Material Matters: CNY And Commodity Prices, Oz Steel Updates

This story features BLUESCOPE STEEL LIMITED, and other companies. For more info SHARE ANALYSIS: BSL

By Chris Shaw

On the news China has removed the peg of the renminbi against the US dollar, commodity prices received a boost at the start of the week. However, the impact proved relatively short lived as prices have since faded.

The initial jump in metal prices was not unexpected, Standard Bank pointing out during the previous episode of managed renminbi appreciation against the US dollar and other currencies from mid-2005 to mid-2008 commodity prices enjoyed a sustained period of strength.

The bank notes the stronger renminbi during this period increased the purchasing power of Chinese participants in commodity markets. Given the expectation every base metal with the exception of aluminium will be in deficit in 2011, a stronger Chinese currency reinforces the bank's bullish fundamental outlook for commodities.

While a stronger renminbi is a general positive for commodity prices, the impact is unlikely to be felt evenly in the bank's view. Those metals where China is either self sufficient or a net exporter, which include aluminium and lead, are likely to see less of a positive impact from an improvement in Chinese purchasing power.

With any appreciation of the renminbi likely to be a gradual process, Barclays Capital doesn't expect the decision to be a game changing one for base metals. One potential impact in the group's view is operating costs for some metals could see some additional upward pressure.

For Barclays this suggests some of China's higher cost producers could become even less competitive at the margin than their international peers. An example is aluminium, where much of Chinese production is in the upper quartile of the global cost curve.

Macquarie is also not so positive a stronger renminbi offers fundamental support for commodity prices. Similar to Barclays, Macquarie expects any appreciation will be done at a slow pace, while the broker also agrees a stronger domestic currency will push up the cost curve for Chinese producers of metals.

The other factor relative to China is ongoing concerns slower growth in China may impact on that country's demand for raw materials. The construction market has been a featured market in this regard, though according to GSJB Were property bubbles appear to be mainly an issue for first tier cities and the higher end of the residential market.

Slower activity in these markets should be offset by a pick up in the pace of development of low-cost economic housing and by ongoing development in smaller cities and rural areas according to GSJB Were.

This implies while the rate of growth of Chinese demand for raw materials is slowing, absolute consumption is unlikely to contract. With GSJB Were expecting a moderately positive growth contribution from the OECD, overall there should be a significant rebound in global growth demand this year.

For GSJB Were this means the recent correction in commodity prices and associated equities has created an important buying opportunity for investors in the resource sector. The key is which commodity to be exposed to, the broker arguing those best placed are the commodities that have supply constraints in place.

In order of preference, GSJB Were likes platinum as its top pick, followed by metallurgical coal, gold, copper, crude oil, thermal coal and then iron ore. Commonwealth Bank also sees reasons to be positive on copper as recent data show the current market surplus of the metal is being reduced.

CBA expects this reduction will be enough to move copper from a small surplus this year into deficits from 2011 to 2013. This underpins the bank's expectation of strong copper prices during that period.

Macquarie suggests thermal coal could be one of the best performing commodities in the near-term as activity in the European coal market is actually supporting the case for stronger pricing. A potential tightening of supply is another positive, this stemming from export disruptions in both Indonesia and Australia and strike action in Colombia.

Less positive in Macquarie's view are market conditions in the zinc and lead markets, as the latest market data from The International Lead Zinc Study Group showed the markets for both metals were in surplus for the January-April period.

The surplus is worse in zinc, leading Macquarie to suggest further price weakness will be necessary to force some mine production offline. This should help rebalance the market, as any upside surprise in demand is unlikely. In contrast, lead demand remains strong, leading Macquarie to suggests its fundamentals are currently in better shape than is the case for zinc.

On a 12-18 month view Macquarie remains bullish on most commodities from current spot levels as markets are expected to tighten into 2011. The current pullback in prices is simply an earlier than expected correction, as Macquarie hadn't expected it to occur until the second half of this year.

Ongoing credit concerns in Europe and uncertainty about China's growth outlook suggests short-term commodities remain a risky play, but Macquarie sees value emerging for those investors willing to take a longer-term view.

Turning to the steel sector, Deutsche Bank suggests BlueScope ((BSL)), OneSteel ((OST)) and Sims Group ((SGM)) all face some earnings issues on the back of recent global steel price movements.

Weakness in spot prices recently implies around 4% downside to BlueScope's FY11 numbers on Deutsche's estimates, while weaker scrap prices suggest ongoing margin pressure for Sims Group. This leads Deutsche to suggest the FY11 outlook for Sims may be worse than the market currently expects, as evidenced by its FY11 net profit forecast being 12% below the market.

Short-term, Deutsche sees some potential for upside earnings surprise from BlueScope as higher coal costs won't impact on earnings until July 1st. This leaves BlueScope in a superior cost position relative to its competitors.

For OneSteel, Deutsche estimates current spot prices imply an earnings upgrade of around 5% to its forecasts, which supports its Buy rating on the stock. Deutsche similarly rates BlueScope as a Buy, the company being the broker's top pick in the sector. Sims Group is rated as a Hold.

As with Deutsche Bank, GSJB Were has factored in changes to commodity and currency forecasts and adjusted its earnings estimates across the Australian steel plays. For both BlueScope and OneSteel this means minor increases to forecasts in FY10 and similarly small cuts to FY11 estimates.

For Sims Group, GSJB Were has cut its numbers in both FY19 and FY11 by 9-10%. This results in a decrease in price target to $27.08 from $28.36. Targets for both BlueScope and OneSteel have also come down, to $3.66 from $3.69 for the former and to $4.72 from $5.04 for the latter. GSJB Were rates all three companies as Buys. The FNArena database shows sentiment indicator readings for BlueScope of 0.8 and for OneSteel and Sims Group of 0.4.

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