Material Matters: Recent Sell-Off Is But A Correction

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– Commodity sell-off a healthy correction
– Price risks remain to upside
– How to play the sector at present

By Chris Shaw

Early May saw a sell-off in commodity markets, Danske Bank offering five reasons for the price falls and why they should be regarded as a healthy correction in the sector rather than any change in direction for commodities on a medium-term view.

The first factor contributing to the correction in Danske's view was the market starting to question whether US$130 per barrel oil prices would impact on the global economy. As well, the market was long commodities including oil when the sell-off began, forcing a lot of investors to quit their positions.

At the same time the market was long the euro, which became the wrong position when the ECB failed to honour expectations of a June rate hike. As the euro was sold off against the US dollar, this reinforced the rout in dollar-denominated commodity prices.

While investors had been long commodities, Danske Bank's view is the market had run ahead of fundamentals to some extent prior to the sell-off. This is because commodity prices had risen in expectation of tighter future market balances, rather than actual supply and demand movements.

The final factor in Danske's view is recent PMI data out of China and the US suggest the global economy will enter a period of weaker activity in the next few months. This is likely to dampen commodity demand, so limiting price upside.

For Danske Bank this suggests commodity prices will be somewhat range bound over the rest of the year, with price risks still primarily to the upside. For oil this implies a range of US$110-$120 per barrel for Brent crude, with higher prices to eventuate if demand growth is stronger than expected or if OPEC decides against increasing supplies.

Forecasts have been adjusted to reflect this, Danske Bank now expecting an average Brent crude price of US$114 per barrel for 2011, down from US$116 per barrel previously. In 2012 Danske's average price forecast is unchanged at US$119 per barrel.

Among the base metals Danske has cut forecasts for all metals except aluminium, to reflect new lower levels for metal prices as a result of the recent sell-off. Upside appears limited in the September and December quarters thanks to weaker demand, but prices are still expected to edge higher in 2012 as the economic soft patch passes.

Danske Bank's average price forecasts for the base metals stand at US$2,602 per tonne and US$2,694 per tonne for aluminium for 2011 and 2012 and US$9,431 and US$10,125 per tonne respectively for copper. 

For zinc, Danske Bank is forecasting average prices this year of US$2,327 per tonne and next year of US$2,283 per tonne, while for nickel Danske expects average prices of US$25,664 per tonne and US$26,750 per tonne respectively.

Similar to Danske Bank, Citi agrees the shorter-term outlook for commodity prices remains difficult, even though the recent correction has brought prices back to a level that better reflects fundamentals. With headline inflation rates increasing across a number of economies there have been more instances of monetary tightening and this trend is expected to continue in coming months.

China, for example, is likely to have to tighten further to deal with its inflationary pressures and Citi cautions this could threaten growth. At the same time, quantitative easing in the US is likely to have soon run its course, which could make markets more vulnerable to price shocks. 

Assuming the end of QE2, some lingering uncertainty about a US economic recovery and further policy tightening in emerging economies, Citi sees scope for a move back to US assets and the US dollar. Such a move would be likely to add to pressure on commodity prices.

This could come at the same time as seasonally slower growth given the northern hemisphere summer. This sets the stage for a continuation of the short-term correction in commodity prices, with Citi anticipating an eventual resumption of the uptrend of the past several years.

Price performance in the sector will still be somewhat commodity specific, as for example Citi expects bulk commodities such as iron ore and coal should hold up reasonably well during the current period of volatility. This reflects solid demand and ongoing supply constraints. 

Forecasts stand at US$120 per tonne FOB Australia for thermal coal for JFY2012/13 and more than US$300 per tonne for coking coal through the second half of 2011. Iron ore prices should remain around US$180 per tonne this year before easing to US$150-$160 per tonne over the next couple of years in Citi's view.

In contrast, copper has likely seen its cyclical high according to Citi, as excess stocks in China continue to be run down and mine supply appears likely to improve. This leaves Citi forecasting prices of US$9,413 per tonne in 2012 and US$8,646 per tonne in 2013.

