The Global Commodities Outlook Continues To Improve

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Andrew Nelson

Global commodity markets have continued to perform far better than most would have dared to hope, starting to rise in the second quarter of last year on the back of Chinese stockpiling and then continuing the advance into the new calendar year on an increasing expectation of economic recovery, a declining US dollar, supply concerns and growing interest in commodities as an asset class and a hedge.

Yet so far the steady recovery has been without any real increases in physical demand. However, as recovery turns from hope to a shaky reality, analysts are starting to ratchet up their commodity price expectations. Most seem to be betting on a continuation of the improving investor sentiment toward commodities, with a recovering Western World and a firming Chinese economy expected to underpin commodity markets well into 2010.

In fact, notes Canadian investment bank BMO Capital Markets, improving demand expectations and the numerous labour issues that are popping up in producer countries have many beginning to anticipate tighter supply/demand conditions, which could lead to possible deficits as early as late 2010 to early 2011. Thus, BMO predicts that commodity markets will remain firm as long as the demand prospects keep improving, especially in the United States and China.

But prospects of demand and actual physical demand are two different kettles of fish, so BMO, while seemingly optimistic, still thinks prices wont run that aggressively over present levels in the nearer-term. This is a view that is echoed by analysts at Deutsche Bank in Australia, who yesterday made significant and sweeping increases to their commodity price forecasts pretty much across the board. While the team from Deutsche believes 2010 will see the return of real physical demand for commodities, the analysts still see the year as being one of ebb and flow for commodity prices.

Deutsche Bank thinks base metals will likely peak in the months ahead and then weaken in 2Q-3Q due to seasonally lower Chinese imports and an expected bottoming of Chinese GDP growth in mid 2010. This in turn will see the as yet to materialise physical demand recovery in the US and Europe take a breather in the medium-term. But by late 2010, the broker is expecting to see renewed demand from China, making 2011 a good year not just for base metals, but the commodities space as a whole.

Deutsche is most bullish on the bulks (iron ore, thermal coal, coking coal) and aluminium, upgrading price forecasts by 20%-40% across the space. The broker also remains positive on copper, nickel and gold.

Yet despite expected strong increases in bulk commodity prices in 2010, the broker thinks that both coal and iron ore stocks have priced in much of the upside. The team sees Rio Tinto ((RIO)) as being the best way to take an exposure to the bulks, particularly iron ore. Thus the broker prefers Rio over BHP Billiton ((BHP)). Deutsche also thinks that small names such as Avoca Resources ((AVO)) offer better leverage.

The broker’s iron ore and base metal upgrades see it earnings estimates for Rio increase by around 35% in 2010 and 2011, while its BHP numbers increase by about 25%. The biggest EPS increases the broker pushed out yesterday were for Macarthur Coal ((MCC)) and Centennial Coal ((CEY)), whose FY11-12 forecasts were lifted by 40-60%.

Looking at sectors on a Price to Earnings basis, the broker finds that the cheapest sector is still copper at 12x 2010 and 8x 2011. This is followed by Nickel at 13x 2010 and 8x 2011. Even after the upgrades, the large diversified miners are still looking affordable on the broker’s numbers, with Rio trading at 14x 2010 and 11x 2011, while BHP is currently trading at 13x FY11 on Deutsche’s numbers.

The broker also continues to like Alumina Ltd ((AWC)) given further increases to what it call its “contrarian” aluminium view. The broker’s aluminium price forecasts were increased by around 20% in 2010 and 2011 and this saw EPS increases of 20-50% and a 2011 PER that falls to sub 10x levels. This optimistic view is also shared by Canadian broker Salman Partners, who thinks that not only do the most recent numbers for aluminium look good, but claims the metal has made “a clear unequivocal turn”.

Yet while Deutsche believes its long-term bullish case for commodity prices is well founded, it fears the prospect of asset market volatility during 2010 could put the brakes on the commodities complex.

The team from BMO are right on board with this view, believing there could be a bit of a correction in the short run in some commodities such as copper, zinc and aluminium given the size of the recent rally in these metals and the rally’s non-fundamental (demand-less) nature. Rising inventories for some metals, moderating Chinese imports, the recent firmness of the US dollar and an end to work stoppage concerns could well be catalysts for a modest correction in the near term, reason the Canadians.

Looking later into 2010 and BMO thinks the aggressive monetary and fiscal stimulus programs put in place by China, the US and most other major economies will begin to have a very positive cumulative impact on consumption. Low inventories, plus consumer and government spending are also expected to re-ignite demand and lift manufacturing.

The team notes sharp declines earlier in the year in manufactured good inventories and stocks of steel and other raw materials held by manufacturers around the world mean that a considerable level of restocking should begin to occur as demand bounces higher. This view is fairly consistent with what is already occurring in China.

And it’s not just metals that will benefit, notes BMO, whose view on oil is also optimistic. The bank expects 2010 global oil demand will increase by more than one million barrels a day.

This, along with OPEC production discipline and the sharp drop in oil and gas development investment over the past year will likely turn prices meaningfully  higher in the year ahead. This is a view that is echoed by Australian analysts at JP Morgan, who today lifted their 2010 oil price forecasts by 14% to US$79/bbl and by 24% to US$87/bbl for 2011.

Click to view our Glossary of Financial Terms