Material Matters: QE3 And Commodities, Copper, Zircon And Oil

This story features ILUKA RESOURCES LIMITED, and other companies. For more info SHARE ANALYSIS: ILU

 – QE3 a boost for gold
 – Standard Bank outlines its other commodity preferences 
 – Copper and zircon markets reviewed
 – Oil sector preferences updated

By Chris Shaw

The market had been expecting QE3 and on news of further action by the US Federal Reserve the view of Deutsche Bank is that the proposal is modestly ahead of expectations. As a result Deutsche expects the gold market will remain well supported, though the broker cautions there may be some selling pressure once the market has had time to digest the Fed announcement.

Beyond QE3, Deutsche suggests China could act as the next catalyst for the gold price, as to date the Chinese government has been more reserved than expected in terms of stimulus actions. Part of this can be explained by the upcoming transition of government in October.

Deutsche also suggests the People's Bank of China may see a benefit in following the Fed in terms of stimulus measures, which implies scope for more supportive actions in the final quarter of this year. 

This is enough for Deutsche to suggest the macroeconomic environment for gold is turning more positive, especially given the inflation concerns associated with the introduction of QE3. Low interest rates should also be supportive of gold as this lowers holding costs for the metal.

In terms of forecasts, Deutsche Bank expects gold will average US$1,726 per ounce in 2012, rising to US$2,050 per ounce in 2013. By 2014 Deutsche expects the gold price will weaken, declining to an average of US$1,800 per ounce in that year.

Standard Bank goes a step further and suggests most commodities are likely to rally on the back of QE3, meaning the benefit is in identifying which commodities are likely to rally more than others. For the bank preferred exposures are gold, silver, Brent crude and aluminium. 

According to Standard Bank, these four commodities are the most likely to move higher as both Brent and silver rallied strongly on the back of QE2 and both gold and aluminium benefit from the new easing Fed action. Aluminium's benefit stems from the metal's link with energy as an input in production, while for gold Standard Bank notes if the Fed were to expand its balance sheet by a further U$1.3 trillion, fair value for the metal would increase to around US$1,900 per ounce.

Second tier picks for Standard Bank would be platinum and them palladium, the former in particular performing well in the months after QE2 and so offering a reasonable basis from which to expect similar performance this time around.

Base metals in general show a lesser reaction to QE measures than the precious metals, which puts the base metals suite with the exception of aluminium on the third tier for expected performance in the view of Standard Bank. 

Further on the base metals, Macquarie suggests a tight supply chain should continue to drive copper prices higher. Ongoing underperformance in terms of mine supply has been a feature of the copper market for the past 10 years and Macquarie points out mine supply growth expectations for this year have steadily moved lower.

For 2012, Macquarie expects copper mine supply growth in year-on-year terms of 3.4%, which implies a market deficit of around 240,000 tonnes of the metal. Refined copper production growth should be a little stronger next year, to the extent Macquarie expects a small copper market surplus in 2013. 

This surplus won't be enough to allow for the market to replenish depleted stocks along the supply chain, as stocks are critically low. LME stocks of copper are expected to fall below 200,000 tonnes this year, the lowest level since the onset of the GFC. This leads Macquarie to suggest copper prices will remain sensitive to any upside growth surprises and any positive shift in sentiment. 

JP Morgan's analysis of the zircon market suggests market fundamentals remain strong, as recent weakness in demand appears to have been largely sentiment-driven de-stocking through the value chain. 

This implies demand should rebound in 2013 and 2014 back to long-term trend levels. As JP Morgan notes, zircon demand has consistently growth by 3% per year for more than 20 years, with any anomalies in this growth rate tending to normalise within a year or two.

Given the zircon market has limited room for substitution in traditional end markets, as well as growth potential in new end markets such as chemical applications, JP Morgan suggests recent high prices are unlikely to temper long-term demand trends.

Having conducted a supple/demand analysis, JP Morgan has incorporated into its expectations a supply response from Iluka ((ILU)) over the next three years but none from any of the company's peers in the industry. 

Even allowing for some brownfield expansions such as the Moma project and some smaller greenfield projects coming to market, JP Morgan's forecasts imply the zircon market will remain in deficit at least until 2015. This reflects a market with highly concentrated supply and a fragmented customer base and few new large scale projects.

JP Morgan estimates the top five producers account for around 70% of market supply, though zircon passes through a number of hands before reaching the end-market. This includes intermediary processors and industrial manufacturers.

