Material Matters: Resource Stocks, PGMs, Coal Risks And Mining Volumes

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

By Chris Shaw

Since the end of June, the Small Ordinaries index has gained 19% which suggests solid outperformance compared to the 7% rise in the ASX100 large-cap index. In the view of UBS this outperformance is likely overdone, particularly as it has been a 31% increase in the Small Resources index that has driven the gains.

This compares to an 11% increase in the Large Cap resources index, while UBS notes the gains also reflect a higher resources weighting for small cap stocks in general. The gains among the small resources mean the Small Ordinaries are now trading at a 95% relative earnings multiple to the ASX100, which UBS points out is above the long-term average of 88%.

UBS estimates the Small Resources index alone is trading on a relative earnings multiple of 103% at current levels, which is also well above its long-term average of 81%. In the broker's view this supports a switch from small cap resources into larger cap plays.

In particular UBS suggests investors switch into the large cap bulks such as BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)). Supporting this view is the broker's current commodity preference for bulks compared to base metals.

The other supportive point highlighted by UBS is the stronger Australian dollar, and higher commodity prices appear to be the main drivers of the small cap sector at present. But a strong level of correlation between the Australian dollar and the Small Caps index suggests if the Aussie currency does take a breather, it is unlikely small cap stocks will continue to outperform.

Turning to coal markets, Deutsche Bank suggests while underlying drivers remain positive there is scope for some short-term price weakness. This reflects recent trends of power generators holding sizable stockpiles and not re-stocking and the potential for energy efficiency goals to reduce coking coal consumption.

Over the medium-term, Deutsche continues to see coal prices moving higher which along with an expectation of rising production is reflected in its earnings forecasts for the Australian producers. Short-term however Deutsche sees downside earnings risk from the stronger Australian dollar, the impact ranging from 5-8% in FY11 to 13-20% in FY12 based on current spot currency rates.

Factoring in this risk sees Deutsche retain its Hold ratings on Centennial Coal ((CEY)), Macarthur Coal ((MCC) and Whitehaven Coal ((WHC)), with respective price targets of $6.20, $13.00 and $6.00. By way of comparison, Sentiment Indicator readings according to the FNArena database stand at minus 0.3 for Centennial, minus 0.2 for Macarthur and 0.2 for Whitehaven.

In the precious metals, Citi has lifted its platinum group metals basket price forecasts to reflect a more bullish outlook for palladium. This reflects the expectation the palladium market moves into a rising deficit from 2011 onwards, which contrasts to expectations for a medium-term surplus in the platinum market.

For palladium Citi expects strong production growth in gasoline-based markets and a likely depletion of Russian stockpiles over the next 12-24 months. For platinum however, Citi sees rising mine supply and growing auto catalyst recycling as being enough to outstrip the expected growth in demand.

Citi's new forecasts for palladium stand at US$492 per ounce this year, US$575 per ounce in 2011 and US650 per ounce in 2012, up from US$447, US$450 and US$400 per ounce previously. The broker's long-term price forecast has increased to US$450 per ounce from US$400 per ounce previously.

While not as bullish on platinum, Citi has also lifted its price forecasts for that metal in 2010 to US$1,585 per ounce, in 2011 to US$1,625 per ounce in 2011 and to US$1,600 per ounce in 2012. Previous forecasts were US$1,548, US$1,600 and US$1,500 per ounce. There is no change to Citi's long-term price forecast for platinum of US$1,500 per ounce.

Elsewhere in the precious metals, Standard Bank's Gold Physical Flow Index remains in negative territory, meaning there is continued resistance in the physical market to higher gold prices. This resistance tends to weakens as gold approaches US$1,300 per ounce, a trend the bank expects will support the gold price over the next few weeks.

Looking more generally at the resources sector, Citi notes there continues to be a strong correlation between earnings growth and the earnings multiple at which a mining company trades. The important element of this for the broker is much of the premium being paid for the earnings growth on offer is a function of the commodity price cycle.

What this means is volume growth is often overlooked, especially in a flat commodity price environment. This is significant, as Citi's base case forecasts imply stable to declining commodity prices over the next three to five years.

This means earnings momentum can come either from volume growth or by reducing costs, with Citi expecting the former to be of greater significance. As an example, the broker is forecasting on a copper equivalent basis, Australian mining sector volume growth of around 39% over the next three years.

Given some companies are expected to grow volumes by more than 100% over this period, Citi suggests with a flat commodity price environment it becomes even more important to pick the stronger volume growth companies to generate earnings momentum.

Having assessed the companies in its coverage universe, Citi suggests the market appears to be undervaluing the volume growth on offer in Kingsgate Consolidated ((KCN)), Medusa Mining ((MML)) and Fortescue Metals in particular and to a lesser extent in Whitehaven Coal. Citi rates all four stocks as Buys.

At the other end of the spectrum Citi suggests the market is paying up for promised growth from Riversdale Mining ((RIV)), Paladin Energy ((PDN)) and Platinum Australia ((PLA)). Citi's analysis also shows some relative opportunities, the broker highlighting Medusa over Newcrest Mining ((NCM)), Panaust ((PNA)) over Oz Minerals ((OZL)) and Fortescue over Macarthur as examples.

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