Material Matters: Exploration, Metals, Zinc, Steel And Contractors

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-Explorers becoming more picky
-Metals rally but demand needs to lift
-Zinc signals a supply shock
-Steel mills enjoying margin uptick
-Expectations for contractors more realistic
 

By Eva Brocklehurst

World Exploration Trends

A report from SNL Metals & Mining on world exploration trends suggests a 19% decline in budgets in 2015. The mining sector's aggregate market capitalisation is now at levels not seen since early 2009. Another statistic: the mining industry's estimated total budget for non-ferrous metals exploration in 2015 was US$9.2bn, less than half the record of US$21.2bn budgeted in 2012.

The report notes more junior players are moving out of the sector and seeking opportunities in non-mining industries, and it could be some time before those junior players still in the market derive any benefit from an eventual upturn.

Despite the junior troubles, the number of active projects with drilling activity is stable and significant results are well above the levels reported in 2008-09. The report also notes that over the last 15 years, budgets have moved away from grass roots work upon which new discoveries largely depend.

With risk aversion continuing to plague the sector, companies are intent on developing existing or well defined projects to ensure an adequate level of reserves to support production. The report envisages a 15% decline in exploration budgets in 2016.

Metals

To Ord Minnett, the rebound in metals prices in the face of flat or deteriorating fundamental conditions means the pricing is probably the result of short covering, the positive influence of a more stable US dollar, a rally in oil and a fresh round of Chinese monetary policy easing.

The broker believes the correlation between equity markets, oil and now metals is due to a global search for yield from riskier assets. While Chinese policy makers have exacerbated the loose monetary conditions, Ord Minnett believes the subsequent rallies in the price of metals are only justifiable if the new policies have the potential to lift demand.

In sum, the broker continues to expect cost deflation, a relative resilience in supply, particularly in copper, and weak demand growth globally. Ord Minnett remains bearish on the fundamentals but from a tactical trade perspective is moving towards a more neutral stance on base metals, given momentum and volatility.

If prices appreciate around 10% from current levels the broker would find value in re-establishing short positions. Unless the fundamentals turn more positive.

Zinc

Zinc is the best performer on price in the base metals complex, with Morgan Stanley observing it is now up 15% over the year to date. This is mainly a result of mine curtailments since the downstream market remains well supplied. The broker notes there has been a surge in China's metal imports in December-January which has been bullish for the metal.

China appears to being offsetting a lack of concentrates by lifting metal imports. Hence, the broker suspects zinc is the first to report a supply shock as, in response to a low price, the sell-off in preceding years has prompted mines to curtail supply and a shortage developed. This has happened despite weak demand.

Nevertheless, the broker believes the market is ignoring the downstream signals in the current rally, which reveal adequate, or rising, inventories and weak end-user demand. Around 50% of zinc is used in steel galvanising.

Steel

Macquarie observes some bullishness around steel demand. There has been a sharp turn-up in end-user orders, profitability and production expectations. The broker believes the evidence suggests the market is experiencing a recovery that goes beyond seasonality.

In February, five of the six sectors the broker tracks reported better steel orders, with automotive the only exception. Sure, orders from construction and infrastructure usually go up after January but for white goods and machinery this is not the case. As the latter industries are also large users of copper, Macquarie will be interested to find out if the strength of their steel orders spreads to copper in March.

Macquarie notes a dramatic improvement in steel mill profitability since November. The time lag suggests this is because most mills are enjoying cheap raw materials purchased previously, which means after inventories are exhausted the mills will find it hard to improve margins unless prices for steel are raised.

Contractors

Resource sector contractors appear to be stabilising. Ord Minnett notes margins may level off and a more disciplined approach to tendering follow the recent downturn. The market appears to be starting to re-rate the likes of NRW Holdings ((NWH)), WorleyParsons ((WOR)), Ausdrill ((ASL)), UGL ((UGL)) and Mineral Resources ((MIN)). The broker observes all theses stocks are up more than 50% over the past three weeks.

While FY16 earnings are still likely to be soft, contract wins announced in 2015 were ahead of 2014 by 25%, a strong leading indicator that signals revenue has found a base. Recent M&A is also likely to be a catalyst for re-rating, the broker contends. The market often buys ahead of the worst of the bad news and it may have reached that point.

Ord Minnett cautions against owning stocks identified with low quality results, as the chances of a negative earnings surprise is much higher. The broker also emphasises that an earnings recovery is not occurring, rather the sector is being re-rated but forward expectations are now looking more realistic.

In the short term, Ord Minnett believes the safest way to play the market at present is via Service Stream ((SSM)), RCR Tomlinson ((RCR)) and Mineral Resources.
 

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