Given a large number of participants in the industry, zircon inventory cycles are exacerbated according to JP Morgan. As an example, demand is forecast to fall by as much as 20% this year given some inventory de-stocking, before recovering in the next two years.

Having reviewed the zircon market, JP Morgan has made modest changes to price forecasts. For this year the broker now expects an average price of US$2,363 per tonne, down from US$2,375 per tonne previously, while in 2013 prices are forecast to average US$2,075 per tonne, down from US$2,300 per tonne. Prices should be relatively steady in 2014 at an average of US$2,000 per tonne, down from a previous forecast of US$2,125 per tonne.

On the back of its zircon market review, JP Morgan has upgraded its rating on Iluka ((ILU)) to Overweight from Neutral. With consumption expected to rebound next year and with Iluka acting to limit market supply the expectation is for a tight market expect year, so supporting prices.

As well, JP Morgan notes Iluka offers a strong balance sheet, unique assets and valuation upside given significant share price falls this year. Together, this supports the broker's view there is upside at current levels. Price target for Iluka has been set at $14.50, down from $15.15 previously.

By way of comparison, the FNArena database shows a Sentiment Indicator reading for Iluka of 0.8, with a consensus price target of $13.03. Targets range from Macquarie at $10.50 to Citi at $18.00.

In the energy sector, Citi's analysis suggests the recent cancellation or deferral of some high-cost projects such as Shtokman and Fort Hills implies a growing realisation in the industry that a steepening cost curve cannot be supported.

There has been a slight shift in the cost curve according to Citi, though marginal cost in oil remains around US$90 per barrel. The changes reflect in part a shift in supply expectations, with Iraq, heavy oil and unconventional gas disappointing to some extent, while supply from Kurdistan and East Africa has surprised on the upside slightly and the outlook for North American unconventional oil remains robust.

Citi notes the Australian LNG market has been one to show some signs of cost inflation and looking forward Citi expects a tightening utilisation picture across all things offshore will post some risks to the industry in coming years. Most likely losers in such an environment are marginal deepwater developments and some offshore projects expected later this decade.

In general Citi suggests the market is currently unwilling to reward the growth ambitions of certain companies, as the likes of Santos ((STO)) in Australia appear substantially undervalued on an unlevered basis. 

Citi's global review included only Santos and Woodside ((WPL)) among ASX-listed companies. The former is rated as Buy, the attraction being that the current transition will shift Santos from a high cost and declining asset business to one where value is underpinned by LNG revenues and a reinvigorated Cooper Basin asset. Citi sees Santos as the base value large cap Australian exploration and production play. 

Woodside is also rated as Buy, Citi seeing upside from growth projects such as Browse LNG, Sunrise LNG and a potential expansion at Pluto. While timing of these projects remains uncertain Citi sees tangible value in the portfolio. With market expectations for Woodside's growth now low, Citi suggests there is little downside risk for the share price from current levels.

Credit Suisse has also reviewed its order of preference in the energy sector post the August profit season, the broker retaining Oil Search ((OSH)) as its top pick among the large cap names. The stock offers both near-term catalysts and a clear path to future growth. Oil Search is rated as Outperform.

Both Woodside and Santos are being discounted by the market for a lack of clarity on growth for the former and some capex risk for the latter. As Credit Suisse expects this will remain in place for some time, both stocks are rated as Neutral.

For Caltex ((CTX)) there is significant execution risk and potential for capex overruns from the closure of the Kurnell refinery, while the Lytton refinery remaining open leaves the company exposed to the volatility of refinery earnings. Caltex is rated as Underperform by Credit Suisse.

Among the most preferred for Credit Suisse in small cap plays are Molopo ((MPO)) and Tap Oil ((TAP)), the former for attractive acreage in an area largely de-risked by larger operators and a fully funded exploration position. The attraction of Tap is exploration potential, though this means the stock is more of the high risk/high reward category. Both are rated Outperform by Credit Suisse.

AWE ((AWE)) continues to make progress in its WA shale program and the Ande Ande Lumut project is expected to be sanctioned by the end of the year, while Karoon ((KAR)) also has an extensive exploration program underway that offers potentially high rewards. Both stocks are rated as Outperform by Credit Suisse.

Aurora Oil and Gas ((AUT)) is rated as Neutral, as while funding is in place for exploration this year and production continues to increase, the stock is offering less value than others in the sector in the view of Credit Suisse. 

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