Material Matters: Lead, Nickel, Uranium, PGMs; Sector Consolidation

This story features ENERGY RESOURCES OF AUSTRALIA LIMITED, and other companies. For more info SHARE ANALYSIS: ERA

– Nickel and lead outlooks subdued
– PGM fundamentals remain positive
– Sentiment a negative for uranium
– Some cracks emerging in Chinese growth
– De-Linking of commodity and equity prices suggest consolidation opportunities

By Chris Shaw

Commodity prices have come under pressure of late thanks to another round of risk aversion due to European sovereign debt concerns and nickel has been one of the worst performers among the industrial metals.

Prices fell to a 7-month low of US$21,600 per tonne last week, RBS suggesting at least part of the fall may be due to concerns over surging supply of the metal. A number of major expansion projects are due to come on line in coming years, RBS suggesting the key for prices will be how successfully these metallurgically complex projects can be commissioned.

HPAL or High Pressure Acid Leach2 technology is the major concern, RBS noting the success record of such projects is not good. On RBS's numbers total nickel production will increase by 565,000 tonnes per annum between 2010 and 2015, with four of the 10 largest projects of the HPAL variety.

The Ambatovy project in Madagascar has already run into problems that will delay scheduled production, which RBS expects will narrow the expected surplus in the nickel market this year.

While further such disappointments should be a positive for nickel, RBS expects this will be offset by successful capacity additions. This is expected to limit the potential upside for nickel prices relative to other base metals in coming years.

Still on base metals, Citi notes International Lead Zinc Study Group figures showed the global lead market recorded one of its highest ever surpluses in April. Demand fell during the month, while supply increased.

Citi notes that related to other base metals, stocks-to-consumption is low at less than three weeks. This means while the price remains above fair value, lead remains vulnerable to any supply outages. As these have occurred relatively frequently over the past few years there has continued to be support for the price.

One potential positive according to Citi is planned capacity closures in China. At present, 585,000 tonnes of outdated lead smelting capacity is earmarked for closure this year. Awaiting evidence of these closures, Citi suggests lead prices may tread water for some quarters.

Turning to the platinum group metals, Goldman Sachs remains of the view there is potential for further upside in coming years. This comes from a combination of highly constrained mine production growth and recovering demand from the automotive sector. 

In Goldman Sachs's view, consumption growth is likely to run ahead of incremental production thus keeping the PGM markets tight. Widening deficits are expected for both platinum and palladium through 2015. This should push prices higher, which is needed to destroy jewellery and investment demand and so make more metal available for industry. 

Shorter-term palladium is favoured given platinum is expected to be in surplus this year, but Goldman Sachs is positive on the medium-term fundamentals of both metals and suggests the distinction between each metal is less important for equity investors.

In terms of forecasts, Goldman Sachs expects palladium prices will average US$808 per ounce this year, rising to US$850 per ounce in 2012 and US$950 per ounce by 2015. For platinum, forecasts are for average prices of US$1,885 per ounce this year, US$2,079 per ounce in 2012 and US$2,350 per ounce in 2015.

To play the potential for upside Goldman Sachs prefers Aquarius Platinum ((AQP)), rating the stock as a Conviction Buy with a $7.50 price target. This is well above the consensus price target according to the FNArena database of $6.37. 

In uranium, Citi expects the current poor sentiment will continue for at least the next few months, limiting performance even given a more positive longer-term story. This longer-term story is based on expected new demand, with the likes of China, South Korea and South Africa all looking to add capacity.

Citi's numbers suggest even if Japan, the UK and the EU decided to cancel any plans for expansion, new planned and proposed capacity globally would still exceed today's nuclear fleet.

Following a change in analyst coverage of the two leading Australian uranium plays – Energy Resources of Australia ((ERA)) and Paladin ((PDN)), Citi has revised its models. Paladin has been upgraded to a Buy from Hold previously, while ERA remains a Hold. 

Earnings estimates and price targets have been adjusted in both cases, Paladin's target moving to $4.05 from $5.50 and ERA to $4.90 from $12.70. Consensus targets according to the FNArena database stand at $6.81 for ERA and $4.34 for Paladin. Sentiment Indicator readings for the two companies stand at 0.4 for Paladin and minus 0.3 for ERA.

Given China's role as a driver of commodity demand the state of the Chinese economy is of great relevance. Macquarie's analysis of the latest macro data suggests while headline numbers remained solid, some cracks are emerging. 

Sales of excavators and heavy trucks contracted in year-on-year terms in May, while construction activity is also slowing. Macquarie suggests the signs of a slowing are not yet enough for any loosening in monetary policy, especially given inflation remains elevated.

Macquarie's view is there will be one further hike in interest rates before policymakers react to the deteriorating growth outlook. 

Taking a broad view of the resources sector, BA Merrill Lynch suggests while commodity prices have held up relatively well so far this year, resource stocks have not delivered similar performance. This de-linking between commodity and equity prices presents an opportunity for sector consolidation.

Screening the sector for free cash flow generation ability and companies to find the most attractive valuations, BA-ML suggests the iron ore, coal and precious metals assets screen the most favourably. Adding to the attraction is in general it is easier, quicker and cheaper to buy new capacity rather than to build it.

Among the Australian companies, BA-ML estimates the 29 miners covered will generate US$142 billion in free cash flow in the next three years. This, plus operating synergies, growth options and infrastructure are likely to be key factors driving any consolidation in the sector.

BA-ML's numbers suggest Macarthur Coal ((MCC)) screens very well in the coal sector, while most emerging iron ore companies in Australia have built up relationships with strategic investors. Atlas Iron has not yet done so, but BA-ML notes it is now generating solid cash f lows from its operations.

Where Australian M&A activity levels have already picked up is among junior gold miners, BA-ML noting there have already been four transactions announced this year. Further deals are likely, with those most likely to move being companies with strong production growth and or exploration upside. 

In the uranium sector BA-ML sees Paladin and Extract Resources ((EXT)) as best placed to benefit from consolidation appeal. For Paladin the attraction is valuation following recent share price weakness, while for Extract there is likely Chinese interest in the Husab deposit and good synergies with Rio Tinto at the Rossing mine. 

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