Material Matters: Gold, Nickel, Miners, Iron Ore And The Australian Dollar

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-Europe's gold pact lacks clarity
-Nickel bans are working
-Miners reduce earnings volatilty
-Which iron ore miners outperform?
-Australian dollar to remain robust
 

By Eva Brocklehurst

European central banks have renewed their longstanding pact on gold sales (known as the Washington Agreement) for a further five years. For the first time the new pact will have no actual limit. To Macquarie the pact is little more than a declaration that no large sales are planned. If the bankers change their minds they will liaise and co-ordinate any sales. Macquarie does not think they will change their minds and that is good news for the gold bulls.

The fact central banks have no plans to make large sales of gold is credible for Macquarie. Holdings are now at more reasonable levels in most member states and the economic situation in Europe is less conducive to gold sales than it was before 2009. Despite this, Macquarie's analyst finds the new agreement somewhat unsatisfactory. The maintenance of the pact without any limit on gold sales supports neither short-term stability nor long-term concepts regarding the practicality of gold as a reserve asset.

Citi remains bullish on nickel. The broker expects further upside to the price with a peak at US$26,500/t in 2016. The broker has a preference for Western Areas ((WSA)) and has initiated coverage of Independence Group ((IGO)) and Sirius Resources ((SIR)) on the back of the bullish outlook. Citi considers that removing Indonesian ore from the nickel market is equivalent to removing Saudi Arabia from the oil market. The broker expects Indonesia would generate more revenue from higher prices through companies PT Antam and PT Value than it would lose from nickel ore exports. Moreover, the ban's intentions are working, as at least four nickel pig iron/ferronickel projects are being considered in Indonesia.

Diversification does not measure risk. That is one of the conclusions from Citi's assessment of whether diversified miners are less exposed to commodity price volatility. The broker notes mining is capital intensive, and as much about capital deployment as about earnings. Citi argues that miners were undone in 2008 by their balance sheets rather than by their earnings streams, but concludes that the mining companies are marginally reducing earnings volatility and significantly reducing the overall value at risk.

The broker has run various scenarios and measured earnings and cash flow volatility against balance sheet risks, finding cash flows of the large mining companies are less volatile than their earnings streams. Capex has been significantly de-risked to changes in commodity prices over the past four years and the broker thinks large mining companies could defend their dividend yields and de-gear, even if there is a repeat of the 2008/09 pricing scenario. The broker believes the large diversified miners will outperform the sector in 2014 and favours Rio Tinto ((RIO)), BHP Billiton ((BHP)) and Glencore-Xstrata.

As iron ore prices sneak below US$100/t Macquarie has examined the operating levels at which iron ore miners will break even as well as maintain free cash flow. There is still value in the sector but the broker concedes the downside risk to forecasts and valuations, given the price at which spot iron ore is trading. Of the listed pure play producers only Mt Gibson Iron ((MGX)), Fortescue Metals ((FMG)) and Grange Resources ((GRR)) have managed to outperform the decline in the iron ore price. Macquarie prefers BC Iron ((BCI)) in the mid cap sector as it offers the highest yield and remains insulated against continued weakness in iron ore prices on a break-even price basis. Western Desert Resources ((WDR)) and Grange Resources offer the best exposure to lump and pellet premiums, in the broker's opinion. In terms of development, Sundance Resources ((SDL)) offers a number of near-term catalysts with the most significant being the selection of an infrastructure partner in the next few weeks.

JP Morgan has tested the outlook for the iron ore majors under a range of scenarios. Their free cash flow yields and valuations look attractive even under the bear case. The bear case is for growth in global iron ore demand around 2% per annum with a high proportion of the Chinese iron ore market displaced by lower cost imports and prices trending well into the cost curve. The broker's base case is for demand growth of around 3% per annum and iron ore prices holding above US$110/t until 2016, with a long term price of US$80/t. The bull case is for 5% growth in global demand, which requires Chinese production to re-start as growth in imports slows and this would mean prices trending back to US$125/t by 2018. BHP Billiton is buffered the most because of its diversification under any scenario, while Fortescue Metals ranks highest on a FY16 free cash flow yield of 12% followed by Rio Tinto at 5% on the bear case scenario.

The fall in the iron ore price has put some downward pressure on the Australian dollar, which is largely because of perceptions that such a fall in iron ore must suggest some weakness in Chinese demand. Commonwealth Bank analysts do not believe declines in either the iron ore price or the Australian dollar will be sustained. A lift in China's domestic supply of iron ore in the warmer months, from May to September, dampens prices at this time of the year and the analysts do not think the 7.5% fall so far is unusual.

Furthermore, while iron ore supply has increased over the last year, if the iron ore price were to average US$90/t for the remainder of 2014 global steel demand would need to contract 4.0% from 2013 levels. This is considered highly unlikely. The International Monetary Fund has forecast stronger global growth of 3.6% in 2014 and 3.9% in 2015. Despite this, Chinese steel output growth is expected to slow materially, to 3% in 2014 from 9% in 2013. This will result in global steel demand growth of 3%, slower than the 4.5% experienced in 2013 but, nonetheless, still growing.

In terms of the Australian dollar's sustainability, the analysts ask whether commodity prices or commodity volumes are the main driver of the currency. The currency is influenced by both, of course. Commodity export volumes influence real GDP via net exports but the stronger driver will be prices, because export prices influence Australia's terms of trade. Given the analysts' expectations that iron ore prices will recover to average US$115/t over 2014, a modest decline is indicated for Australia's terms of trade and, therefore, the Australian dollar. Moreover, there are other factors likely to underpin the Australian dollar, including the improving global economy, the country's relative interest rate advantage and a soft US dollar.
 

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