Material Matters: Picks For 2011, Nickel and PCI Coal Updates

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 By Chris Shaw

The drawing to a close of 2010 has seen a number of brokers offer their views on how 2011 might shape up for commodity markets and the latest is BA Merrill Lynch, which maintains its bullish stance on the metals and mining space.

BA-ML expects commodity prices will move broadly higher next year thanks to growth in emerging markets, as this should counter relatively weak growth in developed markets. Liquidity should also act as a catalyst for prices, as commodities will be a place to hide from inflation and currency concerns.

As Exchange Traded Funds or ETFs enter the commodities market, BA-ML suggests there could be a significant impact on the supply/demand balance for metals. While this will increase price volatility, the broker expects higher prices will also result.

Concerns over potential increases in Chinese interest rates are being overplayed in BA-ML's view, as it notes during the last rate hike cycle in that economy in 2006 to 2008 the mining sector actually outperformed.

In terms of how best to play this positive view, BA-ML sees the earnings upgrade trend as very important as higher earnings will be reflected in higher share prices. The best exposure in this regard according to BA-ML is iron ore with 20% mark-to-market upside, while copper and coal also look positive.

Another important theme for the sector according to BA-ML is consolidation, which is expected to continue through the next several years. Driving this trend is likely to be China, which is expected to attempt to address situations where it is structurally short of a particular commodity. This implies action in copper, iron ore, metallurgical coal, bauxite, mineral sands and uranium.

With respect to specific stock picks, BA-ML's top selections are Rio Tinto ((RIO)), Fortescue Metals ((FMG)), Newcrest ((NCM)), Oz Minerals ((OZL)), Iluka ((ILU)), Paladin ((PDN)) and Macarthur Coal ((MCC)). These stocks offer from 9-36% upside relative to BA-ML's price targets.

There have also been some commodity conferences as the year comes to an end, with RBS attending the 2010 Metal Summit. The broker notes speakers at the Summit were bullish on the outlook for metals, with strong copper demand anticipated to deliver higher imports and premiums in China. The demand outlook for aluminium is also strong, but in this market RBS notes overcapacity and rising raw material costs remain key points of concern.

In terms of the Chinese government's 12th five-year plan, RBS notes the aim is better control over metal output in coming years. The big issue in the broker's view is whether capacity growth can be controlled effectively to achieve this goal and here the outcome is currently uncertain.

Goldman Sachs was at a mineral sands conference where the likes of Iluka Resources ((ILU)) and Mineral Deposits ((MDL)) gave presentations and were similarly bullish in their comments. The main reason for the bullishness in the broker's view is the lack of new mineral sand projects nearing production.

Goldman Sachs notes analysts speaking at the conference pointed out new projects in the sector will realistically only replace existing projects that are being depleted, meaning there won't be any meaningful volume increases in the market.

As well, other comments at the conference related to the Chinese zircon market indicated there is a significant shortfall in domestic supply at the same time as consumption is increasing sharply. This should ensure markets remain tight for some time.

Given the generally bullish sentiments expressed at the conference matches its own view, Goldman Sachs is comfortable retaining its Conviction Buy rating on Iluka, with a $9.50 price target. Mineral Deposits is also rated as a Buy with a price target of $8.00.

Consensus targets for both stocks according to the FNArena database stand at $7.70 for Iluka and $5.05 for Mineral Deposits, while respective Sentiment Indicator readings are 0.6 and 0.0.

Turning to nickel, Citi's analysis of the market suggests supply disappointments are still likely as laterite leaching projects in particular have continually fallen short of expectations, both during ramp-up and in terms of the ultimate level of production achieved.

As Citi points out, while there is no shortage of proposed new nickel projects, leaching projects account for half of the potential increase in supply. Assuming ongoing technical challenges and higher operating and capital costs at these projects, Citi sees scope for a major impact not only on nickel supply but on prices in coming years.

Assuming a market where such projects reach only 75% of capacity over a five-year ramp-up, Citi estimates the nickel market in 2013 would move from a market surplus of around 124,000 tonnes to a sustained deficit through 2015.

Under a more bearish assumption where a number of these new projects simply fail, the market's likely deficits would be significantly larger. To date Citi has not changed its base case nickel price forecasts, but the broker points out the risks to these forecasts are rising as its analysis suggests the disappointing outcome is becoming increasingly likely.

At present Citi is forecasting nickel prices of US$24,895 per tonne in 2011, US$23,675 per tonne in 2012, US$21,364 per tonne in 2013, US$19,053 per tonne in 2014 and US$16,250 per tonne in 2015. Under the broker's disappointment scenario prices could reach as high as US$33,069 per tonne in 2015, while under its failure scenario it suggests prices could hit US$39,683 per tonne in the same year.

Deutsche Bank has conducted a fresh analysis of the PCI (Pulverised Coal Injection) coal market, which typically trades at a discount to premium coking coal of around 25%. What the broker's analysis shows is under a value in use calculation, a discount as low as 10% could be justified.

Demand for PCI is a function of the number of blast furnaces designed to handle the material and the injection rate that is allowed for, while Deutsche notes it actually offers a number of advantages in that it results in lower consumption of coking coals, it extends the coke oven life, improves blast furnace productivity, reduces emissions from steel plants and improves the consistency in terms of the quality of hot metal.

This leads Deutsche to suggest PCI value is not being fully captured in current prices. Assuming PCI closed the gap somewhat to premium coking coal, this would mean increases to earnings among the Australian coal plays.

As an example, Deutsche notes if the PCI discount to premium coking coal closed to 10% there would be a FY12 earnings per share (EPS) increase for Macarthur Coal ((MCC)) of around 18%, while for Whitehaven ((WHC)) the increase would be around 9%.

As both stocks currently trade close to Deutsche's price targets, there is no change to the broker's Hold rating in either case. Deutsche's price targets stand at $12.70 for Macarthur and $7.00 for Whitehaven, while consensus price targets according to the FNArena database stand at $12.79 and $7.21. Sentiment Indicator ratings for the companies are 0.1 for Macarthur and 0.3 for Whitehaven.

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