has not been kind to small-cap stocks in general or alternative energy stocks in particular. But if you look at these stocks in terms of their ability to generate future earnings, there is a lot to like. The assets should produce growing cash flows, and who doesn’t like that?

–We showed a chart a few weeks ago demonstrating that GDP growth and electricity are pretty well correlated. A growing economy needs its energy doesn’t it? Australia’s economy is growing and so are its energy needs.

–Perhaps that’s why Citigroup reckons Origin Energy (ASX:ORG) will grow its earnings by 16% a year for the next five years, according to Rebecca Keenan at Bloomberg. And perhaps that’s why Britain’s BG Group Plc. offered to buy Origin for $12.9 billion. That represented a 40% premium on yesterday’s closing share price of $10.47. Proving that markets can sometimes be pretty darn efficient, Origin is up 37% in early trading.

–As a trade, we might even consider shorting or buying puts. After all, Origin hasn’t accepted the bid yet. But our interest isn’t in trading these events, it’s in anticipating them. BG’s bid is based on asset quality and earnings growth. It’s a stock picking story, not a China narrative, although the two are related. Take iron ore.

–”Right now, I think this is the best stock picker’s market in resources that we’ve seen for quite some time,” says fund manager James Bruce in today’s Financial Review. He could not be more right.

–He was referring to today’s breaking news that China’s first-ever hostile takeover of an Australian company-Sinosteel’s $1.37 billion bid for Midwest (ASX:MIS)-looks like it will go through. Midwest is in a trading halt this morning, suggesting an announcement could be forthcoming.

–Sinosteel raised its bid for Midwest from $5.60 a share to $6.38 a share. This seemed to please the board of Midwest, which had been holding out for $7 a share. It probably doesn’t hurt that, as Michael Vaughan reports in today’s Financial Review, Sinosteel agreed to support the issue of 15 million options to two Midwest directors.

–The exercise price on the options is $1.46. With the bid at $6.38, that means those 15 million options are worth about $73.8 million. That’s a nice pay day, if you can get it. We’ve always said that owning your own business is the only real way to get wealthy.

–”China was busy last night,” writes Diggers and Drillers editor Al Robinson. “It closed the net around one little iron miner, and took stakes in a couple of others. It looks like Chinese steel mills are focusing on the leaders in the second tier of iron companies. By that, we mean the companies outside of BHP, Rio Tinto and Fortescue who have the best-developed assets.

–The “other” company which Sinosteel appears to have set its sights on is Murchison Metals (ASX:MMX). Al has more details over at Money Morning. The entire mid West region of Western Australia is ripe for this sort of Sino-Japanese financing and takeover. The ore in the region is a little lower quality than the famous hematite of the Pilbara. The infrastructure doesn’t exist yet, either, to move that ore from mine to port and on to points North.

–On that score, keep your eyes on May 9th . That’s the deadline for proposals to be submitted to the WA government for building out the iron ore infrastructure in the mid West. There are two major proposals, one backed by China and one essentially backed by Japan.

–In the meantime, if you want to catch up on who the junior producers are in the mid West, you may want to introduce yourself to the Geraldton Iron Ore Alliance. Don’t be shy. She’s friendly.

–There are seven firms in the alliance. Mount Gibson (ASX:MGX), MidWest (ASX:MIS), Gindalbie (ASX:GBG), Murchison (ASX:MMX), GoldenWest Resources (ASX:GWR), Royal Resources (ASX:ROY), Asia Iron Holdings (not listed), and Atlas Iron Limited (ASX:AGO).

–Who will win? This is where we reach the limits of the free security analysis we provide in the DR. The heavy lifting and deeper digging goes on at Diggers and Drillers. We will tell you that valuing the companies comes down to looking at the quality of their assets and their ability to finance projects without a lot of debt.

–Better hurry, though. “The Chinese invasion of corporate Australia is continuing apace with Chinese Iron and Steel Group announcing plans to lift its stake in outback prospector Apollo Minerals to 19.9pc, just short of the 20pc level that would require it to mount a full takeover under Australian law,” according to David Litterick in Britain’s Telegraph.

“Is China preying on BHP Billiton (ASX: BHP)? Or is BHP preying on Rio? Who are the barracudas and who are the minnows?” asks Dan Denning of the Daily Reckoning Australia.

