An emerging opportunity in the nickel sector?

At current price levels, industry experts believe up to 50% of all active nickel production in the world right now is loss-making.

In comparison with copper, iron ore and crude oil, nickel producers operate in an environment that is much more fragmented. The top four major producers supply less than 50%. This becomes a major negative when supply catches up with demand. 

Nobody offers voluntarily to go out of business so that others can continue to generate profits and cash flows, so the process of market rebalancing has to develop through brute force. During this process, marginal producers often stay in business for longer than anyone expects. This leads  to lower prices than anticipated and causes a great deal of shareholder pain.

On stock broker Bell Potter’s estimates, the global nickel market is only over-supplied by 6%. However, supply has been adding 10% per annum, outweighing sluggish demand outside China since 2010. To make matters worse, additional supply is coming on-line with new production scheduled to start up in New Caledonia, Finland, Canada, the Philippines, Brazil and several other places.

The rough ride for the sector is easily illustrated by the fall in the share price of Western Areas (ASX: WSA). Its core asset is the 100% owned Forrestania Nickel Project, 400 km east of Perth. Flying Fox and Spotted Quoll are its two operating mines, producing approx 25,000 tpa nickel in ore. Being a high quality, low cost producer it is often touted as the premier Australian nickel stock. However, its shares were trading above $7.00 in March 2012, but today are trading just above $2.00.

The story gets worse for lesser lights such as Independence Group (ASX: IGO) and Panoramic Resources (ASX: PAN). The former is a mineral exploration company that derives 57% of revenue from nickel and 41% from copper and zinc mining in Australia. Its share price has come down from $7.00 in March 2012 to the current level of $3.00. Over the same period, Panoramic Resources’ share price has plummeted from $2.30 to 24cents. It has a 100% focus on nickel with two operating mines, Savannah and Lanfranchi Projects, in Western Australia.

Bell Potter, are anticipating price increases for nickel beyond 2014. This is largely based upon widespread belief that the present situation is simply not sustainable.

Investors should thus prepare for production cuts, for potential supply to be postponed, for explorers moving into delay mode and for the large diversified resources giants to re-consider the importance and value of their assets. Bell Potter is a strong believer it is only a matter of time before BHP Billiton (ASX: BHP) announces the divestment of its Nickel West assets. Such a move would likely set off consolidation frenzy among junior nickel producers in WA.

Foolish takeaway

The prevailing negative tone above might suggest there are no opportunities for investors among nickel stocks. However, a low base and small changes in market dynamics can do wonders to a quality company’s bottom line, and to its share price, once the downturn is completed.

Western Areas is a quality stock and is at the lowest end of the cost curve. Additional support to the current share price would also be provided should the Australian dollar continue its recent slide. 

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Motley Fool contributor Mark Woodruff does not own shares in any of the companies mentioned in this article.

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