More Questions Than Answers For Resources Companies

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By Rudi Filapek-Vandyck, Editor FNArena

To most investors, I am sure, the relentless de-rating of mining and energy stocks, not just in Australia but worldwide, has sneaked up on them, masked by macro-economic issues such as sovereign debt threats in Greece, Italy and Spain.

Most investors might assume this de-rating process is relatively new as share prices for the likes of BHP Billiton ((BHP)) and Rio Tinto ((RIO)) surged to much loftier price levels in April last year, the truth is back then the de-rating process was already in full swing. First these companies were being de-rated on sharply rising profits, which allowed share prices to continue rising, but when subsequently profit forecasts started falling share prices had to follow suit.

It is important to note this de-rating is a global phenomenon, thus local issues such as the carbon tax, the proposed Minerals Resource Rent Tax (MRRT) and the strong Australian dollar are only some issues among many others. Australia is one of global resources powerhouses so this de-rating for miners and energy producers has hit the Australian share market and investors in this market in significant fashion. Last week I calculated how significant the overall impact has been: were it not for the de-rating of metals and energy stocks, the ASX200 would today be some 16% higher.(*)

This is significant in anyone's language.

Let's have a look at the main question marks behind this de-rating process.

Question Mark 1: have prices for industrial commodities now peaked?

Not everyone is equally convinced as yet, but there's growing consensus that the Big Push underneath prices for base metals, bulks and crude oil prices is behind us. While demand-supply assumptions and price projections have already diverged for different metals and bulk commodities, and some might still see higher prices in the year ahead, the underlying trend is nevertheless establishing itself in analysts' forecasts and price projections: either a peak in price is behind us or the event is not far off in the near future. Incorporating this shift has not only had a severe impact on forecasts for profits and cash flows, but also on the market psyche overall.

All of a sudden the unthinkable has become possible: BHP shares may never return to $50. In fact, the Big Australian's relative underperformance since mid-2009 no longer automatically suggests loyal shareholders will be compensated through outperformance in the years ahead. Note that some large shareholders in the Big Australian have been reducing their exposure over the past year.

Commodities analysts at Citi, once firmly on the Super Cycle bandwagon, issued a series of research reports in March under the all-encompassing theme of "The Super Cycle Sunset". The implication was that prices for industrial materials, including crude oil, were in the final stages of a decade long uptrend, with some already on the way down. Just as a side-note: these Citi reports received remarkably no attention at all in Australian media.

Citi analysts are far from the only ones with this view. Probably fair to say there's a general view in the post-2008 era that nothing lasts forever, including this once-in-a-lifetime Super Cycle boost for commodity prices. The only disagreement, or so it seems, is about the exact timing and speed of price declines in the years ahead.

Also, US based securities firm Stifel Nicolaus recently offered an alternative view based upon cycles as theorised by the Russian economist Kondratiev. According to this scenario commodity prices are now well on their way to lower price levels, but in ten years time or so there should be one more final boost in the years leading into 2035, before embarking on a long-term decline to early 1990s lows.

Question Mark 2: have profits and margins now peaked?

US energy expert Daniel Yergin explained today's key problem for gas and oil producers as follows in his recent masterpiece "The Quest"(**): ten years ago bringing a major project online cost these companies on average US$500m. Today the average cost is US$1.5bn, and rising. What goes for oil and gas equally applies to miners, in particular for those with projects in Australia which has rapidly become one of the world's most expensive places to build a new, capital intensive business. Again, this is not a problem that is solely related to local issues in Australia.

The above mentioned analysts at Citi published a global comparison in March of appreciation that took place in prices as well as in cost levels over the past decade. The table below offers no less than a cold shower for those investors who only focus on the top line, while casually ignoring what happens with cost levels. Part of the reason behind the global de-rating for miners and energy producers is the realisation that for many in the sector profit margins have peaked sometime during 2007-2008. Since then margins in general have been in decline.

The problem facing these producers, explained analysts at Macquarie recently, is that while most product prices stopped rising in 2012, margin pressures from rising costs have not. This pretty much sums up the conundrum that boards at BHP, Rio Tinto and the likes are facing: how best to counter this double squeeze? Traditionally, the obvious response has been to compensate through sharply increased volumes, but this will eventually pull price declines into acceleration mode.

Question Mark 3: Depreciation and Amortisation

Spending billions of dollars on new projects that will deliver increased volumes and benefits in years to come has its widely known drawbacks such as reduced profit potential and shareholder benefits in the short term. Note, for example, Royal Dutch Shell pays circa 5% in dividends while BHP shares trading near a three year low still only yield an estimated 3% (Rio Tinto yields even less). But owning and running mega-projects comes with serious ramifications that have as yet not attracted much attention from media or investors: higher annual maintenance costs plus elevated accountancy charges for depreciation and amortisation.

