Material Matters: Caution On Aluminium And Silver

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By Chris Shaw

In the view of UBS, a second round of quantitative easing (QE2) is likely to be a game changer for commodities as it will mean strong international capital flows will reinforce already strong domestic credit creation in emerging markets.

UBS expects this will flow through to further strong commodity intensive growth in emerging market economies, so prolonging the bull market in commodities. To allow for this, UBS has revised its commodity price forecasts, while also adjusting its exchange rate assumptions for the Australian dollar against the US dollar higher.

Post the review, UBS has thermal coal, iron ore, palladium, copper and zinc as its preferred commodity exposures, while least preferred are uranium, nickel and aluminium as all of these markets look to remain well supplied.

In terms of the magnitude of changes to forecasts, UBS has lifted its copper price estimates by 7% in both 2010 and 2011 to US$3.38 and US$3.68 per pound respectively, while nickel and aluminium forecasts have risen by between 3-6% over the same period. Long-term price forecasts across the base metals are unchanged.

Forecasts for zinc have increased by 6% this year but are relatively unchanged in 2011, while UBS has increased its gold price forecasts by 2% this year to US$1,228 per ounce and in 2011 by 8% to US$1,400 per ounce (note: these price forecasts are all averages for the year).

Among the bulks, UBS expects producers will seek price increases to offset the weaker US dollar, so the broker has lifted its iron ore prices by 20% over the next two years and its metallurgical coal prices by 3-10% across the same period.

Long-term coal price forecasts have also been increased by 13% for hard coking coal to US$130 per tonne fob, by 22% for LV-PCI to US$110 per tonne fob, by 18% for semi-soft to US$110 per tonne fob and by 13% for thermal coal to US$85 per tonne fob.

UBS's new forecasts for metallurgical coal are now in line with consensus forecasts through 2011 but slightly below consensus for 2012-2014. Reflecting its bullish thermal coal view, UBS's forecasts in this market are 5-15% above consensus through the 2015 Japanese financial year.

There is reason for this bullish view, Standard Bank noting thermal coal prices continues to enjoy support from relative pricing in the energy complex and from significant exposure to emerging markets.

In gold UBS is now 4-9% above consensus until 2012, then 4-6% below the market until 2014, while in palladium the broker is 5-20% above market consensus through the next four years.

The changes to commodity price forecasts have meant changes to earnings estimates for Australian resource stocks. The largest changes have come in the coal sector as higher Australian dollar forecasts have pushed earnings estimates lower in most cases, though UBS notes its coal sector valuations have increased by 10-25% thanks to the increases in its long-term coal price forecasts.

The only change in rating caused by all these price revisions in Australia is for Gloucester Coal ((GCY)), which UBS has upgraded to a Buy from Neutral.

While UBS has aluminium as one of its least preferred metal exposures at present, Citi is similarly cautious on the metal's outlook, taking the view downside risks to aluminium prices have risen as incentives for lucrative financing deals put in place gradually shrink.

According to Citi, deals involving storing aluminium in warehouses and selling metal forward to take advantage of the contango in the aluminium price curve have artificially supported prices and boosted physical premiums for the metal.

But now the front end of the aluminium price curve has moved into backwardation, Citi sees scope for some of these financing deals to come under pressure, which could see metal released into the market. Supply is also an issue for prices in the broker's view, with attempts at limiting capacity in China proving unsuccessful.

For any successful long-term solution Citi suggests there must also be capacity closures in the West, particularly in the likes of the Netherlands, Spain and Germany. Citi is forecasting aluminium prices of US96c per pound this year, rising to US102c per pound in 2011 and US105c per pound in 2012.

Barclays Capital has looked more closely at silver prices following a year-to-date gain for the metal of 44%. This is almost double the gain in the gold price over the same period. At prices above US$24 per ounce, silver is now trading at levels last seen in 1980.

As Barclays notes, the strength in the silver price has seen the gold-silver ratio fall below its long-run average to less than 60, which implies silver is overvalued. Such a view is supported by the fact over the past decade, silver supply has outpaced demand.

Barclays expects total silver supply will hit a record in 2010 and then increase further in 2011, as while official sector supply has fallen in recent years this has been more than offset by increases in production. With new mines expected to ramp up in coming years, this trend is not expected to end anytime soon.

As well, Barclays suggests current silver prices are more than high enough to support future projects and developments as producers at present are not suffering from cost pressures thanks to cash costs on average of less than US$10 per ounce.

Demand in 2011 is forecast to fall short of 2008 levels, leading Barclays to forecast a market surplus excluding Exchange Traded Products (ETP) demand of around 5,000 tonnes next year.

With investment demand so critical to the market at present given silver has offered something of a safe haven, Barclays cautions if investors stop accumulating fresh metal to position against market uncertainties, prices could correct sharply before fundamental support levels are established.

Looking broadly at the commodities sector, Barclays Capital notes investment flows rebounded strongly in the September quarter to US$8.5 billion. This is the third highest level of quarterly flows in record.

Exchange traded commodity products remain the largest single investment category, with US$132 billion under management out of an estimated US$320 billion investment in commodity assets overall. Commodity index swaps are the next most popular with around US$127 billion invested.

While commodity assets have performed strongly over the past month or so Barclays remains positive, holding long positions in copper, crude oil, corn and gold. A bearish position is held in natural gas markets.

This reflects more positive sentiment towards growth sensitive assets on the back of expectations of further quantitative easing measures by the US Federal Reserve in particular and the weakness this has caused in the US dollar.

Such a positive view is not without risk, Barclays cautioning sentiment could easily turn more negative if markets prove to be disappointed by the scale of any Fed asset purchases, as such an outcome would likely see the US dollar strengthen. This in turn would likely cause some liquidation of speculative positions in commodity markets.

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