Rudi's View | Apr 12 2007
This story was first published two days ago in the form of an email sent to registered FNArena readers.
By Rudi Filapek-Vandyck
In case you wondered why share prices of companies such as James Hardie (JHX) and Boral (BLD) continue to underperform the broader market: securities analysts are still in the process of cutting their earning estimates on the back of a worsening outlook for the US housing sector.
Investors in base metals, however, have chosen to neglect the doom and gloom predictions for US housing with the bellwether for industrial materials, copper, swiftly moving beyond US$3.00/lb in the past week. This is a significant development because most resources analysts had not expected to see the metal back at these elevated price levels, not for many years to come.
So can investors in resources companies expect another wave of earnings forecast increases on the back of securities analysts playing catch up with reality one more time?
Don’t bet on it just yet. While some copper price forecasts for calendar 2007 are nearly one full dollar below the current spot price, most analysts will stoically await what the next few months will bring before deciding whether their price estimate requires adjusting. This is because most of them don’t believe current price developments are a true reflection of the market’s fundamentals.
Is it the fault of speculators, again? Some specialists believe so pointing at a general return of risk appetite since March which, in combination with ongoing elevated levels of global liquidity, has pushed hedge funds and the likes into commodities again.
Certainly, the price surge of base metals, and copper in particular, has been nothing short of spectacular over the past few weeks. At US$3.31/lb copper is priced 16% higher than at the beginning of the year and 30% higher than its price at the start of the Chinese New Year on Feb 14, 2007. And market watchers believe there’s more to come still in the weeks ahead.
So why would this price level not be sustainable? One factor analysts point at is the US housing sector with current sub-prime loan problems bound to aggravate the sector’s downward spiral. Some commentators believe the US will see a significant amount of houses coming on the market again as millions of home owners won’t be able to meet their mortgage obligations. According to the latest official estimates up to 2.4 million homeowners could be due to report failed loans. The anticipated over-supply in second hand houses might take years to be fully absorbed by the market. This is likely to depress demand for new houses and thus for building-related materials such as copper.
The US still represents circa 15% of global copper demand. An estimated 30% of this is related to the US housing sector which thus, in effect, determines a little less than 5% of global copper demand. Many bearish oriented market watchers don’t see anything positive coming from US housing for many months – at least. Meanwhile, the risks are skewed to more negative news, they believe, as the US economy as a whole is likely to weaken due to worsening housing sector problems.
Strategists at Merrill Lynch believe global industrial production will start trending south anytime soon with the broker’s global lead indicator signaling decline lays ahead. If accurate this should be a clear negative for industrial resources such as copper.
Given the metal’s bellwether status, as well as its importance for earnings of large diversified resources companies such as BHP Billiton (BHP) and Rio Tinto (RIO), as well as for second tier companies such as Newcrest Mining (NCM) and Oxiana Resources (OXR), copper’s price direction tends to show the way for the sector as a whole.
The team of resources specialists at Merrill Lynch believes investors are currently wrong in solely focusing on LME inventories, which have been declining over the past month, and ignoring signals such as that China’s inventories at the Shanghai Futures Exchange are expanding.
Merrill Lynch believes Chinese imports are bound to fall as the price of copper continues to climb. The broker suggests a large price correction between now and mid-year would seem inevitable.
But resources specialists at UBS believe any correction should remain relatively benign, partly because the Chinese authorities are expected to rebuild some of their reserves (they did the opposite in 2006). This should underpin copper demand throughout the year. In addition, UBS believes consumers who missed the chance to buy copper at prices below US$2.72/lb will rush into the market again, further strengthening demand.
UBS’s average price forecast for 2007 stands at a relatively bullish US$3.00/lb. This compares with Merrill Lynch’s average price forecast at the bottom of the market of US$2.35/lb for the year. As an indication of the size for the potential price fall Merrill Lynch experts are predicting, the broker’s price forecast currently implies an average copper price of U$2.60/lb for the first six months of the year followed by an average of US$2.10/lb for the second half of the year.
So far spot copper has averaged US$2.72/lb in 2007, and the trend is up.
The main difference between top and bottom forecasts in the market revolves around estimates of Chinese demand in the months ahead. China bought more than 24% of total available copper in 2006. Its weight in the global copper market is expected to increase further this year. It is therefore not difficult to see why experts at UBS and GSJB Were largely dismiss any loss of demand from US housing – as long as the US economy doesn’t fall into recession, they believe Chinese demand should keep the global copper market in deficit this year.
GSJB Were analysts recently raised their price forecast for 2007 to US$3.14/lb while noting this may still prove to be conservative. They are equally bullish for 2008.
Whatever happens over the next few months, one of the above views will be proven wrong. This is going to be either a significant catalyst for resources stocks as the majority of securities analyst will be forced to increase price and earnings forecasts, or it will be a major negative given the wide gap between most price forecasts and the surging spot price.
In China we trust?
