Material Matters: Indonesian Ban, Cost Deflation, Cash Margin And Europeans

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-Low likelihood of Indonesian supply cut
-Will a cost deflation cycle emerge?
-Cash margins key to stock picking
-Citi becomes more neutral on Europeans
 

By Eva Brocklehurst

Will Indonesia enforce a strict ban on export of unprocessed minerals? JP Morgan has concluded that the probability of a deep and prolonged cut to supply in 2014 is low. Even before recent economic weakness emerged, January 2014 was not intended to be a hard cut-off point for exports. There were three proposed dates before which exports would still be allowed on certain criteria. What underpins the analysts' view is that weak economic trends and a lack of progress in developing onshore processing capacity indicates a strict ban would be counter productive. Secondly, the legal status of the ban remains unclear. A third reason is that implementing measures at the local level, even if there is legislative clarity, remains difficult.

JP Morgan expects the current status will continue, with the possibility of an increase to export taxes. This removes a potential source of supply tightness from nickel and, to a lesser extent, aluminum markets. A major improvement in Indonesia's economic conditions and outlook would be required to increase the probability of a stricter enforcement of the ban, in the analysts' opinion. The ban in question was originally enacted as a ministerial decree in 2009. The aim was to increase investment in value-added domestic processing capacity. The largest potential impact is on the nickel market. Indonesia supplies 24.8% of global primary contained nickel-in-ore and JP Morgan estimates China’s nickel pig iron industry is 60% reliant on Indonesian ores.

Coal is Indonesia’s largest commodity export by value but is exempt. The majority of copper ores are produced under Contracts of Work and are also exempt from the ban, which applies only to those operating under mining business licences (IUPs). Gold and silver are already refined onshore and so are also not affected. In 2012 Indonesia supplied 16% of global bauxite but there are alternatives to Indonesian bauxite, with India and Australia likely to increase supply in the event of prolonged Indonesian shortfall. Of note, Chinese pre-emptive stockpiling has been very aggressive. According to Wood Mackenzie estimates, Chinese smelters have accumulated around one year's worth of bauxite.

Falling productivity and rising commodity currencies have been major drivers of cost inflation in the minerals and mining sector over the past decade. This was preceded by cost deflation, which lasted 15 years through the 1990s and early 2000s. During that period costs for many commodities fell over 50% in real terms on falling input costs, such as labour and consumables, along with increased productivity and weak commodity currencies. The current dynamics warrant consideration of a return to such a scenario, in Goldman Sachs' view.

Productivity gains drove much of the cost deflation in the 1980s and 1990s, when competitive pressure in commodity markets ensured companies focused on productivity and asset utilisation. Goldman thinks there's some risk to commodity demand growth on the back of softening emerging markets growth. This could lead to the minerals sector returning to a time of deflation, meaning a protracted period of marginal cost pricing and renewed focus on productivity. The analysts' modeling indicates that a structural contribution (grade, strip ratio) was only 20% of the cost escalation from 2003 to 2012. It means a cyclical easing in input costs can be an important driver of overall cost deflation.

Improving productivity should deliver greater volume and falling cost curves. Goldman estimates 3-5% per annum of cost reduction over the next five years, affecting the cost curve support for various commodities. While this is not the analysts' base case, significant reductions to commodity price forecasts, margin compression and valuation destruction could ensue. Assuming long-term marginal cost support falls 10% across all commodities, valuations decline by 12% for BHP Billiton ((BHP)), 19% for Rio Tinto ((RIO)) and 21% for Fortescue Metals ((FMG)). BHP is the broker's preferred exposure in the sector because of valuation, the diversified asset base and lower downside risk in a cost cutting scenario.

Morgan Stanley finds, in volatile markets, the ability to generate strong cash margins is a key point of differentiation. Coupled with a sound balance sheet, these factors contribute to the ability to weather further volatility. C1 cash costs are arguably the most common tool used to rank miners within the same commodity group but Morgan Stanley contends this is often misleading, as it does not account for cash outflows required for operations, such as mine development, corporate overheads and debt servicing. The broker thinks debt is not necessarily a bad thing, as long as it can be serviced. Notably, PanAust ((PNA)) and Western Areas ((WSA)) made effective use of debt for mine development, which has led to good returns on invested capital compared with those of un-geared peers.

Most miners show upside against Morgan Stanley's base case valuations, even if near-term margins are weak. Current equity markets appear more focused on near-term macro concerns, which weigh on market valuation. The outcome of the analysis is that PanAust remains the broker's most preferred mining stock and Paladin Energy ((PDN)) the least preferred. What detracts from Paladin is a combination of weak cash margins, due to high corporate and debt servicing costs, and a stressed balance sheet, particularly at current depressed spot uranium prices.

Citi has moved the short-term view on European metals stocks to a more neutral stance, from bearish. The sector has rallied more than 20% from its lows but remains one of the worst performing sectors in the UK market. The analysts think there could be additional short term price momentum in the sector on positive rhetoric, especially from Glencore's capital markets briefing, scheduled September 10. Nevertheless, valuations are now looking more fully priced and the broker thinks the rally will fade towards the end of the year.

Earnings may be recovering but the upside appears capped. Spot commodity prices and foreign exchange suggest 10% upside to consensus earnings but this is primarily driven by higher-than-expected iron ore prices and weakening commodity currencies. This is only the second time in the past two years that Citi has seen positive earnings momentum in the sector. The large UK miners have now re-rated against the UK market, trading at a 10% discount but above the historical discount. The broker suspects the sector will start to run out of steam.

Citi also thinks large mining companies are taking the right steps to improve shareholder returns. Glencore-Xstrata is expected to announce aggressive cost-cutting targets and capex cuts which would be a warning to other mining companies to remain prudent. The broker retains a preference for Rio Tinto among the large cap UK diversified mining companies, followed by Glencore-Xstrata. The broker is underweight on gold and base metals companies and the least favoured name among the large-cap miners is Anglo American.
 

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