Material Matters: Commodity Indices, Citi Positive On Metals, Oz Coal Takeover Multiples

This story features WHITEHAVEN COAL LIMITED, and other companies. For more info SHARE ANALYSIS: WHC

By Chris Shaw

As commodities have emerged as an asset class in recent years the correlation of commodity returns to equity markets has strengthened, particularly over the past 18 months. One impact of this according to Deutsche Bank is commodities are no longer seen as providing the same diversification benefits in a portfolio.

In the view of Deutsche Bank this is encouraging the commodities index space to evolve, particularly via the Risk Parity Commodity Index. A risk parity portfolio tries to assign equal weighting to each underlying asset while adjusting for different levels of risk based on volatility and the correlation of different components.

This means a risk parity index will tend to assign a smaller allocation to sectors where volatility is high, such as energy, while increasing the allocation of lower volatility sectors such as gold.

Such a change is important as Deutsche Bank notes for example the S&PGSCI benchmark index has around 70% of its US dollar weighting in the energy sector, but on a risk-weighted basis energy accounts for an even greater contribution.

As an example, Deutsche estimates the amount of risk contributed by the energy, agricultural, industrial metals and precious metals sectors in the S&PGSCI are actually around 89%, 5.5%, 3.5% and 2% respectively.

This implies a problem for investors as it means there is less diversification benefit from investing in the benchmark index, as any recent major negative macro event that has caused a sell-off in equities has seen volatility in the energy market increase. This as a result increases the risk of the commodity portion of the portfolio.

In Deutsche's view, as commodity index returns continue to be strongly positively correlated with the S&P500 index more commodity indices will emerge, especially those that better balance the risks among the various commodity sectors.

Looking at recent trading activity in the base metals sector Citi suggests the rally over the past three weeks reflects speculative short covering and an improvement in fundamentals. Falls in open interest levels on the LME support the view some short covering has been undertaken.

While there may be a short-term correction in prices the outlook for the fourth quarter of the year is increasingly positive in the broker's view. The data supports this as US copper shipments are recovering in both percentage terms and as measured by volume, while merchant premiums are also picking up in various markets.

Stocks are also falling in markets such as nickel and zinc, while Citi notes US aluminium shipments also increased in June and LME stocks are falling as the metal is taken off warrant for financing.

In terms of price forecasts, Citi expects a year-end aluminium price of US93c per pound, rising to US100c in June next year and US103c by the end of next year. For copper Citi expects prices of US310c per pound by the end of this year, US330c per pound by next June and US327c per pound by the end of 2011.

In nickel Citi is forecasting prices of US901c per pound as at the end of December, US960c per pound at the end of next June and US958c per pound by the end of next year, while for zinc its forecasts are for prices of US83c per pound, US89c and US91c respectively for the same periods.

Turning to the Australian coal sector, Credit Suisse has reviewed the recent merger and acquisition activity among the Aussie coal plays to determine of there are any implications for the stocks the broker covers in the sector.

Based on the seven transactions in the sector since May of 2009, Credit Suisse estimates the average transaction multiple works out at around $3.33 per tonne of resource, with a range of $0.67 per tonne up to $7.39 per tonne.

Current trading multiples for companies listed in the sector have a somewhat similar range, Credit Suisse estimating Coal and Allied ((CNA)) trades on the highest multiple at present of $6.57 per tonne, while the lowest is Centennial Coal ((CEY)) at $0.64 per tonne.

But the broker concedes a degree of caution is needed when using Australian dollar per tonne multiples, as this is a fairly simple measure and doesn't account for variables such as coal quality, project economics, asset type and the rate at which a company is commercialising its resource.

On its number,s Credit Suisse suggests equity valuations in the Australian coal sector at present are incorporating a premium for corporate activity. The stocks under its coverage are currently trading at more than 10 times FY11 and FY12 earnings and Credit Suisse suggests this assumes average coal prices of US$210 per tonne for hard coking coal, US$150 per tonne for PCI and US$95 per tonne for thermal coal.

In terms of an example using a specific company, Credit Suisse sees the Yanzhou acquisition of Felix Resources as the most relevant for Whitehaven ((WHC)). Whitehaven is trading at $5.33 per tonne against the price for Felix of $5.22 in August of last year.

While coal prices are higher now, which suggests a higher transaction multiple is possible, Credit Suisse also points out Felix's Moolarben project is arguable lower risk than Whitehaven's Narrabri project.

Looking generally at the multiple paid by Yanzhou for Felix, Credit Suisse suggests there is significant share price upside potential for Centennial, Riversdale ((RIV)), Macarthur ((MCC)) and Aquila Resources ((AQA)) if these stocks were priced at current transaction multiples. The upside ranges from 18% for Aquila to almost 700% for Centennial.

On the other side of the equation the broker estimates there would be downside for Coal and Allied, Newhaven ((NHC)) and Whitehaven using this multiple, this downside ranging from 2% for Whitehaven to around 20% for Coal and Allied.

In contrast, using the multiple offered by Banpu for Centennial of $0.67 per tonne there would be significant downside for all the stocks in the Australian coal sector. This highlights the volatility of current valuations depending on what others in the market are prepared to pay for assets.

On the back of the analysis Credit Suisse has not changed its ratings in the sector, continuing to rate Coal and Allied, Newhaven and Whitehaven as Neutrals, while Centennial, Riversdale, Aquila and Macarthur are all rated as Underperform.

Sentiment Indicator readings according to the FNArena database stand at 0.7 for Coal and Allied, 0.5 for Whitehaven, 0.3 for New Hope, 0.3 for Riversdale, 0.0 for Macarthur and minus 0.3 for Centennial and Aquila. 

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