Rudi's View | Mar 15 2007
This story was first published two days ago in the form of an email sent to registered FNArena readers.
By Rudi Filapek-Vandyck
It seems like there’s always something wrong nowadays for shares of natural resources companies. Either a continuous surge in product prices triggers fears for rising inflation, or a downturn in US housing causes fears for a slump in demand, or regulatory measures in China trigger investor panic that the world’s main growth engine might be in danger.
Who’d ever thought the Super Easy Super Profits in the slipstream of the Super Cycle would come to an end this Super Quick?
The sector seemed to have embarked on a solid recovery path in February, but what do you know, one day the Chinese stock market plummets by 8.8% and all securities analysts and market strategists seem to be talking about ever since is “risk re-assessment”.
Given the highly volatile nature of spot prices for energy and metals one could easily translate “risk re-assessment” as “natural resources, no thank you”.
Meanwhile signs are accumulating fundamentals for most basic products are better than what most securities analysts and other experts had been expecting.
Recently concluded contract negotiations for various coal prices surprised by more than 10%. Indications are that iron ore supply will not catch up with demand this year, as widely expected, but probably by next year handing the three leading producers another opportunity to negotiate a further price rise by year end.
Global steel prices too have significantly outperformed expert expectations. This has already led to revised forecasts at many stock brokerage. Various experts believe the outlook is for further price rises, possibly in the order of 10%.
As a result of a stronger than expected global steel market, prices for related resources such as molybdenum (used as an anti-corrosive and as a strengthening agent in steel) and chromite (used to derive chromium coating for steel) are now forecast to significantly surprise on the upside as well.
Spot uranium has jumped from US$75/lb to US$90/lb this year and experts have already started to look beyond US$100/lb now that Australia’s leading producer Energy Resources of Australia (ERA) has called force majeure on its contractual obligations due to flooding problems at its Ranger mine in the Northern Territory.
Admittedly, price swings for base metals and crude oil have been wild and at times erratic so far in 2007. Warmer than usual temperatures in the Northern Hemisphere are holding the price outlook for crude oil in the balance at the moment, but even if the outlook for a repeat of US$78 per barrel seems very distant, oil is still priced near US$60 per barrel and that cannot be labeled as “cheap”.
As far as the base metals are concerned, resources specialists at UBS recently pointed out the further potential for market upgrades as aluminium was trading 11% above 2007 consensus forecasts, while copper was priced 6% above consensus and nickel a whopping 78% above consensus.
Part of the expert community expects a better second half for many resources, including copper, so it would seem things can only improve further from here on.
So why aren’t share prices for the likes of BHP Billiton (BHP) and Rio Tinto (RIO) decisively moving closer to their twelve month price target?
Some market commentators have sought the answer in the lack of enthusiasm from US investors who’ve grown worried about the impact of the downturn in the US housing sector on global demand for the likes of copper, steel and nickel.
It remains yet to be seen whether US economic data will provide investors with enough confidence to fully embrace resources as a longer term investment again anytime soon. So far US economic indicators are ambiguous at best and ongoing news stories about deteriorating problems with sub-prime housing loans are scary, even under the more optimistic scenarios.
(Recent surveys have revealed whole housing blocks of up to 200 units in some cities have been abandoned by their owners who’ve given up trying to meet their mortgage requirements. At the very least this suggests a highly fertile ground for ongoing doom and gloom stories regarding US housing markets.)
The fact the US bond market is pricing in three official rate cuts throughout the remainder of calendar 2007 is not exactly a token of trust in the strength of the US economy either.
But what is likely of an even bigger importance than the rate of slowdown in US demand for natural resources, is the fact that everybody agrees prices for base metals will fall towards lower sustainable levels again. Current disagreements between experts relate to the timing and the rate of decline, not to the fact that prices will fall from elevated levels.
In my view this is likely to be the major impediment for resources stocks to close the gap between their share prices and the underlying valuations which are often between 20-30% higher. As such, we’re simply talking common human instinct: who wants to pay full price for an asset of which the underlying valuation is in decline?
Even if iron ore prices will again positively surprise next year, investors are likely to assume a price fall in the following year. Idem ditto for other resources. And, as already suggested by some experts, more positive surprises now may not necessarily translate into positive action as it might spark fears that future price declines may simply be more severe.
This is not to say there is no upside from current share prices of resources companies. Recent indications as mentioned previously are that price prospects for many resources are likely to be better than anticipated by cautious analysts and investors, however, the fact that prospects are for overall weaker market fundamentals -at some point- is likely to prevent share prices from fully reflecting their underlying value.
Resources heavyweights BHP Billiton and Rio Tinto have been among the highest recommended stocks in the Australian share market since the start of the current bull market in 2003. At present both stocks are rated nine times Buy with one Accumulate and nine times Buy plus one Hold respectively.
If my gut feeling is correct, both stocks are likely to continue enjoying many Buy recommendations for a long time still, but no longer because of the sheer endless upside caused by the economic awakening of China and India, but because investors are likely to remain hesitant to pay up today for something that may well decline in value tomorrow.
