Material Matters: Energy, Nickel, Steel And Iron Ore

This story features BEACH ENERGY LIMITED, and other companies. For more info SHARE ANALYSIS: BPT

 – Oil Sector ratings revised
 – Weak short-term nickel price outlook
 – Global steel output a record in April
 – Mid-Cap iron ore plays revisited

By Chris Shaw

With share prices across the oil and gas sector having declined in recent weeks, Citi has reviewed its sector ratings to account for respective share price performance during the period. The result is changes to a number of ratings.

Among the larger cap plays, Citi upgrades Oil Search ((OSH)) to Buy from Neutral, with a price target of $8.41. The stock has underperformed the ASX200Energy index by 10% in absolute terms since late in April, this despite the story for the company improving. In Citi's view Oil Search is a relatively low risk growth play on the back of the PNG LNG project.

At the smaller end of the sector, Citi has also upgraded ratings for Beach Energy ((BPT)) and Aurora Oil and Gas ((AUT)), in both cases to Neutral from Sell. For Beach the upgrade reflects both improved valuation following 36% underperformance on an absolute basis since mid February and a share price essentially underpinned by assets already in production. 

Aurora has underperformed the ASX200Energy index by 20% in absolute terms over the past month, this reflecting both a recent equity raising and the risk-off occurring in the market in general. An increased drilling program offers some risk given a step-change in the pace of development, but the share price accounts for this given on Citi's numbers the stock is now trading broadly in line with valuation. 

The FNArena database shows Sentiment Indicator ratings of 0.9 for Santos, 0.0 for Beach and minus 0.2 for Aurora.

Since the highs of April the LME nickel price has fallen more than 10%, Macquarie attributing the decline to growing concerns with respect to the European debt crisis and reaction to recent Chinese macro data.

The falls mean most nickel pig iron producers in China are now loss-making, with the exception of new rotary kiln electric furnace and 1.4-2% Ni blast furnace producers. Despite this, Macquarie notes there has not been any significant impact on Chinese nickel pig iron production levels.

While some production cuts have been announced these are too small to have any price impact, this given weaker demand and an overhang of unsold nickel pig iron stocks. As well, Macquarie notes most of the production cuts will be offset by a ramp up of output from new producers.

Given nickel pig iron inventories continue to rise, Macquarie suggests nickel prices in general need to stay lower for longer to force major cuts in nickel pig iron output. This implies a weak outlook for LME nickel prices in the shorter-term, as any price recovery will need both lower nickel pig iron inventories and an increase in Chinese stainless steel production in Macquarie's view.

With respect to steel production, the latest data from Worldsteel suggests global crude steel output hit a new high in April. The April numbers are likely to be the high for the year according to Macquarie, as gains in Chinese production appear limited and output from the rest of the world is likely to be a bit slower.

Credit Suisse agrees, as production is unlikely to increase given strengthening concerns with respect to demand from both Europe and China. The data indicates while US production in April was broadly flat, Chinese output slipped around 1% and European production declined by 3.25% after a fall of 0.2% in March.

This should not weigh on raw materials prices in Macquarie's view, as iron ore supplies remain constrained at current price levels and the composition of steel production from core buyers of seaborne met coal is improving.

Steel prices may remain under pressure in coming months as inventories at service centres are high, though Macquarie sees some upside risk to 3Q contract prices given better rates of Asian steel production and a currently subdued rate of seaborne met coal production.

Still on the bulks, JP Morgan has looked again at Australian mid-cap iron ore plays given substantial share price falls in the sector in recent weeks. The falls reflect pressure on the iron ore price in general, this due to both macro concerns and a bout of risk aversion by investors.

In April JP Morgan updated its view on Aquila Resources ((AQA)), Atlas Iron ((AGO)), Gindalbie Metals ((GBG)), Grange Resources ((GRR)) and Mount Gibson ((MGX)), rating Gindalble and Grange both as Buy and Atlas and Mount Gibson as Neutral. The broker is currently restricted on Aquila.

Since that report the share prices of the five companies have fallen on average by 26%, Aquila the worst-performed in declining by 42% against a 17% fall in the share price of Mount Gibson. Over the same period the iron ore price has fallen 11% to US$131 per tonne.

The current price is above the October 2011 low of US$116 per tonne, which to JP Morgan suggests some further shorter-term downside risk. But given Chinese steel and iron ore data of late has shown little change rather than falling further, there is some evidence to suggest iron ore prices should stabilise rather than weaken in coming weeks. 

According to JP Morgan, evidence of stability in iron ore prices is likely to act as a Buy signal for the sector. Assuming this the sector looks cheap at current levels, though the broker suggests allowance needs be made for the current short-term macroeconomic headwinds.

Assessing the five stocks in relative terms, JP Morgan notes four are trading at relatively close levels on a price to net present value basis. The exception is Atlas Iron, which is trading at a 38% premium to peers on JP Morgan's estimates.

On a company specific basis JP Morgan sees updates on the Horizon 2 project as the key drivers for Atlas, while asset sales and financing for the West Pilbara Iron Ore Project will be a key for Aquila. Gindalbie needs finalise a debt facility, while financing for the Southdown project remains a key for Grange. 

Mount Gibson is in a different position, JP Morgan suggesting key catalysts for the company at present are M&A activity and how current cash levels will be deployed or distributed. 

Having re-run its numbers to account for recent share price falls, JP Morgan makes no changes in ratings. This leaves Grange Resources and Gindalbie Metals as preferred exposures, this reflecting both valuation upside and less in the way of operational and construction risk relative to peers.

Both Atlas and Mount Gibson are rated as Neutral, the former a valuation call given a premium to peers, which offsets a proven management team and low risk operations. JP Morgan expects it will take the market some time to become more comfortable with Mount Gibson's strategic direction following recent management changes, while there is also acquisition risk given a current focus on M&A options.

The FNArena database shows Sentiment Indicator readings for these junior iron ore stocks of 1.0 for Gindalbie, 0.8 for Grange, 0.6 for Atlas, 0.3 for Mount Gibson and minus 0.3 for Aquila. 

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