Material Matters: Henry Downgrades And the Oil Price Distortion

This story features ENERGY RESOURCES OF AUSTRALIA LIMITED, and other companies. For more info SHARE ANALYSIS: ERA

By Chris Shaw

There continues to be a general dislocation in the global oil market according to Barclays Capital, as the logistics of the Cushing oil hub in the US Midwest has caused prices in that region to separate dramatically from values in the Gulf Coast and elsewhere.

Since the end of the first quarter Barclays notes the June WTI contract has fallen by US$10.17 per barrel, against a fall in June Brent of US$3.59. Over the same period the value of the OPEC basket has declined by just US27c, which shows just how the build-up in inventories at Cushing in the US has impacted on prices.

On the estimates of Barclays this has taken away at least US$9 per barrel from prompt West Texas Intermediate (WTI) values, this at the same time as sovereign debt and oil demand concerns have added to downward price pressure for oil.

But for Barclays this dislocation at the front end of the curve is not a major factor with respect to the overall outlook for oil prices, partly as a number of producers have moved to different benchmarks in setting their prices.

The bigger impact according to Barclays has been felt by those who use the oil futures market for risk management, as arbitraging the WTI market has become more difficult. Given this, Barclays would prefer to wait for signs Cushing inventory levels have turned before trying to position for the end of the current dislocation in prices.

Turning to the natural gas market, Barclays notes US domestic production has shown to have very little elasticity, as evidenced by months of low prices not resulting in drilling activity turning lower. But this should eventually change, Barclays expecting low prices to eventually flow though to a response from producers.

This may take some time however, as rig count is expected to move higher before it moves lower. As well, Barclays notes a lower rig count would not materially impact on production this year, as it would simply see a cutback in more marginal drilling.

Medium-term Barclays suggests gas production can't simply ignore the signal being sent by lower prices, so without a steep cut in drilling production should be enough to see 2010 result in a loose market balance.

With respect to the base metal market, where prices have generally struggled as the European sovereign debt crisis has grown, GSJB Were notes the latest data from China has not been so positive. An 18-month high in consumer inflation is leading to fears of fiscal tightening, which in turn would weigh on demand for industrial metals.

Barclays suggests China has actually become a weight on the aluminium and zinc markets. This reflects a rise in visible inventories in that market, as well as the combination of weak price spreads and a softening in import levels.

As an example, Barclays notes China finally appears to be taking steps to limit growth in the aluminium industry by reducing or removing power discounts, while also lifting capital ratios for primary aluminium projects.

Barlays expects these moves will help reign in supply growth, something needed to counter what is significant overcapacity. The result should be to limit the downside in prices in the group's view.

With respect to aluminium demand elsewhere, GSJB Were notes US year-to-date aluminium orders are running 10% above year-ago levels, an outcome in line with its estimate of 12% growth in US aluminium consumption in 2010.

In a more specific update on Australian resource stocks RBS Australia has factored the RSPT or resources super profit tax into its model, meaning changes to its earnings estimates and valuation through the sector. The analysts point out they are taking a conservative stance by factoring in the RSPT as is, noting that any watering down of the details before application or a rescinding of the tax policy if Labor loses the election only provide upside potential to the numbers.

Those hit worst from a valuation perspective are Energy Resources of Australia ((ERA)), Fortescue Metals ((FMG)) and Rio Tinto ((RIO)), their respective net present values falling by 26%, 24% and 15% if the RSPT is factored into RBS's model.

Despite this both Rio Tinto and Fortescue remain among RBS's highest conviction Buy ratings, along with BHP Billiton ((BHP)) and Equinox Minerals ((EQN)). RBS also rates ERA and OM Holdings ((OMH)) as Buys, while Atlas Iron ((AGO)), Iluka Resources ((ILU)), Mount Gibson Iron ((MGX)) and Newcrest ((NCM)) are rated as Holds. Newcrest has been downgraded from a Buy as a result of factoring in the RSPT.

Earnings estimates across the sector have been reduced, the changes being more significant from FY12 for Rio Tinto, with RBS's forecast being cut by 13% that year. From FY13 the cuts to forecasts are more broadly based.

Credit Suisse has conducted a similar assessment of the impact of the RSPT on the Australian iron ore sector, suggesting there are three main variables that will influence the level of impact the tax has on different companies.

The first is the capital cost base as at 30 June 2009, as this determines the accelerated depreciation profile. Next is the level of operating margins, as the higher the margin the more tax a company is required to pay. The final variable is mine life, as the longer the mine life the greater the hit to the net present value tail.

With respect to operating margins, Credit Suissse suggests Fortescue is hurt the most given a total production cost of around US$40 per tonne. In contrast, OneSteel ((OST)) is the highest cost producer and so has lower margins. For mine life Fortescue is again hard hit, followed by OneSteel, then Mount Gibson ((MGX)) and Atlas Iron.

Overall Credit Suisse suggests OneSteel is the least impacted by the tax given its level of non-mining assets. Among the pure iron ore miners the impact is greatest for Atlas according to the broker given its low capital cost base of $61 million and the estimated 13-22% discounted cash flow (DCF) downside.

Next is Fortescue, where the DCF impact is estimated to range from 1% to minus 26% depending on the volume and price scenarios incorporated into the model. Least affected will be Mount Gibson in Credit Suisse's view as it has a combination of a high book value, a short mine life and relatively low margins. Factoring this in suggests a DCF valuation impact of minus 1 to minus 12 percent.

Credit Suisse rates BlueScope and Fortescue as Outperform, has Neutral ratings on Atlas, Mount Gibson and OneSteel and an Underperform recommendation on Sims Metal Management ((SGM)).

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