If you think these side-effects are trivial you better think again. Analysts at Barclays recently calculated that incorporating all of the above implies all recently developed oil fields are running at an average cost level of US$109 per produced barrel. (Just goes to show the higher oil price has predominantly benefited producers with older assets that still produce at much lower cost levels). Analysts at Citi conducted some in-depth analysis about this earlier in the year and their calculations suggested valuations across the global mining sector could well be inflated by between 20-30% because financial accounts are still working off D&A levels that seem too low given today's capex.

Also, this certainly puts today's apparent undervaluation in a new perspective with shares for the likes of BHP Billiton and Rio Tinto trading some 37% and 47% below Net Present Value (NPV) respectively. Simply put: reduce these valuations by 20-30% and a lot of today's implied upside potential instantly disappears.

Question Mark 4: where has the profit growth gone?

We can talk about the share market and investment strategies until the cows come home but one thing should never be neglected: investing in stocks ultimately comes down to profit growth. Right now this appears to have become a Big Question Mark for many in the mining sector. Earnings forecasts in Australia have been in decline for a long time now and miners and energy companies are amongst the heaviest hit. This process is still ongoing. Later this week, Rio Tinto, BHP Billiton, Fortescue ((FMG)), Santos ((STO)) and Woodside Petroleum ((WPL)) will all release quarterly production reports, and this will lead to more updates and revisions from securities analysts.

UBS analysts already updated in advance, and while their estimates are not industry standard, they do reflect the key issues these companies are facing for the years ahead (long term investors take note). Take a look, for example, at what UBS analysts have currently penciled in for Rio Tinto in the years ahead:

What this means, in a nutshell, is that Rio Tinto's earnings per share (EPS) in calendar 2014 will be pretty much unchanged from last year's. Things look even worse for BHP as UBS's projections show a steadily decline in EPS in the years ahead:

Of course, it goes without saying these calculations and predictions can instantly change, and they most definitely will, as new developments occur and new insights are gained, but it does summarise all of the issues mentioned above in one succinct table with forecasts for the years ahead: where is the profit growth? How are loyal shareholders going to benefit from this once-in-a-lifetime Super Cycle Era?

(Note that growth forecasts for Fortescue, Santos and Woodside are much higher with double-digit EPS growth projected for each of the years ahead).

Question Mark 5: Short Term Versus Long Term

It may not have become apparent in share price movements as yet, but many of the world's China-watchers have turned more positive on the outlook for the Chinese economy later in the year. The suspicion is that Chinese authorities, in the face of a slowing economy, have already started to re-stimulate the domestic economy which should mean that Q1 or Q2 will mark the low point this year and growth in the second half should accelerate.

Take, for example, Goldman Sachs' Yu Song who post the release of unexpectedly large credit supply data concluded China's monetary policy has quietly but aggressively nevertheless shifted into loosening (stimulus) mode. This loosening, he says, "is important not only because it provided much needed liquidity and gave activity growth a boost but it also answered two key questions of the day:

1) will the government take action if GDP growth is low (say 8.0%) but still above the new GDP “target” of 7.5%?; and
2) does the government have the ability to loosen monetary conditions even if it wants to loosen policy given the lower demand for loans?"

Yu believes the answer from the March data is clearly "yes" to both questions. (Judging by the research reports issued in recent days, he's far from the only one with such an optimistic view).

Increased market confidence may well provide share market traders at some point with enough confidence to start playing the resources theme again, after all, miners and energy stocks are perceived to be cheap following the relentless de-rating that has made them underperformers vis-a-vis industrials and financials.

However, investors with a longer term horizon have a much bigger challenge at hand, as illustrated by the fact that shareholders in Newcrest ((NCM)) have seen no net appreciation since October 2008 (or April 2009 depending on one's perspective). Shareholders in Santos have on a net basis hardly booked any gains since 2007 while long term shareholders in Woodside have to date seen no net appreciation since late 2005.

Shareholders in Fortescue have fared better, but are still in stand-still mode, on a net comparison, since October 2010.

In my view, all of the above raises serious questions about the suitability of resources stocks for long term, Buy and Hold strategies. This is a view I have expressed on multiple occasions since 2009. I am yet to be convinced the years ahead will offer investors something completely different from the experiences in years past. I can only hope that investors running their own SMSF portfolio and strategies have not been overweight these sectors, just like most investors in Australia were overweight banks when subprime disaster struck in 2007.

(This story was originally written on Monday, 16th April 2012. It was sent out in the form of an email to paying subscribers on that day).

Notes: (*) See last week's Weekly Insights "Not As Bad As You Think"

(**) I am still reading Daniel Yergin's "The Quest. Energy, Security, and the Remaking of the Modern World" and will publish a book review once I have finished reading it

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