Material Matters: Index Re-Weightings, Plus Miners With Cash

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

By Chris Shaw

January will see the annual re-weighting of various commodity index funds. Macquarie estimates there is US$220-$230 billion tracking commodity index products as at the start of this month, suggesting changes in index weightings can generate significant buying or selling of various commodities.

The two most important indices are the S&P GSCI and the Dow-Jones UBS Index, which together with other products that track the performance of these indices, account for about US$180 billion of the money in commodity index products.

On Macquarie's numbers, the split in terms of where money is invested is roughly US$109 billion in energy commodities, US$29 billion in industrial metals, US$18 billion in precious metals and US$59 billion in agricultural commodities.

The DJ-UBS index is the more important for the base metals given a higher weighting, while Macquarie notes the re-weightings that occur with respect to the DJ-UBS index tend to be far more significant given this index is weighted by dollar value.

In the view of Macquarie, it will be natural gas and zinc that will see significant buying when indices re-weight this time around. For zinc the broker expects buying of around 100,000 tonnes, which equates to close to 10% of monthly consumption and about 2.5% of monthly zinc cash 3-month open interest. Buying in natural gas is estimated by the broker to be around US$3 billion, which is close to 10 days of US consumption at 65BCF per day and US$4/MMBTU pricing.

In contrast, selling of nickel is likely to be around 15,000 tonnes, which is about 12% of monthly consumption and around 3.5% of monthly nickel cash 3-month open interest. Selling should also be significant in cotton, corn, coffee and silver, this reflecting the strong price performance of these commodities over the course of this year.

Macquarie notes index re-weighting tends to impact markets before any actual re-weighting takes place, so late December and early January is when any potential impact is likely to be most significant. Index re-weighting involves the selling of futures rather than physical products, meaning the price impact of any changes will be less than if it was genuine physical buying or selling in the market.

Citi has turned its focus to the financial position of the global mining market, the broker estimating by the end of 2011 there will be a net debt position of only around US$4 billion, this expected to improve to a net cash position of around US$72 billion by the end of 2012.

Driving the improved cash position is a combination of strong commodity prices and solid company balance sheets. Going on history, Citi suggests capex is likely to be ramped up as cash positions strengthen, but big ticket capital management initiatives are unlikely.

Along with capex, acquisitions have also been playing a big role in the sector, Citi noting since 2005 dividend payments of US$129 billion have almost been matched by acquisitions worth US$126 billion. This compares to total cash returns (dividends plus buybacks less equity raisings) of only US$63 billion since 2005.

With respect to BHP Billiton ((BHP)) and Rio Tinto ((RIO)), Citi notes over the past decade capex has accounted for 53% of BHP's cash spend and 37% for Rio Tinto's. This compares to an average for the global sector over the past five years of around 60%.

The combination of capex, acquisitions and returns has accounted for about 70% of EBITDA (earnings before interest, tax, depreciation and amortisation) over the past decade for both BHP and Rio Tinto on Citi's estimates. Over the next five years this is expected to fall to around 35%.

Citi's analysis suggests if both companies were to keep the same rate of spend over the next five years this would imply US$70 billion for BHP and US$50 billion for Rio Tinto. Citi expects a significant proportion of this spend is likely to be channeled to increases in ordinary dividends rather than buybacks.

This reflects Citi's view that while a buyback would deliver a one-off benefit to shareholders and be accretive in earnings per share terms, a pick up in underlying dividends would be a more attractive longer-term outcome. If both companies were to lift their yields to 5% it would soak up an extra US$4 billion and US$6 billion in spend respectively on the broker's numbers.

Both BHP and Rio Tinto are heavily involved in iron ore and it is this end of the commodities market that has received closer attention from UBS. As the broker notes, market consensus at present is for iron ore prices to halve over the next five years as a wall of new supply comes to the market.

For UBS the key to future prices will be when, if ever, and at what price, this new material actually comes to the market, as new projects typically experience delays and higher costs. As well, UBS argues demand for iron ore could easily exceed consensus expectations in coming years as these numbers look to be relatively conservative.

As an example, UBS points out its current forecasts are for a market deficit in 2011, a small surplus in 2012 and then much looser markets. But UBS also notes in the days after it made this market assessment BHP Billiton announced a delay and slower ramp up at its Rapid Growth Project 5. This is significant as this project was to contribute 40% of total production growth over the next three years.

On the demand side, UBS estimates if Chinese steel production growth was assumed to be 6% through 2015 rather than the 4% currently forecast, the global iron ore market would remain in substantial deficit through 2013 and would still be tight in 2014 and 2015.

This leads UBS to suggest the risk is the global iron ore market remains tighter than currently expected for another four years, which could result in the market upgrading its long-term price assumptions by 20% in two years' time. Australian iron ore plays would be sensitive to such an outcome, UBS offering Rio Tinto as an example.

On the broker's current numbers, Rio Tinto is trading at a 25% discount to fair value at present, but this fair value could increase by 20% if consensus price expectations for iron ore were increased. This would imply the Rio Tinto share price would need to rise by around 60% to reach fair value on a two-year view.

Relating this to the Australian iron ore stocks in its coverage, UBS has calculated how much its forecast base net present values would increase if iron ore prices remain stronger for longer. The increases range from 11% for BHP Billiton to 14% for Mount Gibson ((MGX)), 19% for Rio Tinto, 33% for Fortescue Metals ((FMG)) and 35% for Gindalbie Metals ((GBG)).

UBS has Buy ratings on all five companies, while the FNArena database shows sentiment indicator readings for the stocks of 1.0 for Rio Tinto and Gindalbie, 0.8 for Mount Gibson, 0.6 for BHP and 0.3 for Fortescue.

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