Material Matters: Thermal Coal, Iron Ore, Resource Stocks, Gold And Gold Stocks

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-US coal exports decline
-Iron ore oversupply overstated?
-Time to accumulate quality
-Gold price hovering at critical point
-Volatility to stay high for gold stocks
 

By Eva Brocklehurst

Could the thermal coal price be about to turn? Weak seaborne thermal coal fundamentals are showing signs of reversing, in Morgan Stanley's opinion. With prices sitting at 4-year lows over 10 weeks, the market has not been supportive of spot Australian export (Newcastle) thermal coal prices but it appears that pressures that have been in sway since early 2012 may be easing.

Firstly, US coal exports are declining. The broker observes that for the past two years low US gas prices ate into US demand for coal power generation, driving US prices lower and US exports higher. Although still elevated, US exports are now seen annualising less that 40m tons against 45.6m in 2012. Secondly, Chinese electricity production has strengthened every month since April, supported by industrial demand, while China's hydro generation is also lower than in the past two years. Thermal generation is higher and Chinese coal inventories are at their lowest level in the year to date. Another key aspect is slowing supply growth. Glencore's decision to put its Wandoan thermal coal project on indefinite hold in Australia did not surprise Morgan Stanley and it suggests the correct price signal is being sent to producers in an oversupplied market.

CIMB has questioned the assumption that supply growth in iron ore will stay strong and deliver large surpluses from 2015 onwards. The assumption is based on the large project pipeline and relatively healthy prices, but CIMB thinks it's too optimistic and the market is giving too much credence to company timetables, while not factoring in significant capital costs which should act to constrain projects. There is a wide range of supply forecasts outside of the broker's own forecasts, ranging over the next three years from 260m tonnes to 430mt. CIMB has reviewed historical forecasts of iron ore supply and found that, over the past five to six years, the market has over estimated supply by between 100mt and 450mt in various years. While there have been unexpected events, such as the financial crisis in 2008 which caused demand to collapse within a few months, in general the market has consistently over estimated supply.

The broker maintains a price forecast of US$130/t in 2014, US$127/t in 2015 and US$121/t in 2016. Historically, prices have traded around the 90th percentile of the cost curve (currently at US$96/t) over the medium term. Thus, the size of the market surplus or deficit can also have a material impact on prices. Deficits have seen a price premium over the 90th percentile of between US$40-$80/t, while surpluses have seen this switch to a discount of US$10/t. With a tight market until 2015, the broker thinks prices will remain elevated. As the market enters surplus in 2015, prices are expected to ease but still be resilient. CIMB, at the top of consensus estimates, envisages the market will upgrade price forecasts as supply growth disappoints and Chinese steel consumption forecasts are re-based after a strong 2013.

RBS Morgans thinks, during a period when resource stocks are unfashionable and commodity markets struggle to create price tension, it might be smart to accumulate stocks such as BHP Billiton ((BHP)) and PanAust ((PNA)), which appear to be good buying in current weakness. The broker suggests that flat commodity prices, indecisive outlook commentary and a lack of catalysts are the reasons why investors have put resource stocks out to grass. This is all despite the fact that the "hard landing" that was feared for the Chinese economy last year has not eventuated. RBS Morgans notes China has just reported very strong increases in steel demand and industrial output, all while inflation and the property market remains in check. RBS Morgans expects 2014 is the year when some synchronisation will return to global growth.

So now is the smart time to accumulate value among high quality mining stocks, in the broker's view. The market continues to reward companies that can demonstrate material growth in free cash flow that's available for dividends. Quality big caps like BHP, Oil Search ((OSH)) and Santos ((STO)) fit this category, and are expected to be the best performers in the sector. RBS Morgans is waiting for a more attractive entry point for Rio Tinto ((RIO)) and Fortescue Metals ((FMG)), should unexpected iron ore strength moderate. The broker distances from companies that are still investing significant capital, on which cash returns are some years away. These include Whitehaven Coal ((WHC)) Atlas Iron ((AGO)) and Newcrest Mining ((NCM)). The gold sector is undergoing a major shake up. Hence, RBS Morgans thinks it is difficult to play. As the US economic recovery is showing signs of being slow, gold remains in a short-medium term downtrend. Upward spikes in the US recovery, or political and military crises, may instigate a bounce in the precious metal but the broker is inclined to see this as just relief rallies in a broader downtrend.

Looking closely at the gold sector JP Morgan finds there are two key investor concerns. These are a lack of conviction in the next major move in the gold price and an improved understanding of just what makes up the all-in costs of production for gold. Gold equities enter FY14 under significantly changed operating conditions, with lower prices eroding margins and lower price expectations prompting a shift in focus towards profitable production. Earnings momentum remains the primary driver of share price performance. Of Australian gold stocks the broker prefers Regis Resources ((RRL)) as a quality exposure. JP Morgan is also Overweight on OceanaGold ((OCG)), for leverage.

The gold price of US$1200/oz is a key inflection point in FY14 with just over half of assets under the broker's coverage expected to be cash flow negative below this level. Hence, gold stocks are expected to remain volatile and this reflects the tight cash margins producers face. With spot gold hovering not far above the cash break even it means the majority of companies under coverage in FY14 will be significantly affected by a major movement in the price.

JP Morgan also expects to see a growing trend in reserve to resource re-classification in the gold sector, to reflect revised economics under more conservative price and cost assumptions. The debt maturity profiles are also under scrutiny. The broker notes, for stocks under coverage, impairment charges have contributed to an average 5% increase in book gearing. Investors are increasingly questioning miners' ability to repay debt. The most exposed to debt levels are Newcrest and Evolution Mining ((EVN)). A sustained US$200/oz fall in the gold price is seen as likely to prompt a de-gearing of balance sheets. In summary, despite a mildly positive view on the gold price – JP Morgan expects FY14 to average US$1345/oz – the broker suggests a conservative bias for long-only investors, given the expected volatility in gold prices and slim cash margins around spot prices.
 

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