Steel prices are up by about 10% this year already.

First, the big fish. “With iron ore prices rising explosively,” says China’s National Development Reform Commission (NDRC), “many domestic firms are very enthusiastic about investing in overseas mines, which needs strengthened macro guidance from the country.”

Macro guidance is about what you’d expect from a nation that has methodically and with stunning success, pulled itself from centrally planned poverty to centrally planned prosperity (at least for some). But what does ‘macro guidance’ mean? GPS? RFID?

–Today’s Australian has all the intriguing details on China’s Grand Strategy towards Australia in a story titled, “Beijing takes over BHP raid plans.” The comments from the NDRC are a fascinating take on how at least some Chinese officials think capitalism works. “Globally, iron ore mines that are of high quality and easy to exploit are basically in the hands of major multinational companies. Our firms need to pay a high cost to mine iron ore resources abroad. Their exploitation risks and costs are increasing.”

–Is it really ‘exploitation’ to pay the market price for natural resources? Or is that just the language of socialism? Perhaps a crash course on free market economics is in order for the NDRC.

–Not to sound too condescending (this coming from someone who uses the royal We), but you have to wonder if there is some wishful thinking going on in Beijing. Or maybe, after having lost money in Blackstone and Bear Stearns, state backed firms are wary of buying equity chunks in public companies. Maybe they want a different arrangement.

–Either way, it is clear the Chinese have woken up to the fact that the century is theirs for the taking. But there seems to be some confusion about what rules the century is going to operate under: will it be mostly free market rules…or other rules. The market price for the resources China wants is rising. So it would prefer to not pay the market price.

–By the way, we reckon free markets are headed for a bit of a bear market. Globalisation, in the bastard form we find it (where trade isn’t really free and currencies are manipulated regularly) has produced US$114 oil, massive inflation, the worst credit crisis since 1929, food riots, and a growing popular backlash. Expect more direct government intervention and regulation in financial markets and, perhaps, resource markets. That should play right into China’s hands, actually.

–This latest line of probing rhetoric coming from China is not exactly a new line of attack. After all, the resources are there for the taking on the public markets. There’s no need to attack at all. But it does feel like an attempt to flush out Australia’s politicians and get them more involved in China’s plans for Australian resources. The government is already involved, of course, with the Takeovers panel quashing the bid by Shougang Steel and APAC resources to take a 40% stake in iron ore up-and-comer Mt. Gibson (ASX:MGX).

–Let’s put this whole affair in the context of steel and GDP. We found the chart below yesterday while preparing for a radio interview with a Canadian business show. The host wanted to know how steel companies could afford to pay a 300% increase in coking coal prices and a 75% increase in iron ore prices. We asked him to picture the chart below.

Steel and GDP, Marching Hand in Hand

Source: Mining and commodities exports, Angelia Grant,
John Hawkins and Lachlan Shaw, 2006

–The chart shows that world steel production leapt ahead of GDP growth during the two big periods of Asian industrialisation of the last 50 years, in Japan and Korea. With China now industrialising, and coming off a much lower base in steel production, a period of growth in steel production that exceeded world GDP would be quite the spectacle. It would also mean China’s consumption of base metals is just now hitting high gear.

–From an Australian perspective, what’s so flabbergasting about the chart is that both Korea and Japan have been devoted customers of the black coal from the Bowen Basin that is so well suited for coking. They’ve also been tied up for years as customers of Rio Tinto and BHP for the iron ore that comes from the Pilbara. Now you add China to the queue.

–Despite its surge to the top in terms of global steel production, China’s individual steel firms are still smaller, at least according to the latest figures from the International Iron and Steel Institute, than Japan and Korea. Nippon Steel, Posco, and JFE are all bigger producers than Baosteel. Keep in mind, however, that as recently as 2002, China was a net steel importer. It’s now a net exporter.

Source: International Iron and Steel Institute

Meanwhile, listed financials have gone from shaky to shaken.

That’s no coincidence. The fear surrounding banks sparked a stampede of financial capital. A lot of it has charged into the commodities sector. The tide of money flowing out of financials is gushing your way.