Among the precious metals, Citi still expects silver prices will revert to the mean, though this will now come from a much higher level. Citi is forecasting an average silver price for the second half of 2011 of US$31.60 per ounce, before falling to US$27 per ounce in the first half of 2012 and US$21.50 per ounce in the second half of next year.

To reflect this view, Citi has tactically lowered its weighting to the resources sector, as the recent correction has only reversed recent gains and prices remain on average around 30% higher than year ago levels.

Citi is now below index weight for resources in its recommended portfolio. The shift has been achieved by reducing the mining sector to a small overweight position and by moving the energy sector to an underweight position via removing Oil Search ((OSH)) from the recommended portfolio.

Within the resource sector, Citi's most preferred plays include Rio Tinto ((RIO)), Fortescue Metals ((FMG)), Medusa Mining ((MML)), OceanaGold ((OGC)), Western Areas ((WSA)) and Resource Generation ((RES)). Least preferred are Coal and Allied ((CNA)), Alumina Ltd  ((AWC)), Lynas Corp ((LYC)), Macarthur Coal ((MCC)) and Murchison Metals ((MMX)). 

Among the exploration and production plays in the energy sector, Citi has Australian Worldwide Exploration ((AWE)) as its most preferred, while least preferred is Beach Energy ((BPT)). 

RBS Australia's view is valuations for many miners now appear too compelling to be ignored, especially as commodity demand remains reasonably strong. With many miners pricing in lower commodity prices than current levels, solid earnings results are expected, something RBS Australia expects will see investors return to the sector.

Given such a view RBS Australia has offered a number of trading ideas for the sector. The first is Rio Tinto ((RIO)) over BHP Billiton ((BHP)), as on relative value grounds Rio Tinto appears the cheaper play.

The second idea is to buy Fortescue Metals, as the stock offers leverage to strong iron ore prices, significant production growth and impressive cash flows. At current levels Fortescue offers cheap valuation metrics as well according to RBS Australia.

Alkane Exploration ((ALK)) is also considered a Buy as the first of what is expected to be several Memorandum of Understandings for offtake of future production has just been signed. This adds confidence in the quality of Alkane's product and with a long life rare earth mine in place, RBS Australia sees value.

Given significant cost curve support in both alumina and aluminium, RBS Australia suggests buying Alumina ((AWC)), which is supported by strong cash flows and a low gearing position. An attractive dividend yield should also support the share price, while upside to RBS's valuation stands at around 20% at current levels.

OZ Minerals ((OZL)) should also be bought for the potential for value accretive exploration success at Prominent Hill and given improved valuation following a recent share price pullback. RBS Australia also likes Iluka ((ILU)), this given the potential for zircon prices to continue to surprise to the upside relative to current expectations. This should be more than enough to offset the negative earnings impact from the stronger Australian dollar.

Regis Resources ((RRL)) also looks attractive as RBS Australia sees potential for the DFS into the Garden Well project to be better than the market currently expects. As well, Regis offers gold exposure with a low level of operational and political risk.

Atlas Iron ((AGO)) offers value relative to net present value on RBS Australia's numbers, this reflecting high margin production, a growing cash balance and a suite of development projects offering additional upside potential. Atlas is RBS's preferred iron ore junior.

On the other side of the ledger, RBS Australia has Aquila Resources ((AQA)), the broker rating the stock as a Sell given some uncertainty over funding options for developing upcoming projects. With selling down some project ownership to fund the West Pilbara project a possibility, this implies some downside risk to current forecasts.

The other Sell for RBS Australia is Energy Resources of Australia ((ERA)), as there is seen to be downside risk from a strategic review if the conclusion is the heap leach and Ranger 3 Deeps projects are unviable. As well, RBS suggests operations don't have the capacity to absorb another significant rainfall event given the open pit mine is already flooded.

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