Production Reports Generally Disappoint

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This story features BHP GROUP LIMITED, and other companies.
For more info SHARE ANALYSIS: BHP
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The Macquarie analysts have drawn our attention to Newton’s third law this morning – that for every action there is an equal and opposite reaction. This, they suggest, goes a long way to explaining what’s happening to BHP Billiton ((BHP)) and to other resource stocks.

At the end of the day, BHP’s third quarter production report disappointed. Most of the disappointment stemmed from production delays in base metals due to planned and unplanned maintenance at different mines. This, say the analysts, is where Newton comes in.

Global commodity prices are high for two reasons – demand coming out of China et al, and supply constraints due to insufficient capacity and antique infrastructure. It took analysts a while to realise the China story was going to be as big as it is, from the demand side, but from the supply side analysts always assumed the old rule that demand breeds supply would serve to eventually bring prices back into line. This hasn’t happened to any great extent because capacity is simply being pushed to the limit, and is failing to cope.

Hence analysts have been forced to continually raise commodity price forecasts. This has had a material effect on the share prices of resource stocks such as BHP, particularly since numbers such as a 50% increase in the iron ore price have been bandied about. But why have analysts assumed such significant increases?

Yes, the China story is still firing along. But there is also a substantial effect from production constraint. Were mining companies not suffering from an inability to get the stuff out of the ground and across the ocean fast enough, then commodity prices would not be where they are. So if BHP had actually produced a better then expected production result, would that have been good for the share price?

The short term answer is probably yes, but if BHP was producing commodities at a rate faster than analysts had expected then the offset effect would that price expectations need not be as substantial as expected. If production exceeds, price forecasts should fall. If production disappoints, price expectations can be confirmed. If BHP had come out and announced a big jump in iron ore production for the quarter, for example, then those 50% price increase forecasts would quickly be tempered.

Although, last quarter’s production is somewhat old news. But BHP has also flagged that planned maintenance will continue, and there is always the risk, of course, that unplanned maintenance will crop up again as well. Thus analysts were somewhat underwhelmed by the result.

And Newton works not only on the production volume side, but also on the revenue side. It is well understood that mining productions costs are rising at an uncomfortable rate. This means mining companies are either forced to slash their margins, or forced to put their prices up. Given every mining company across the globe is in the same boat, it is likely the only result will be a price rise. So we’re back to another reason why iron ore might rise 50%, but not to a reason why this would mean an equivalent boost to BHP’s bottom line.

There has been  no change to the B/H/S ratio in the FNArena database following BHP’s production result, it remains at 5/5/0. There has been some movement in the average target however – it has jumped from $44.90 to $46.81 (yesterday’s close $46.00). The range is from $43.00 (JP Morgan) to $52.00 (UBS). One might expect that those with targets under or near the current share price are the Holds, and those above are the Buys. But this is not quite the case. JP Morgan is Overweight, while Citi ($48.00) is Hold.

That nobody is at Sell implies that everyone agrees BHP should form a part of any portfolio, and that is exactly analyst sentiment. Those with Buy ratings, even if their targets do not reflect such a rating, are positive largely because commodity prices can be a bit of  lottery, and all the recent expectation is that they will move higher. The Holds, however, just think investors are already building too much expectation into what those price rises may be.

The same can be said of Oxiana ((OXR)), except that Oxiana (a sort of mini BHP) is rated 5/3/2. Once again the Buy raters are focussing on commodity price upside, as well as Oxiana’s growth potential. The Holds don’t disagree, but they see the share price as already factoring in that potential. They are also becoming increasingly concerned about capex costs blowing out at the Prominent Hill mine, which is one of the projects offering said upside. JP Morgan (Underweight) simply believes the market is already assuming top level exploration success.

Oxiana’s average target is currently $4.00, against yesterday’s close of $3.83.

Newcrest ((NCM)) probably released the best received production report yesterday, as it contained no bad news. This was good news.

Whenever Newcrest has released a production report in the past, analysts have held their breath in anticipation of the next bout of disappointment from Telfer. But lo and behold, there wasn’t any. Production was a bit below what might have been hoped but still – analysts are beginning to feel more confident Telfer has turned the corner. Overall, Newcrest’s production was in line to slightly above expectation. The average target price has moved up from $27.73 to $29.46, but this is mainly due to some analysts taking the opportunity to lift their gold price forecasts. (Last close $28.94).

Analysts have been madly lifting their gold price forecasts of late, mainly due to their views on the US dollar. While this should be good for Newcrest, particularly given the company has now announced it’s buying back its hedge book, Newcrest still only rates a 2/8/0. Apart from the fact a lot of the excitement is already built into the price, a falling US dollar also means a rising Aussie dollar, and that is another scourge of the resource companies.

And when it comes to Newcrest, analysts still need to be fully and happily convinced Telfer – which should be Australia’s second biggest gold mine – is on track.

The Aussie weighs heavily on Gloucester Coal ((GCL)). All in all, Gloucester’s production report was in line or below expectations. Port congestion is an ongoing problem (which harps back to the antique infrastructure argument). Only three brokers in the FNArena database cover Gloucester, and the ratio is 1/1/1. Citi rates Sell because it believes shareholders are factoring in too much for a possible takeover battle. ABN Amro upgraded to Buy this morning given recent share price weakness.

The average target is virtually irrelevant, given three brokers manage to come up with a spread from $4.30 (Citi) to $5.46 (ABN). This probably sums up the dichotomy of opinions in the resource sector at present. Do you just buy with your ears pinned back on the China story? Or have stock prices already factored in years of high commodity prices?

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