Material Matters: Precious Metals And UBS’s Preferred Oz Commodity Plays

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By Chris Shaw

In the view of Latin America and commodity specialists Hallgarten and Company, the fact gold appears to have run out of puff of late is no great surprise given the precious metal (alternative currency?) struggled to push above the US$1,250 per ounce level. Now, without the tailwinds of either inflation or the euro crisis to keep up momentum further weakness appears likely in the group's view.

This reflects Hallgarten's assessment that in an environment where the likes of Canada, Australia and China are tightening monetary policy and only the US is continuing to print money, inflation appears to be either under control or under attack by central bankers intent on stamping it out. Such an outcome is not favourable for gold or silver.

This view is at odds to that of Barclays Capital, who sees the combination of heightened risk aversion, fears of spiralling inflation and low interest rates as favourable for higher gold prices. While economic growth is expected to slow in the second half of 2010, so delivering surpluses in both gold and silver, Barclays sees these surpluses being absorbed by investment demand.

Barclays also sees underlying fundamentals in the gold market improving through the course of this year, as overall supply continues to fall and demand continues to improve. As well, Barclays points out gold often ignores fundamentals as it assumes its currency hat and acts as a safe haven alternative for investors.

Once there is greater comfort in the shape of any economic recovery and interest rates start to move higher in more markets then investor interest in gold is likely to wane, meaning jewellery demand will need to step in to provide a cushion to the market. Barclays expects this will occur, at levels higher than has historically been the case.

Hallgarten suggests US$1,100 per ounce and even US$1,000 per ounce are possible targets for the gold price in coming months if some of the market's current liquidity is taken back by central banks. Such a fall in gold may not be all bad in the group's view, as it suggests there could be a corresponding refocus on the broader metals space if this occurs.

With respect to China, Hallgarten suggests a return to more sustainable rates of growth in China mean that nation will still be a major metals importer, though low Western growth may mean China is simply compensating for lack of demand elsewhere rather than being a source of incremental demand growth.

This implies a more settled demand environment in coming months, something Hallgarten suggests is not a bad thing. The group goes further, suggesting prices of around US$3.00 per pound for copper, above US$1.00 per pound for lead and zinc and nickel below US$10 per pound would actually be a positive from a longer-term perspective.

Barclays remains more positive with respect to both gold and the platinum group metals (PGM), seeing further gains ahead. This positive outlook for PGMs reflects the view of Barclays auto demand will rebound this year, so improving market fundamentals given supply growth is likely to remain constrained. Growing investment demand will further tighten the PGM market in the group's view.

 

 

Last week UBS revised its commodity price forecasts, cutting its base metal estimates by 5-10% for 2010/11. Bulk commodity prices were largely unchanged, while precious metals forecasts rose marginally.

Having factored in the changes UBS has set its list of preferred commodities over the short to medium-term as thermal coal, copper, zinc and gold. Aluminium is the broker's least preferred exposure.

There are a number of key signals for commodity markets in UBS's view, the first being that China's physical traders in commodity markets trade on policy and not on macro data. As evidence mounts Chinese policy is to pause in terms of tightening, these traders may soon return to the markets and so support prices.

UBS also uses a dollar funding signal but notes this has turned amber at present as global monetary authorities have not followed up on liquidity injections from the middle of May. This suggests further volatility in investment markets for some time.

There are some specific factors to have caught the broker's eye as well, as in aluminium UBS suggests there is the potential for structural changes effected in recent years to allow alumina producers to break the current alumina/aluminium price linkage. This would see a switch to spot-based contract pricing as contracts roll off in coming years.

In thermal coal, UBS expects strong Indian demand and constrained supply from Indonesia to push prices higher by as much as 20% next year, while in zinc the stockbroker suggests years of underinvestment are likely to limit production growth and so generate a period of super normal returns over the next two years.

In terms of the earnings impact of the changes, UBS has factored in cuts to earnings estimates for BHP Billiton ((BHP)) and Rio Tinto ((RIO)) of 2-4% this year and 6-11% in 2011. Despite the changes both stocks remain top picks with Buy ratings given they are trading at discounts of greater than 30% to estimates of net present value while offering strong earnings growth in coming years.

Once commodity prices base out UBS expects cash flows for both companies to be re-rated, especially as growth projects are phased in or as capital management initiatives are introduced. UBS's overall view is now is time to accumulate exposure to such companies, though there is no rush to get set given current conditions remains difficult.

Other Australian stocks on UBS's list of preferred commodity plays are Newcrest ((NCM)) given a positive view on gold prices, Alumina Ltd ((AWC)) for scope to higher returns from any break in the alumina/aluminium price linkage and Riversdale Mining ((RIV)) given it is a potential M&A target in the coal sector. All three score Buy ratings from the broker.

Among the Australian stocks favoured by UBS the FNArena database shows Sentiment Indicator ratings of 0.7 for BHP Billiton, Alumina and Newcrest, 0.9 for Rio Tinto and 0.4 for Riversdale.

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