Material Matters: Coal, Gold, Iron Ore and Aluminium

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

By Chris Shaw

The debt crisis in Europe and a growing view growth in China is set to slow have raised concerns over the global growth outlook, which Citi notes is weighing on aggregate commodity prices.

But Citi points out there is another issue for investors in resource companies in that the crisis is causing the US dollar to strengthen against the euro. As many commodities are priced in US dollar terms, a stronger greenback means earnings for resource companies are tougher to generate as end market prices impact on profitability.

This leads Citi to suggest it is currently unlikely resource stock prices can recover, at least until there is greater clarity on the direction of commodity prices and economic cycles. The broker has highly correlated valuation metrics and these support its view underperformance is likely in the Materials sector, with the Metals and Mining sub-industry group a particular concern on this basis.

While earnings estimates have been revised down among resources stocks, Citi suggests stock prices haven't fallen as much as could have been expected, which implies some further downside risk. This supports the broker's Underweight stance on the sector, as conditions still do not favour a “buy the dips” approach.

Turning to coal, JP Morgan expects a slowdown in the coal market in the second half of 2010, which implies some downside risk to prices in the shorter-term. Forecasts reflect this, with hard coking coal estimates standing at US$240 per tonne in the third quarter and US$220 per tonne in the fourth quarter.

Longer-term there is no change to JP Morgan's positive view, though as with commodity markets generally, China remains the key variable. There is a growing belief in the market in 2009 China was something of a forced buyer of commodities such as iron ore and coking coal, a trend that raised expectations for import prices.

JP Morgan suggests this belief is also behind the Australian Government's new proposed resources super profits tax.

The reality, in JP Morgan's view, is more that increased imports by China in 2009 were a strategic and opportunistic move, as since then the availability of domestic coal is now improving. This change has created some disappointment with respect to Chinese demand for coal imports.

On the positive side, JP Morgan takes the view China will continue to import coal, just not at any price. What should also prove supportive for coal prices, even if the Chinese economy slows, are supply side issues, one example being an accident at the Raspadskaya mine impacting on Russian exports. As well, Indonesia may consume more of its own coal, which would support thermal coal prices via reduced exports from that country.

JP Morgan's more cautious shorter-term view has not stopped BA Merrill Lynch from lifting its thermal coal price forecasts, reflecting the view the seaborne thermal coal market will remain relatively tight through the next few years.

Where BA Merrill Lynch agrees with JP Morgan is in the view supply issues will be supportive for prices in the medium-term, with rail issues impacting in both the South African and Australian markets. BA-ML also points to the Indonesian market as likely to support prices as while exports thermal coal from that country grew by 80% over the past five years, this growth is likely to decline to just 20% over the next five years.

Mongolia is expected to step in as a source of new coal supply, BA Merrill Lynch forecasting its exports could increase to 60 million tonnes by 2015. But even allowing for this, the broker sees China as continuing to import significant volumes of seaborne coal in coming years.

Add in the fact European coal imports are not expected to decline further and that India should remain a solid importer supports the view of a tight market for several years. To reflect this, BA Merrill Lynch has adjusted its thermal coal price forecasts higher, now expecting Japanese Financial Year averages of US$110 per tonne in JFY11 and US$100 per tonne in JFY12 and JFY13.

This implies increases to forecasts of 29% in JFY11 and 28% in JFY12. The broker's long-term price forecast is unchanged at US$74 per tonne. The changes have an impact on earnings estimates for both BHP Billiton ((BHP)) and Rio Tinto ((RIO)), BA Merrill Lynch estimating an impact of 0.3-5% for BHP earnings through 2014 and 2-3.5% for Rio Tinto over the same period.

BA Merrill Lynch continues to rate both stocks as Neutral, with price targets of $45.30 for BHP and $70.00 for Rio Tinto. Average price targets according to the FNArena database are $48.87 and $93.52 respectively, while BHP is rated as Buy seven times and Hold twice and Rio Tinto as Buy eight times and Hold once.

With respect to iron ore, GSJB Were notes prices have shown some resilience over the past week or so, enough that some commentators are suggesting with prices down 20% since April, the market is now bottoming out at the mid US$140.00 per tonne range.

GSJB Were doesn't necessarily agree, pointing out recent price cuts by Baosteel for July suggest an oversupplied Chinese steel market and weak order books. Other Chinese steel mills are likely to follow suit on prices, making it more difficult for spot steel prices to move higher in the short-term.

Given the pressure on steel prices, buyers look to be in a wait-and-see mode and the longer this continues the more likely iron ore spot prices fall than rise in coming weeks, in GSJB Were's view.

The broker has also looked more closely at the gold sector, as the likely merger of Newcrest ((NCM)) and Lihir ((LGL)) will change the structure of the sector in Australia as the merger means the next largest player in market cap terms will be Andean ((AND)), a company not yet in production.

This means there is an opportunity in the broker's view for one of the current mid-tier producers to step up to the next level, which implies in the order of 500,000 ounces of annual production and a market cap of $2-$3 billion. A company taking that step could be due a re-rating given it would fill a niche in the market.

Assuming gold prices remain high, GSJB Were suggests potential candidates to continue to explore consolidation within the sector include Avoca Resources ((AVO)), St Barbara ((SBM)) and OceanaGold ((OGC)). Given West Africa is becoming a global focus for gold exploration, the broker suggests the potential for corporate activity among companies involved in this region is increasing.

Finally, BA Merrill Lynch has also updated its view on the aluminium market, taking the view further consolidation is needed to further tighten physical market conditions. What could help bring about change is the desire of sellers to shift alumina pricing to more of a spot basis, something the broker suggests would make alumina more expensive.

If this was the case, BA Merrill Lynch suggests there would be a negative impact on those smelters in Europe and the US that have high higher power costs and a need to buy alumina. Higher alumina prices would feed through into production costs at non-integrated smelters, something the broker suggests would provide support for aluminium prices.

Click to view our Glossary of Financial Terms