Material Matters: Copper, Iron Ore, Coal And Oil, And Strategies For 2011

This story features BOUGAINVILLE COPPER LIMITED, and other companies. For more info SHARE ANALYSIS: BOC

By Chris Shaw

The Bougainville copper mine was closed in 1989 following sabotage by the Bougainville Revolutionary Army and it has remained closed since, awaiting peace on the island before the project can be re-started.

Bougainville Copper ((BOC)) shares have remained listed, with Rio Tinto ((RIO)) still a major owner with a stake of 53.6%. This equates to around 18c per Rio Tinto share at current prices, making it a marginal asset for the global mining giant.

But over the past six months shares in Bougainville Copper have risen threefold and are now trading at more than $1.60, which equates to a market capitalisation of better than $600 million. The gains have prompted DJ Carmichael to ask if the project could at some point have more value for Rio Tinto.

Assuming around US$3 billion in capex to get the mine up and running and to replace old infrastructure, and factoring in historical indicative cost data inflated to today's dollars and current spot prices for copper and gold, DJ Carmichael suggests it is possible to justify a valuation for Bougainville of around $5.00 per share.

This would only equate to about $0.55 per Rio Tinto share, while DJ Carmichael notes the project would be marginal at best if more conservative long-term forecasts for copper and gold were applied. In the broker's view this analysis highlights a major issue for copper producers, in that it is cheaper at present to buy existing production or do nothing than it is to build new projects to bring additional production to market.

According to DJ Carmichael this means either copper consumption will decline, copper project construction costs will fall and/or the copper price will rise further. Until one or more of these things occurs, the broker suggests there is little incentive for copper players to look at new projects.

Given Rio Tinto is a diversified resource play and the Boungainville project is relatively minor in terms of impacting valuation for the company overall, DJ Carmichael retains its Buy rating. The rest of the market agrees as the FNArena database shows Rio Tinto scores a perfect eight-for-eight Buy ratings. The database shows no coverage of Bougainville Copper.

Turning to iron ore, Macquarie suggests as marginal Chinese domestic production is at the top end of the global cost curve an understanding of this market is important to gaining insight into the outlook for iron ore prices generally in coming years.

On Macquarie's numbers, when there is a need for 300mtpa of domestic iron ore on a 62%Fe equivalent basis, the cost structure of the industry in China offers support for seaborne prices at around US$120 per tonne.

When sourcing iron ore Macquarie expects the Chinese to buy whatever is available on the seaborne market, then use its domestic material to fill any gap. With the absolute volume of domestic iron ore required expected to stay around this year's level, cost support should remain at the top end of the domestic cost curve in the broker's view.

By 2014 and 2015 new iron ore supply should moderately outpace demand, so reducing China's domestic material requirements. By this time though cost inflation at domestic miners will have pushed up support prices, so what would be US$70-$80 per tonne cost support this year looks more like US$100-$110 per tonne in 2015 on Macquarie's numbers.

This implies cost support at volumes of 280-300mtpa of domestic material will have risen to around US$149 per tonne by 2012 and to US$170 per tonne by 2015, though Macquarie doesn't expect by 2015 China will require as much domestic ore to meet its needs.

To reflect this Macquarie expects average iron ore prices will trade in a range of US$130-$150 per tonne CFR China out to at least 2013 and above US$100 per tonne into the second half of this decade.

Moving to coal, BA Merrill Lynch notes hard coking coal prices have settled at US$225 per tonne for the first quarter of 2011, up from US$209 per tonne for the final quarter of this year. The price settlement is slightly above the broker's forecast of US$220 per tonne and BA-ML expects further gains to US$240 per tonne in the second quarter of next year.

In the thermal coal market BA-ML expects China's imports will increase by around 20% in 2011, this increase coming at the same time as global supply is coming under pressure from heavy rains in Australia, Columbia and Indonesia.

While BA-ML is forecasting thermal coal prices of US$110 per tonne in Japanese financial years 2011 and 2012, the combination of restricted supply and stronger seasonal demand from the northern hemisphere leads the broker to suggest price risk is to the upside.

Deutsche Bank has similarly taken a more positive view on thermal coal prices, lifting its price forecasts through 2013. The changes see a 5% increase in the broker's 2011 price forecast to US$115 per tonne, a 12.5% increase in 2012 to US$135 per tonne and a 20% increase in 2013 to US$120 per tonne.

As Deutsche notes, the fact both China and India are growing increasingly dependent on the seaborne thermal coal market is only now becoming better understood by the market in general. In both countries, growing power demand is outstripping existing infrastructure, so forcing both countries to look overseas for supplies.

This is occurring at the same time as producers such as Australia and Indonesia are being impacted by adverse weather conditions, which is bringing about a tightening in the market globally. Deutsche Bank is forecasting a deficit in the global thermal coal market of 28 million tonnes in 2011, an expectation that should support prices going forward.

Best placed among Australian producers to benefit from this in Deutsche's view is Whitehaven Coal ((WHC)), as 60-70% of group sales are in the thermal coal market. Having lifted its coal price forecasts Deutsche has also made minor increases to its earnings estimates for Whitehaven, which produce an increase in price target to $7.00 from $6.90 previously.

In contrast Macarthur Coal ((MCC)) has no thermal coal exposure, so Deutsche makes no changes to its forecasts for that company. Following the sector review Deutsche rates Whitehaven and Macarthur as Holds, while the FNArena database shows respective Sentiment Indicator readings of 0.3 and 0.1.

Both BHP Billiton ((BHP)) and Rio Tinto have relatively little leverage to thermal coal prices, so Deutsche has made only minor changes to forecasts and price targets for the stocks. It continues to rate both BHP and Rio Tinto as Buys, while Sentiment Indicator readings for both companies according to the FNArena database stand at 0.8 and 1.0 respectively.

On oil, BA-ML now sees the global oil market as moving to a tighter balance than previously expected, this due to ongoing demand strength that continues to outpace supply growth. To reflect this, the broker has lifted its oil price forecasts to US$78.90 per barrel for this year and to US$87 per barrel in 2011 for West Texas Intermediate, up from US$77.70 and US$85 per barrel respectively.

BA-ML has also lifted its long-term oil price forecast to US$85 per barrel from US$80, while it has increased its long-term AUD/USD forecast to US88c.

These changes mean some adjustments to earnings estimates and price targets across the stocks in BA-ML's Australian oil coverage universe, with targets increased in all cases except for Roc Oil ((ROC)) where there is a minor cut.

On a relative basis BA-ML's preferences in the sector remain Woodside Petroleum ((WPL)) and Oil Search ((OSH)), which also reflects greater challenges for Santos's ((STO)) new projects when compared to the other two companies.

As a final summation on the outlook for commodities in 2011, BA-ML has offered its top themes for the coming months. For those worried about inflation or sovereign debt defaults, continued investment in gold, silver and platinum is recommended.

In terms of preferred bull cycle plays BA-ML is most positive on copper, oil and coal, with further gains and in some cases record prices seen as likely during the course of the coming 12 months. Gold should also move higher, but with downside risks growing the broker suggests investors at least consider some downside protection when investing in commodities. One way to achieve this may be via commodity index options, which look inexpensive in the broker's view.

With respect to which commodities could underperform next year, BA-ML's picks for best shorting candidates are natural gas and wheat, the former due to record inventory levels and the latter thanks to an expectation production of other grains will soon start to normalise. 

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