Material Matters: Gold, Bulks, And What If A Recession?

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– Gold forecasts revised higher
– Iron ore reference rates losing relevance
– Global steel production remains strong
– Soft landing for Chinese construction still likely
– Stocks for different commodity market scenarios

By Chris Shaw

While gold has sold off from the record highs achieved earlier this week, ANZ Bank continues to expect a further rally in the price, with a peak price unlikely to be seen prior to the second quarter of 2012.

The bank's senior metals strategist, Nicholas Trevethan, now expects a peak gold price of US$2,200 per ounce, up from a previous estimate of a peak around US$1,800 per ounce in 1Q12. The change reflects a bleaker assessment of the US dollar outlook, ongoing sovereign risk issues in Europe and slow growth from the US economy.

Looking ahead, Trevethan also expects emerging central bank buying will underpin demand, while gold sales from central banks are expected to slow and so further offset lower purchases by exchange traded funds and the end of de-hedging by gold miners.

Jewellery sales should also increase further in Trevethan's view, in part because of limited investment alternatives in China. Trevethan sees scope for Chinese per capita gold consumption to match India's over the next 3-4 years, something that could lift demand by as much as 200 tonnes annually.

While this is a positive for the medium-term, by 2013 Trevethan sees some additional headwinds emerging for gold, such as an increased focus on the US QE exit strategy and the onset of higher interest rates in the US.

While downside may be limited by rising Asian central bank buying, Trevethan is forecasting a gold price of around US$1,480 per ounce by the end of 2013.

Citi has similarly lifted gold price forecasts, again to factor in increased global financial tensions. For 2012 Citi now expects an average gold price of US$1,650 per ounce and for 2013 US$1,500 per ounce, up from previous estimates of US$1,325 per ounce and US$1,225 per ounce respectively. 

The changes in gold price expectations flow through to earnings and price target changes for the gold stocks covered by Citi, but the only change in rating is an upgrade to a Buy recommendation on Gryphon ((GRY)).

Overall, Citi rates Regis Resources ((RRL)), Perseus Mining ((PRU)), Medusa Mining ((MML)), Kingsgate Consolidated ((KCN)), OceanaGold ((OGC)), Newcrest Mining ((NCM)), Resolute Mining ((RSG)) and Gryphon as Buy, while Beadell Resources ((BDR)), St Barbara ((SBM)) and Alacer Gold ((AQG)) all score Hold ratings. 

Key picks for Citi are Regis, Perseus and Medusa given quality assets and the potential to add to production in the future.

Turning to bulk commodity markets, Macquarie suggests iron ore reference prices are now losing relevance as while contract prices are likely to remain largely unchanged into the December quarter of this year, average Australian export values have been falling.

This reflects a new form of market arbitrage in Macquarie's view, where terms are being set by individual cargo and there is increased involvement in the market by traders sourcing off-take below benchmark prices.

In June, trade value was at its largest ever discount to contract benchmarks of 31%, while Macquarie notes the average discount to reference prices this year has been 17% for contract prices and 23% relative to spot prices. This discrepancy is too large to to be accounted for by carryover tonnage.

Even lower grades don't fully explain the difference in prices, leading Macquarie to suggest in the market now negotiations between producers and customers revolves around marketing arbitrage with prices being set by the individual cargo and depending on individual grades. 

This leads Macquarie to suggest the market should not be surprised if both iron ore export value to the Australian economy and average sales prices achieved by iron ore producers come in below current expectations.

Still on the bulks, Macquarie notes global steel production growth in year-on-year terms continues to accelerate, even despite increasing outlook concerns. The onus is increasingly being put on China to keep this growth going, Macquarie putting this down to concerns over future demand and prices eating into the cost curve.

In terms of coming months, Macquarie suggests price falls are now causing severe margin pressures for many steel mills, hence the expectation is for some further rationing of supply in coming months. With the global macroeconomic situation not yet appearing to have fed through to the steel sector, Macquarie expects September quarter production to display the highest year-on-year growth of any quarter this year.

With respect to China, Macquarie expects a further rise in benchmark interest rates given a recent jump in yield paid on central bank paper bills of one year maturity. While the effect of the global economic problems on commodity prices are quickly apparent , the impact on the Chinese economy is taking more time to materialise.

There are signs of a real tightening in China's economy, Macquarie noting bankers acceptances have fallen in recent months and bank loans are becoming more costly, not only through the People's Bank raising benchmark rates but also from banks increasing their own prices.

Sales and inventories are two additional factors for how things relate to construction levels in China, Macquarie expecting the former should continue to increase in coming months while inventories also rise modestly.

Looking at all the factors Macquarie suggests a soft landing for the Chinese construction sector remains most likely, as some strength in developer financing is helping offset the rise in inventories. The strength of construction has been the big surprise of the Chinese economy in 2011 in Macquarie's view, so understanding what influences the level of construction activity is clearly of importance.

Turning to a broad view on commodities, Morgan Stanley has looked at prices under the scenario of a recession in developed markets. In such a scenario not all commodity prices would fall equally, Morgan Stanley expecting those where China has a deficit would fair better. This suggests copper and iron ore would be among the better performers.

In relative pricing terms under such a scenario, Morgan Stanley suggests the big diversifieds, namely Rio Tinto ((RIO)) and BHP Billiton ((BHP)) would hold up well, while Fortescue Metals ((FMG)), Oz Minerals ((OZL)) and PanAust ((PNA)) would also remain attractive. 

Western Areas ((WSA)) would be a preferred exposure in the nickel sector and the outlook for mineral sands play Iluka ((ILU)) would also be reasonable, but Morgan Stanley suggests Alumina ((AWC)) and the coal names would become somewhat stretched on valuation grounds. Gold was not included in the analysis.

For a final word on the commodity sector, Credit Suisse suggests while some strategists may group all resource plays into the one sector, a more accurate split would be to put BP, Rio Tinto and the gold stocks into one group and everything else into another.

While BHP and Rio Tinto have been clear outperformers over any long-term timeframe, any shift that sees a recovery in risk appetite is likely to see mid and small cap miners outperform in Credit Suisse's view.

Assuming risk appetite was to improve, Credit Suisse suggests the names of most interest to investors playing a risk-on theme would include Aston Resources ((AZT)), Bathurst Resources ((BTU)), Cockatoo Coal ((COK)) and Panoramic Resources ((PAN)). 

All are rated as Outperform by Credit Suisse given the potential for growth, cash on hand and/or attractive valuation at current levels.

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