Here Come The QE2 Commodity Price Upgrades

This story features ALUMINA LIMITED, and other companies. For more info SHARE ANALYSIS: AWC

By Greg Peel

Citi analysts note the Fed is ready to add to the US$600bn of QE2 so far announced were US economy to prove slow to respond, but do not think additions will prove necessary. That does not, however, detract from the fact the analysts see a weak US dollar, low interest rates and low inflation dominating the new US environment for the foreseeable future. Such an environment is supportive of commodity prices.

While the shift in China from an export-focused economy to a domestic consumption-focused economy will ultimately reduce commodity intensity, it will be a prolonged transition, Citi suggests. In the meantime, emerging market demand growth, with India now an important driver as well, will continue to put upward pressure on commodity prices. Throw in increased commodity demand from speculative fund investment, with QE2 a backstop, along with further exchange-traded fund introductions on metals et al, and the scene is set for some significant price increases in Citi's view.

To that end, the analysts have made some substantial increases to their 2011 commodity price forecasts. Their forecast aluminium price rises 16%, alumina 8%, copper 26%, nickel 18%, zinc 25%, thermal coal (used for electricity production) 8%, gold 18%, oil 4%, zircon 22% and rutile 8%.

Note that while some of these increases look rather steep, the end result depends on what Citi's previous forecasts looked like. For example, the 26% copper forecast increase equates to US$4.14/lb, which is only 6% above current spot, while a new gold price of US$1444/oz is only 3.5% above current spot compared to Citi's 18% increase. Commodity analysts will always play to the conservative side of year-average price forecasts and prefer not to change them too often.

It is nevertheless a constant dilemma for resource stock analysts. If they changed their assumed commodity prices in their models every time there was a spot price movement then they would equivalently have to change their mining company forecast earnings and target prices as a result. Were price targets to move around with abandon, investors would soon lose faith in the value of the analysts' views.

On the flipside, typically analysts rejig their commodity price forecasts once a quarter. In this day and age, once a quarter can mean quite substantial moves in forecasts following an update and, as a result, quite substantial forecasts earnings and target changes for mining companies. It is not unusual for a Hold rating to suddenly become a Buy rating after such an update, for example.

So the trick is to update forecasts not too often but not to infrequently either. And clearly something like QE2 is grounds for what might constitute an “extraordinary” price update.

Notably, Citi has not upgraded its iron ore and coking coal forecasts. But that is only because the analysts were already bullish on these commodities as reflected in their price forecasts and are just pulling everything else into line. Copper is Citi's preferred metal exposure, but coking coal (used for steel production) is Citi's preferred overall commodity exposure. Gold, suggests Citi will be the biggest direct winner from QE2.

The other side of the coin for mining companies, however, is resultant increases in local currency values against the US dollar which reduce the value of revenues once translated back to local currencies from US dollar-priced sales. Aside from the soaring Aussie, Citi notes Australia's big diversified miners are also being hit by increases in, for example, the Brazilian real and the South African rand.

Hence as a very rough rule of thumb, we might say that commodity price increases based on US dollar devaluation are offset by exchange rate increases for local currencies. However, an offset assumes static volumes, so the swing factor is rising demand.

This relationship is best exemplified by Citi's downgrade of Alumina Ltd ((AWC)) from Hold to Sell. Price forecasts increases for aluminium and alumina are more than offset by an increased Aussie forecast, the analysts note, and that's only taking the Aussie to US$0.96 in 2011 when it's currently over US$1.01.

Alumina is trading at an historically high multiple of 20x 2011 earnings, Citi calculates, based on M&A speculation. The analysts point out that Alumina has been subject to takeover speculation ever since the company spun out of the old Western Mining back in 2002. The previous year, Alcoa had made an unsuccessful bid for all of Western Mining. Today, Citi suggests Alcoa does not have the balance sheet to take out Alumina alone.

There might be some Chinese interest, but realistically Citi implies investors could die waiting for an AWC takeover and a lack of takeover would mean significant downside to the share price.

For the big diversifieds BHP Billiton ((BHP)) and Rio Tinto ((RIO)), upgrades to Citi's base metal, thermal coal and (in BHP's case) oil forecasts are only partially offset by upgrades to the Aussie and other relevant currencies.

Citi has lifted its BHP earnings forecasts by 2-9% in FY11-13 as a result, but has left its target price at $50 with a Buy rating. Increased revenues will be offset by capex increases, Citi notes, for BHP's Pilbara iron ore expansion but also by rising costs in the general mining and oil & gas production games as higher end-prices flow back to tighter supply of equipment and labour.

Citi is assuming BHP's attempted takeover of Potash will not succeed given initial Canadian government disapproval. It is then likely BHP will look to make oil-related acquisitions instead given the company is unlikely to run into competition issues with oil, unlike iron ore for example. Citi further suggests that a spin-off of BHP's oil assets into a separate entity would remove the “mega-cap” perception and subsequent valuation drag suffered by Big BHP.

Citi's earnings forecast upgrades for Rio come in at 2-5% over 2011-12 but with similar Pilbara expansion affecting greater capex, the broker has also left its Rio target unchanged at $100 with a Buy rating.

Once upon a time, mineral sands producer Iluka ((ILU)) was one of the most heavily impacted on the earnings line by increases in the Aussie dollar. But year to date, the Aussie has risen 12% (with a few fluctuations in between) while Iluka's share price has doubled in the same period.

The Aussie still very much impacts on Iluka's bottom line, but the difference in 2010 is a substantial tightening of the zircon market due to increased demand and limited supply. Despite the already strong rise in the zircon price, Citi has lifted its 2011 forecast by 22%. The analysts also now foresee similar global tightness impacting on the titanium oxide market, for which rutile is the feedstock.

Forecast price rises in 2010-11 are not enough to overcome the Aussie's surge, but Citi has lifted its 2012 earnings forecast for Iluka by more than 50%. This leads to a target price upgrade to $8.30 from $6.30 with a Buy rating intact.

Post the Citi target price upgrade, the consensus target price in the FNArena database sits at $6.57. But the range is significant, from Citi's $8.30 down to Macquarie's $4.75 (current trading price $7.46). Macquarie is not as bullish as its peers on mineral sands prices and is the only Sell (Underperform) rating in a Buy/Hold/Sell ratio for Iluka of 4/2/1.

Of course, a lot depends on where one sets one's currency assumptions, as well as commodity price forecasts.

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