Material Matters: Oil Price Risk To Upside, RSPT Impact On Iron Ore

This story features FORTESCUE LIMITED, and other companies. For more info SHARE ANALYSIS: FMG

By Chris Shaw

The sovereign debt crisis in Europe has been viewed as a contributor to recent falls that have seen the oil price decline to around US$70 per barrel, as the crisis has raised concerns over global economic growth.

But in the view of Barclays Capital the problems in a number of European economies are not enough to justify the magnitude of the oil price decline, as the most afflicted euro area economies of Greece, Ireland, Portugal and Spain contribute only 2.6% of global oil demand. This is not enough to have a meaningful impact on global oil balances in the group's view.

This is especially the case given non-OECD countries are reporting some very strong growth in demand, Barclays pointing out this region accounts for a far more significant 47% of global demand.

The fact prices have failed to push substantially below US$70 per barrel is significant according to Barclays, as key producing countries have signalled this price level is the borderline below which, if sustained, there is no guarantee of capacity being maintained.

In other words, US$70 per barrel is a bare minimum sustainable price for oil, especially given the strength of oil demand growth elsewhere in the world. Barclays points out Europe was always going to be the weakest demand region in 2010 anyway based on previous growth expectations.

This leads Barclays to suggest US$70 per barrel for oil is an unsustainable equilibrium as it is too high if the world economy is under dire threat and too low if the global economy continues to perform strongly.

For Barclays this means oil price risk is skewed to the upside at present, so once the initial fears for the eurozone economy fade and the market again focuses on fundamentals prices should move higher.

What would also help is an end to the stockbuild in the US, and Commerzbank suggests there are now some signs this process is underway. The bank notes the latest American Petroleum Institute data showed a decline in crude stocks at Cushing last week for the first time in seven weeks, which may signal an increase in demand leading into the US driving season.

From a longer-term market perspective, Commerzbank notes the US Energy Administration has lowered its long-term forecasts for global oil demand by 2.5%, now expecting a rise to 103.9 million barrels per day up to 2030.

The Administration expects 84% of this growth is likely to come from emerging countries, which ties in with the Barclays view weaker demand from certain European countries is unlikely to impact on oil market balances going forward.

Turning to iron ore, Credit Suisse has conducted an analysis of the Australian players in the sector and concludes the proposed resources super tax is currently less than 20% priced into these stocks. The broker's numbers indicate an average negative 7.4% valuation impact from the tax, but it estimates the equity market is currently pricing in only an average negative impact of 1.3%.

This conclusion is based on attempting to isolate the RSPT impact within current global resource stock weakness which one would feel, given the current skittishness and volatility of markets, is attempting to apply an exact science to a sentimental, inexact market. Nevertheless, CS notes the average fall of a basket of global iron ore stocks not impacted by the RSPT has been 16.5% to date while the fall of a basket of those which are impacted has fallen 17.8%. So there's your 1.3% RSPT "factor".

One possible explanation for this supposed shortfall in valuation is the current uncertainty as to the exact form the tax could take, Credit Suisse noting there is no clear indication yet to where the actual taxing point will be in the iron ore sector. It may be the point at which an “arms length transaction” occurs, or it may be further upstream at the mine gate for example.

Another possible interpretation in the broker's view is assuming its valuation impact of negative 7.4% is correct, the market is pricing in about an 18% chance of the current resources super tax proposal being implemented.

What the tax could do in Citi's view is further tighten the iron ore market, as it estimates the tax could wipe out as much as one-third of the incremental value of new Pilbara projects in Australia. At the very least Citi suggests uncertainty over the implementation of the tax is likely to delay projects by around 12 months.

At present Citi expects the iron ore market will remain in deficit until 2012 before swinging to growing surpluses from 2013 on as supply growth picks up. But any delays of 12 months to new projects in Australia would dramatically reduce the surplus the broker expects in 2013-2014. This means steel production growth of just 5% annually in 2011-2014 would keep the iron ore market in deficit until at least 2014.

Citi expects the biggest winners from the uncertainty generated by the super tax proposal are the Brazilian iron ore producers and those in India and China who can benefit from higher prices but have no tax impact.

The most likely loser according to Citi would be Fortescue ((FMG)) as the company has no projects outside of Australia. The commodity and geographic diversity of BHP Billiton ((BHP)) and Rio Tinto ((RIO)) means any impact on these companies would be more modest.

Citi continues to rate BHP, Rio Tinto and Fortecue as Buys, while the FNArena database shows sentiment indicator readings on the three companies of 0.8, 0.9 and 0.5 respectively.

For Morgan Stanley, the correction in risky assets has gone on enough that the broker is seeing improved value, particularly among Australian mining stocks. This reflects not only the general fall in the market but the fact on its estimates the market is now more than pricing in the risk from any resources super tax (a view contrary to the Credit Suisse conclusion but echoed by others).

Morgan Stanley currently holds BHP Billiton, Alumina ((AWC)) and Oz Minerals ((OZL)) in its model portfolio and the broker has today added Equinox Minerals ((EQN)) to this portfolio. The attraction is twofold, as there is a strategic preference for copper exposure among base metals and the broker also notes the company is not subject to any earnings risk from the proposed tax.

The FNArena database shows Equinox is rated as Buy three times, Hold twice and Sell once.

Click to view our Glossary of Financial Terms