Metal Matters: Equities, Base Metals, Coal And Platinum

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

-Supply growth exceeding demand
-Stock underperformance ending?
-Base metal price forecasts cut
-BHP's plan for coal to limit price upside
-Potential electricity shortage for platinum?

By Eva Brocklehurst

Mining equities have corrected but demand growth remains robust across most commodity markets – for the present. UBS suspects the equities fall is pre-empting price falls, which will emerge with the passage of long-standing constraints on supply. China is managing industrial growth tightly and quantitative easing has buoyed the US economy, while Japan is now doing the same. Only Europe is ailing. UBS notes trade in commodities with seasonal characteristics such as iron ore, metallurgical coal and copper improved along with prices over December-February. By March the upside had been capped and this undermined confidence in equities. The emerging theme suggests supply growth now exceeds demand in most trades. UBS notes commodities such as copper, iron ore and coal, not just perennially supply-choked aluminium and nickel, are vulnerable to price pressures on this basis.

So, UBS has made the following changes to quarterly/annual average price forecasts: base metal prices have been reduced by 2-3% for the 2013 average, while substantial cuts of up to 15% have been made to 2014/15 price forecasts for aluminium and nickel. Copper's price has been pared back for 2013 but lifted for 2014 on emerging supply risks, although the analysts hasten to add they're still bearish. Gold and silver prices have been reduced by 8-12% for 2013 and unchanged over the longer term. Iron ore's 2013 average price has been lifted by 4% while thermal coal's price forecast has been cut by 9% for the Japanese FY13 and is seen flat for FY14. Metallurgical coal and platinum group (PGM) forecasts are unchanged.

Goldman Sachs asks whether the underperformance in mining shares has come to an end. The broker notes the quality stocks are still generating over 40% margin and a 15% return on capital expenditure along with strong cash flow. Returns are expected to improve significantly from 2014 onwards. Goldman believes returns in the future may be about half what was experienced during the boom years, because of the massive capital expenditure over the last 4-5 years that has elevated the asset base. The years 2014/2015 are viewed as the trough in terms of returns and from there the capex spending of 2010-15 should start to generate earnings.

Thus, while absolute returns are lower, in a year's time there will be a period of increasing returns for big miners. The analysts have run a model to test value (NPV) sensitivities under a worst case scenario for the sector. Those with the most limited downside are mainly the larger, more liquid stocks. It maybe too early to become a buyer but the broker sees BHP Billiton ((BHP)), PanAust ((PNA)), Oceanagold ((OCG)) and Sandfire Resources ((SFR)) as having the necessary support.

Goldman takes a closer look at the connection with base metal miners and prices. Copper stocks stand out, as the fall in the copper price is much less in comparison to the significant fall in the share price of the four copper stocks the broker covers, namely PanAust, OZ Minerals ((OZL)), Sandfire and Discovery Metals ((DML)). It suggests to Goldman that the takeover bid, and subsequent withdrawal, for Discovery could have distorted the correlation. Nickel provides a similar story, with the equities significantly underperforming the metal price. On aluminum, Alumina ((AWC)) has had a mixed performance compared with the price but this can be attributed to stock specific items and the fact Alumina has a steady dividend stream from AWAC. Nevertheless, Goldman's findings show a much greater implied leverage between the company and underlying commodity than had been expected. The analysts suggest this may, in some way, be influenced by changes in sentiment as well as macro influences on the allocation of capital towards the commodity sector.

Another close look at copper and JP Morgan has lowered price forecasts by 9-10% for 2013/14 but upgraded the long-term forecast. In doing so, the top pick in the copper sector becomes PanAust, the main beneficiary of bullish longer-term price assumptions and a Buy recommendation is maintained for OZ Minerals. The broker likes Sandfire, retains a Hold, but is less attracted on valuation grounds given the front-loaded production profile. In micro caps the preference is for Hillgrove Resources ((HGO)) as it has producer status as opposed to Rex Minerals ((RXM)) for example.

Now for coal. US coal markets are normalising, helped by the cessation of rapid growth in natural gas supplies. Hence, inventories for both are improving. The strength of the Australian dollar is keeping US coking coal in the export market, although BHP's plan to raise production in Queensland should limit price upside. JP Morgan forecasts hard coking coal at US$173/tonne and European thermal coal at US$86/t in 2013, with modest improvement to US$183/t and US$90/t respectively in 2014. Chinese thermal inventories are higher than average but the recent weakening of seaborne prices has increased the likelihood of higher thermal imports, in JP Morgan's view. The analysts also find the steel makers' coking coal inventories are comfortable and limiting a near-term price recovery.

In terms of the sources of coal, the analysts notes low AP12 coal prices are curbing Russian thermal exports and production has been reduced. The analysts expect more declines in US thermal coal exports should help seaborne coal prices later in the year. China's cold winter helped Indonesian miners re-start production and the strong balance sheets there should help them weather the pricing environment. In India, coal imports are affected by upcoming elections. Power companies are seen buying more international coal to minimise outages during campaigning but, on the flip side, there's unlikely to be progress on the issue of price pooling until later in 2014, after the elections.

On the subject of Japan's nuclear power coming back on line, JP Morgan notes opposition could delay these moves and protect some coal demand. Japan is seeking better prices and is yet to settle for this financial year. Then there's Mongolia and Mozambique, where hopes of new coking coal producers have been dashed. Mongolia's sales to China have fallen because of political instability and, in Mozambique, infrastructure challenges have caused Rio Tinto ((RIO)) and Anglo to walk away from projects while Vale will only develop one phase of its plan.

Finally, platinum group metals. Electricity supply concerns are back on the front page in South Africa. Eskom's reserve margin is 6% again, according to Standard Bank, below the international safety threshold of 10%. Standard Bank expects the situation is not a major risk to PGM production but it is in the background as South Africa heads into winter. It doesn't imply much for prices as the analysts do not think platinum and palladium have a large premium on the possibility of an electricity induced disruption. It does, nevertheless, reduce at least one incentive for adding new long positions.

Palladium remains vulnerable to a sell off. The analysts find there is still substantial speculative length, as evidenced by the positions on NYMEX. They highlight the net speculative length of open interest registered 62% last week, well above the 5-year average of 48%. Palladium dropped through key support and with the price now at US$730/oz the analysts suspect it will re-test US$722. If it cuts through this speculative longs could liquidate positions and the next support level is US$700.
 

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