There are Always Good Resource Stocks…

But tangible assets…and resource companies…are a truly diverse bunch. They come in a variety of shapes, sizes, weights and uses. That diversity ensures there will always be something making gains. Commodity buyers always want more of something than there is available. That’s the beauty of resource investing. You have access to a constant stream of good investment ideas. It’s like a whole separate investment universe.

Unconvinced?

Well, the market was flat for all of February. But Alumina (ASX:AWC) was up 23% because Chinese aluminium demand sprouted wings. In the first half of March, the market was down 4.5%. But iron ore junior Midwest (ASX:MIS) had an explosive 20% gain thanks to a takeover offer.

Tangible assets are in a long-term bull market. Even when the whole share market is floundering… somebody, somewhere is making money in the resource sector. But in their haste for obvious profits, speculators can miss good opportunities.

There are two specific opportunities in particular we’re looking at. These come from two sectors of the Australian resource market that speculators haven’t blown up. Separately, they’re great companies. But together they combine two of the most profitable aspects of the resource boom, with synergies to boot.

We don’t expect this opportunity to stay at the price it is today, though. Money moves towards quality, and this pick is of a high standard. With that in mind, let’s quickly recap the exodus from financials to resources.

Funds Look for Inflation Safety in Commodities

Apart from the fact that resource stocks are in a historic bull-market, a lot of this buying motivation comes from inflation. Commodities tend to outperform other asset classes in an inflationary environment. Speculators are using the resource market as a shield against rising prices.

This is evident in Exchange Traded Funds (ETFs), which track the prices of the commodities they hold.

The Goldman Sachs Oil ETF has added around 22% since last year’s calendar came off the wall. The PowerShares DB Agricultural Fund is up 18%. StreetTRACKS gold ETF (NYSE:GLD) is up 16%.

Here’s an interesting one… the Powershares DB Base Metal Fund (AMEX:DBB). It’s up 13% over the last three months, despite most metals taking a breather.

These high commodity prices are pulling headline companies up with them. Global miner Xstrata (LON:XTA), for example, is up 7% for the year in London, despite the London market being down 13%.

Speculators have definitely moved into the hard asset market. But now that they’re here… what will they do next?

The Factors of Speculation

Different speculators hold different positions on the market’s direction. You could easily identify dozens of difference factors, all of which have the potential to drive the price of oil, wheat, or copper up and down. That leads to a lot of uncertainty, and a lot of people buying and selling.

But there are a few factors that matter more than the others. Here’s a short list of what the speculators are looking at, and what they mean for commodities in general.

1. Profit-taking from commodity gains

This one is unavoidable. Given that commodities are in an uptrend, every now and then speculators will choose to realise their gains. It will mean tangible assets occasionally take a break from the main uptrend.

2. Gloomy economic news from the US

A global recession would certainly cause demand for commodities to fall somewhat. It’s one reason traders have to sell commodities. We don’t agree that it will kill the boom. But there will be times when some commodity holders lose their nerve and sell.

3. Investors’ continuing need for an inflation shield

Given that the Federal Reserve slashed both headline rates by 75 points less than two weeks ago, there’s still plenty of reason to think people will buy commodities to protect themselves from inflating prices. Low interest rates mean cheaper credit. An easy money supply always leads to inflation in the long term. And you can bet that central banks will continue to heave money at falling financial markets to slow the rot. That’s inflationary.

4. Direction of the US dollar

The US dollar will probably head downwards in the long-term, but at the moment it could move either way. The dollar was so depressed before the Fed cut rates that it actually rebounded. This, we feel, is a temporary break against the norm. And when the dollar moves down, commodities quoted in dollars become more valuable nominally. Traders will buy commodities as a hedge against a falling dollar.

5. All types of market participants are willing to bet on the long-term commodity trend

Not just traders and investors, but consumers of commodities – like Chinese steel mills – will be keen to jump into the market and pile on inventories while piling is cheap. When commodity prices fall, there will be dip-buyers keen to make a thrifty purchase.

Looking at that list, it’s not hard to see why the price of grain futures or an oil ETF could fluctuate. Traders and hedge funds have a lot to think about. Those factors won’t all take precedence at the same time, of course. This adds to commodity volatility.

Predicting exactly when each will be most prominent is impossible. Don’t bother trying. Instead, read on. There are two corners of the resource market that have excellent potential for gains… and speculators haven’t taken advantage of them yet.