Investing For Commodity Price Increases

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

By Greg Peel

A couple of weeks ago, BHP Billiton ((BHP)) settled a coking coal supply quarterly contract with a Japanese customer on a 55% increase from last year's annual contract price. From that point speculation heated up as to just what extent of an iron ore price rise the majors might also be able to achieve. Copper has also spiked back from its recent low under US$3.00/lb to be trading near US$3.40/lb once more.

The BHP quarterly contract was significant because it cemented a move away from traditional annual contract pricing between Australian commodity producers and Asian commodity consumers towards a more spot price-influenced system, at least to the point where contract prices last only one quarter. Assuming BHP achieves similar deals in iron ore with both Japan and, more importantly, China, analysts now suggest the next iron ore price rise could be anything from 60-80% above last year's Japanese full-year price.

Citi analysts offer, given iron ore expectations of an 80% price rise (or even more), coking coal at US$200/t, thermal coal at US$95/t and copper at US$3.40/lb, that “we have a very strong suite of commodity prices”. On that basis, resource sector investors could be forgiven for thinking 2010 will bring untold riches in the form of share price increases.

Not so, says Citi.

What one must appreciate is that these are price jumps being forced by strong Chinese demand which has inflated spot prices. In a sense, China has shot itself in the foot by buying so much iron ore, for example. But then it has been China's intention to restart the global economy (its manufactured goods customers) through government stimulus and if Australia's economy is any guide, the plan is working. Citi points out, however, that there are still no signs of commodity restocking coming from the slower recovering economies of the US and Europe.

Until the legacy economies get back on solid footing, there is not going to be any follow-through in demand growth. China's consumption remains strong but with Premier Wen pulling on the reins and targeting 8% GDP growth (down from about 10.5% currently) it is unlikely Chinese demand will further sky-rocket. So what we have is simply a price adjustment. While this is great news, the market is already discounting hefty price adjustments in current share prices, and analysts are adjusting earnings forecasts accordingly.

So unless, for example, iron ore prices are settled closer to 100% higher than the 60% increase most analysts are conservatively expecting, resource sector stocks have already priced in the good news. There is a possibility also that the price increases could now be spread across four quarters, in which case the hope will be for escalation.

Another external factor is the value of the US dollar. If Europe truly has overcome its sovereign debt woes then the greenback could potentially recommence its secular slide (based on its deficit problem). Any fall in the US dollar results in higher dollar-denominated commodity prices. But then (a) higher prices also cause demand destruction and (b) from Australia's point of view there is an offset from a subsequently rising Aussie dollar.

Citi analysts note that earnings momentum has been core to Australian resource share price momentum over the past five years. Citi does not see commodity prices rising much in 2010 after this big adjustment ahead and hence sees earnings growth “rapidly slowing” for a period. This is nothing to panic about, because the big price increases will bring about big jumps in earnings, but they will simply be distributed across the year rather than growing more and more in value.

In other words, when the pricing dust settles don't expect much more out of your BHPs etc in share price terms until more than just China is driving demand.

Choosing which resource sector stocks are the best place to be requires looking for where production volume growth can compensate for a lack of earnings growth, says Citi. To that end the analysts prefer BHP over Rio Tinto ((RIO)) and Whitehaven Coal ((WHC)) among the coal juniors. Outside the bulks, Citi likes Aquarius Platinum ((AQP)) for “precious exposure” and for long term uranium price upside, Paladin Energy ((PDN)).

Sticking with just the big global diversified miners, BA-Merrill Lynch actually prefers Brazil's Vale over all others given Vale has the purest exposure to iron ore when compared to the likes of either BHP or Rio, or Xstrata, Freeport, Anglo and company. But let's stick with Australia (and thus by default, Britain).

The Merrills analysts see the three “big issues” for global mining heavyweights as being organic growth, optionality (or “hidden value”) and cash generation.

Merrills sees BHP as being the closest thing in the global resource sector to a good old-fashioned buy-and-hold stock, or “core” investment. BHP's balance sheet is among the strongest in the sector. It's assets are large scale, long life, low cost and offer plenty of expansion opportunities. The company's petroleum division offers a natural hedge against rising energy costs. And its joint venture with Rio gives it iron ore price leverage. BHP also has “hundred year assets” in the form of Olympic Dam and its coking coal interests, “but how do you value that?” asks Merrills, rhetorically.

But this value is well understood by the global investment community. To that end, BHP is well priced and thus not necessarily the best investment (beyond core). Merrills has a Neutral rating on BHP.

Between the London-listed miners, Rio provides the most upside leverage to an iron ore price increase, notes Merrills, and the analysts suggest this price rise could be closer to 90% than the 50% they are currently assuming. So to that end Rio offers arguably the best trading opportunity in 2010 (Merrills rates Rio a Buy), outside of Vale.

So Citi says buy BHP over Rio and Merrills says Rio over BHP. It's really a trade-off of longer term value versus shorter term upside potential. But then a wise investor is always diversified.

What impact will these raw material price rises have on Australian steel production companies?

UBS has been doing some “stress-testing”. In its Base Case, UBS has assumed a 40% iron ore price increase (2010 annual), a coking coal price of US$200/t and hot rolled coil (HRC) Asian steel prices of US$571/t in FY10, US$677/t in FY11 and US$713/t in FY12.

In Scenario One, the analysts assume a 60% iron ore price increase and all else the same.

In Scenario Two, the analysts assume as above but with steel and scrap prices at current spot through FY12.

We must first note that a 60% iron ore price increase expectation is now at the low end of the range, that contracts may be settled on a quarterly basis and not an annual basis, and that BHP has already signed a quarterly coking coal deal with Japan at US$200/t but analysts expect subsequent quarters to see further rises.

But carrying on, UBS notes that while global steel producers will likely pas through raw material price increases into higher steel prices, the level of idle production capacity in the world at present means an inevitable return to competition that will diminish marginal returns.

UBS notes Bluescope's ((BSL)) iron ore price contracts are renegotiated each July, so the company will enjoy steel price increases at least in the remainder of FY10. In Scenario One, Bluescope's earnings forecasts will not then change by much given the offset from higher iron ore prices on higher steel prices.

Under Scenario Two BSL's earnings will fall into time given static steel prices not overcoming iron ore price increases.

Because OneSteel ((OST)) also produces iron ore as well as steel, the iron ore price increases in both cases will be a driver of increased earnings in FY11-12 with steel price increases balanced.

In other words, Australia's two large steel producers are distinguished by the fact Bluescope is a net consumer of iron ore while OneSteel is a net producer of iron ore. Bluescope can only win in an environment where steel price increases outpace iron ore price increases, and that doesn't look like happening.

But to confuse the issue, UBS currently has a Buy rating on both companies. The rating is realistic FY10 driven, given a standard six-month view only just takes us into the beginning of FY11.

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