Expectations For Bulk Commodities Falling

This story features MOUNT GIBSON IRON LIMITED, and other companies. For more info SHARE ANALYSIS: MGX

The company is included in ALL-ORDS

By Chris Shaw

The past few weeks have been a time of turmoil for the bulk commodity markets as GSJB Were notes changes to financial conditions have caused some buyers to simply stop buying as they run down stockpiles or can’t get letters of credit with which to make any purchases.

As a result spot markets for both coal and iron ore have dried up, which in some cases has even forced companies, and here Mount Gibson ((MGX)) is a good example, to look for alternative buyers at what are low prices compared to previous sales as those previous buyers have defaulted on contracts.

This has caused the broker to reassess what the outlook is for both the coal and iron ore markets, especially in terms of where prices may average next year and what this may mean to company earnings and the outlook for companies involved in the respective sectors.

In respect of the first question as to where prices may settle the broker suggests for iron ore it is more likely prices fall by around 30% than by 50% or more, although its current estimates factor in a 15% price decline next year. This is based on the view Chinese and Indian steel production doesn’t fall to the point where spot Indian and Chinese ore is not required.

For coal the broker is currently factoring in price falls in the order of 13% for hard coking coal, 20% for thermal coal, 18% for low-value PCI and 33% for semi-soft coking coal. GSJBW cautions risk remains to the downside with respect to these estimates given the potential for demand to fall further as the global economy slows.

These estimates imply prices of US$240 per tonne on semi-soft coking coal and US$125 per tonne for thermal coal, which remain more aggressive than UBS’s estimates, which stand at US$180 per tonne and US$100 per tonne respectively after the broker adjusted its numbers in recent days. Merrill Lynch has base case numbers of US$160 per tonne and US$130 per tonne respectively, but has also run an analysis of the coal stocks it covers based on lower price estimates.

The good news to come from this is Merrill Lynch still sees value in some of the coal stocks even allowing for a more bearish analysis, as by factoring in prices at the 50th centile of the cost curve for two years and then reverting to its long-term forecasts, which means US$65 per tonne and US$50 per tonne respectively next year, the broker sees some stocks as still representing solid buying opportunities.

Using such estimates the broker estimates stocks such as Felix Resources ((FLX)), Gloucester Coal ((GCL)) and Macarthur Coal ((MCC)) are trading at between 0.6-0.8x net present value, while all are currently trading at below their historical average P/E (price to earnings) ratios.

Even at such prices the broker estimates Felix, Gloucester and Macarthur would be profitable, though of the three its preferred exposures are Felix and Gloucester. It rates both of these as Buys at current levels, Felix given the company offers some corporate appeal, a strong infrastructure position, upcoming expansion via the Moorlarben thermal coal project and a solid share register, with management owning 37% of the stock.

Gloucester also offers some upside from its low risk expansion plans, while there is also potential for the company to deliver significant resource upgrades that don’t appear fully priced in given the attractive price multiple at current share price levels.

In contrast the broker rates Macarthur as Neutral as it sees scope for some revenue restrictions given existing infrastructure constraints, meaning the stock should trade at a discount to its net present value of $16.30, particularly given there is now a reduced risk of corporate activity associated with the company.

While Merrill Lynch rates Centennial Coal ((CEY)) as an Underperform given it is a low margin thermal producer trading on higher multiples to its peers, GSJB Were has it as its preferred coal play, noting currently the company’s contracts are mostly domestic but as these roll off there is significant leverage to earnings if export contract prices over the longer-term settle above the broker’s estimates. Also attractive is the fact there is little project execution risk in GSJBW’s view.

While accepting there is a higher level of risk associated with Macarthur Coal, GSJB Were also has this stock as a Buy, reasoning Macarthur could sell its PCI coal as thermal coal if required as PCI appears to be less likely to be affected by reduced demand from steelmakers as these attempt to keep costs low.

As with Merrill Lynch, GSJB Were rates Felix as a Buy and for similar reasons, suggesting the Moorlarben project should see the company continue to attract interest from other companies as the project continues to be developed. The other coal plays the broker covers, Riversdale Mining ((RIV)) and Whitehaven Coal ((WHC)) are both rated Hold.

UBS has not only adjusted its coal price estimates but also its forecasts, lowering its earnings estimates and price targets across the sector to factor in the changes to its model. This has also resulted in the broker introducing short-term Sell ratings on Gloucester, Macarthur and Whitehaven, while continuing to rate the stocks as long-term Buys.

The reason is that UBS continues to see potential for steel production to be cut, which in turn would have a negative impact on both earnings and sentiment across the coal sector. At the same time the broker has downgraded both Centennial and Felix to Neutral from Buy for similar reasons. Coal & Allied ((CNA)) the broker already rated as Neutral.

With respect to iron ore, GSJB Were suggests volumes for Australian producers should remain fairly consistent, as it remains the lowest cost material available on the market. As a result, assuming conditions don’t deteriorate much further from here the broker suggests much of this news is currently priced into stocks in the sector, though there is no obvious catalyst to generate an improvement in the shorter-term.

While the situation Mount Gibson finds itself in is obviously disappointing and sees the broker retain its Hold rating on the stock it continues to be more positive on Fortescue Metals ((FMG)), noting the interest payments coming up next year are well covered by cash on hand. As well, while the downturn in the market could see the company scale back its expansion plans, some of this is priced into its estimates.

Of note, the company this morning announced a shut down to allow some work to be done to facilitate future expansion, which means production this year should be around 10% lower than previously expected. Major producer Rio Tinto ((RIO)) equally announced production cuts this morning.

Overall the FNArena database shows Fortescue is rated as Buy twice and Neutral twice, with an average price target of $5.47, while Mount Gibson scores two Buys, two Holds and an Avoid, with an average target of $1.29.

Among the coal plays Felix is rated as Buy twice and Hold three times with an average target of $13.53, down from $14.12 prior to these broker updates. Macarthur is rated as Buy four times and Hold three times with an average target of $8.87, down from $9.30.

The database shows Centennial Coal is rated as Buy six times and Neutral and Underperform once each with an average price target of $4.80, down from $4.91 last week. Gloucester Coal has four Buy ratings and an average target price of $9.42, down from $9.69, while Whitehaven is rated as Buy and Hold once each and only GSJB Were covers Riversdale Mining and rates it as a Hold.

Among the more heavily traded stocks, Fortescue is slightly stronger today and as at 2.00pm was up 4c at $2.64, while Mount Gibson was up 3.5c at 41.5c. Felix was up 9c at $11.42, Macarthur was 8c stronger at $6.21, Gloucester was 9c better at $4.69 and Centennial was 9c higher at $3.25.

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