Material Matters: Weaker Oil Good For Metals, Nickel And LNG

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– Lower oil price a positive for base metals
– Chinese construction activity solid
– Vale cuts iron ore production target
– Low cost producers preferred in nickel
– Skilled labour shortage to impact on Oz LNG sector

By Chris Shaw

Given higher oil prices act as a form of tax hike on consumers, Citi suggests the recent drop in the oil price, if it can be sustained, augers well for an accelerated recovery in the world economy. 

This is because while one view is a lower oil price means a lower cost of production, so making lower prices acceptable to producers, Citi's view is higher oil prices act as a tax on oil consumers. This means if the oil price comes down it is likely to be a positive for base metal consumption, which would be bullish for base metal prices. A lower oil price should also ease inflationary pressures.

Assuming an economic recovery occurs and the lower oil price allows China to hold off on further increases to bank reserve requirements, Citi suggests base metals could hold current levels and potentially deliver significant gains in the second half of 2011. 

Supporting this outlook are signs US and Japanese industrial production will rebound, especially as the earthquake and tsunami related spare parts shortage in Japan comes to an end.

Regardless of increased bank reserve requirements, RBS suggests Chinese construction activity continues to strengthen, as official statistics indicate the year to May saw 24% growth in new floor space started.

This growth excludes social housing, which RBS expects will only reach full momentum of 10 million units annually from 2012. While policy tightening measures have impacted on sales, RBS notes there are no signs of a slowdown in construction plans or launch schedules for private developers.

While the run rate will need to lift if developers are to meet full year targets, RBS notes it was a similar situation last year. Given pressure on officials to deliver on quotas, RBS expects social housing will be the highest priority. This implies some relaxing of policy constraints in the private market to ensure continued strength in government revenues.

RBS expects such changes could occur late in the third quarter and into the fourth quarter of this year. As developers' land acquisition programs tend to pick up momentum from August, this is likely to prove a crucial period, anticipates RBS.

In terms of how this impacts equity markets, RBS remains of the view Australian bulk commodity and diversified miners are trading at significant discounts to fair value. The persistence of this discount reflects the market's unease about the current policy tightening program in China and how this may play out on growth and commodity demand.

For RBS, the expectation is for continued iron ore demand growth from China. This sees the broker highlight Rio Tinto ((RIO)) and Fortescue Metals ((FMG)) as key sector picks. 

Further related to China, Commonwealth Bank notes Brazilian iron ore major Vale has cut its production target for 2015 by 10% to 469 million tonnes. The move reflects concerns on China's growth outlook, while CBA notes Vale is also dealing with labour, equipment and other project-related delays. These are impacting on growth.

Turning to nickel, Morgan Stanley suggests greater than anticipated volumes of Chinese nickel pig iron hitting the market has caused the metal to underperform. There is now a risk nickel lives up to the broker's bear-case forecasts for US$10.42 per pound this year and US$10.19 per pound in 2012.

While nickel stockpiles have been falling so too has the price, with Morgan Stanley noting the spot price is approaching the production cost of around US$10.80 per pound for high cost nickel pig iron operators.

Assuming such an outcome, Morgan Stanley estimates there is around 30% downside to earnings forecasts among Australian nickel stocks. This appears to be priced in, as earnings multiples for the sector are around the 8-12 times the bear-case scenario implies.

Given the potential downside for earnings, Morgan Stanley prefers low cost producers as they are less leveraged to the nickel price. Preferred stocks are Western Areas ((WSA)) and Panoramic Resources ((PAN)), both of which Morgan Stanley rates as Overweight. 

The market shows Panoramic is more widely preferred, scoring a Sentiment Indicator reading according to the FNArena database of 1.0 compared to 0.0 for Western Areas.

In the energy sector, Australia accounts for many of the world's LNG projects currently in design and construction phases. One issue with the projects is the emergence of labour shortages, which Macquarie suggests are emerging as a major constraint to the sector's growth plans.

In Macquarie's view this skills shortage is likely to grow, meaning operators and contractors will find it harder to attract and retain staff. As evidence of this, Australian energy companies are paying as much as 35% more than last year to engineers, geologists and other contractors.

While the government has increased funding for skills related courses, Macquarie suggests this is a long-term solution to a shorter-term problem. This leaves immigration as the only viable solution, as a more flexible work force appears the only real way to address the problem.

Specifically among Australian companies, Macquarie suggests Woodside ((WPL)), Santos ((STO)) and Origin ((ORG)) are likely to be most exposed to the problem of a shortage of skilled labour. 

Best placed to manage the labour issue in Macquarie's view is Oil Search ((OSH)), as the company is operating in the PNG market. While this poses challenges of its own, Macquarie notes the location means Oil Search doesn't face the labour shortages and powerful unions the Australian-based operators have to deal with.

As well, superior economies from the PNG LNG project of Oil Search should leave the company better placed to absorb cost overruns and any slippages in schedule for the project. Macquarie rates Oil Search, Santos and Origin as Outperform, while Woodside is rated as Neutral. 

Sentiment Indicator readings for the companies according to the FNArena database stand at 0.6 for Oil Search, 0.5 for Woodside and 0.8 for Santos and Origin.

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