Material Matters: Still Value In Oz Miners; Update On Bulks

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– Citi sees value in base metals sector, prefers copper exposure
– Cost pressures rising for Australian miners
– Diversifieds and some coal plays best placed
– Still support for iron ore and met coal
 

By Chris Shaw

In the base metals sector Citi notes price remain well off their February highs, raising the question of whether longs should exit or investors should look to add to their positions in the sector. The broker's view is prices are undergoing a pause as the global economy has lost some steam. There have been other factors as well, including a spare parts shortage in Japan and recent strength in oil prices.

Both of these issues seem temporary, which suggests to Citi now is a good buying opportunity in the base metals sector. Having said that, the broke cautions there have likely been better risk/reward opportunities at other times over the past two years.

Citi prefers copper among the base metals, followed by aluminium, tin and nickel. Short-term the prospects for both lead and zinc appear less positive. In terms of price, copper is expected to make some gains over the second half of 2011, though Citi expects these will be more modest than some in the market are expecting.

Aluminium prices should continue to see support above US$2,500 per tonne, this thanks to energy prices staying high and Chinese power cutbacks impacting on production. Nickel in contrast will likely suffer from still sluggish stainless steel demand and solid supply levels, while stocks are expected to continue to increase for both lead and zinc.

In terms of forecasts, Citi expects aluminium will trade between US$2,500-$2,800 per tonne over the second half of 2011, while copper prices may return to US$10,000 per tonne but then struggle to stay at that level.

Citi sees nickel range trading between US$21,000-$26,500 per tonne in the coming six months, while the range for lead is forecast to be US$2,450-$2,750 per tonne. Zinc prices may see some rallies towards US$2,400 per tonne, but Citi suggests lending the metal at such a level.

Taking an Enterprise Value assessment of the commodities sector, Citi remains of the view mining stocks remain favoured over steel companies at present. For all resource-related sectors EVA creation, which is returns in excess of the cost of capital, are expected to decline in coming years.

Citi is forecasting EVA creation of 14-15% over the next three years for miners, which compares favourably to estimates of negative 1.2% EVA for the steel sector for the same period.

To play such a theme via stocks listed on the Australian market Citi prefers Fortescue Metals ((FMG)) and Rio Tinto ((RIO)).

For BA Merrill Lynch, the past few months have been characterised by evidence of rising cost pressures for Australian miners. To date this has not resulted in a margin squeeze as revenues have risen as fast as costs but BA-ML sees a risk of margin pressure if there are not further price increases for metals.

The major cost risks appear to be related to the stronger Australian dollar, as well as rising fuel and labour costs. Assuming there is some impact on margins, BA-ML expects an associated earnings impact and has adjusted price targets across the sector to reflect this view.

BA-ML's spot indicator suggests earnings risk for the resources sector is at present skewed to the downside, as spot earnings in FY12 suggest lower earnings in the sector of 5-15% for gold equities and 25-50% for base metals equities. 

The market has adjusted to this somewhat in BA-ML's view, which means preferred exposures in the sector do not look overpriced at current levels. The major concern is for companies exposed to the dual earnings risk of higher costs and prolonged spot prices. In BA-ML's view this means Alumina ((AWC)), Alacer Gold ((AQG)), Minara Resources ((MRE)) and Independence Group ((IGO)) are most likely to see downgrades to consensus earnings forecasts.

In terms of preferred exposures Independence still makes the list for BA-ML among the base metal plays, along with Oz Minerals ((OZL)) and PanAust ((PNA)). In the golds the broker prefers Newcrest ((NCM)) and Saracen Mineral Holdings ((SAR)). 

To further examine where value or risk most lies in the resources sector, BA-ML has conducted additional analysis, one tactic being to assess valuations when factoring in spot commodity and currency prices.

The valuation at risk framework separates valuation into two parts, cyclical or “at risk” cash flows and core cash flows based on long-term price forecasts. Looking for companies where price/core NPV (net present value) is close to or less than one, which means there appears to be value, identifies the following companies – Rio Tinto, Fortescue, Gindalbie Metals ((GBG)) and Grange Resources ((GRR)), along with Macarthur Coal ((MCC)) and Gloucester Coal ((GCL)) in the coal sector.

Overall, BA-ML suggests the diversifieds such as BHP Billiton ((BHP)), Rio Tinto and Iluka ((ILU)), as well as Macarthur and Gloucester among the coal plays, could pick up the most significant earnings uplift and valuation metric improvement from modeling using spot commodity and foreign exchange prices.

With respect to how the broader market views these stocks, the FNArena database shows Sentiment Indicator readings of 1.0 for Rio Tinto, Grange Resources an Saracen, 0.9 for Newcrest, 0.8 for BHP Billiton, Fortescue and Gloucester and 0.7 for PanAust and Gindalbie. 

Lower down in terms of Sentiment Indicator readings are Alumina at 0.4, Independence Group and Oz Minerals at 0.3 and Macarthur at 0.1.Minara and Alacer score readings of 0.0.

Turning to bulk commodities, RBS suggests Chinese iron ore inventories at major ports have surged recently, with around one week's worth of imports being built up in recent weeks. The increase is somewhat puzzling, as steel production over the period has been unchanged.

A survey suggests steel mills in China may have been drawing down supplies rather than using port stocks, RBS suggesting this may have contributed to the build up in inventories. So far the build up is not an issue in RBS's view, as steel production remains high.

Expectations are for Chinese crude steel production to increase by 6.5% this year, which RBS expects will underpin strong demand for seaborne iron ore. Prices for iron ore peaked in February and RBS expects a gradual decline as production increases, the broker forecasting a 2011 average price of US$180 per tonne CFR China.

Still on the bulks, BA-ML points out continued supply issues and strong demand see coal prices holding well despite a poor macro environment. Helping is a rebound in Chinese imports in April and May, a trend expected to continue in June thanks to ongoing shortages in south east China. Met coal supply in particular remains tight and BA-ML sees scope for Chinese imports to remain robust given quality differentials relative to domestic material. 

This should support prices, as while BA-ML is forecasting 3Q contract prices of US$300 per tonne it notes there have been some deals settled at US$315 per tonne. This compares to market consensus forecasts for the period of US$285 per tonne.

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