Commodities | Sep 27 2011
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– Commodity price outlook under a weaker growth scenario
– Preferred resource sector exposures
– Commodity prices and currency movements
– Reviews of the iron ore and coal sectors
By Chris Shaw
With the global economic outlook deteriorating commodity prices have fallen recently and as Goldman Sachs notes, this suggests some downside risk to existing commodity price expectations. With this in mind, the broker intends to use the upcoming LME Week starting on October 3 as an opportunity to gauge sentiment from both producers and consumers.
Leading into this Goldman Sachs has attempted to determine what is an appropriate downside scenario assuming global economic growth falls below 3.5% in 2012 and stays below 4.0% in 2013. Weaker outlooks for Europe and the US contribute to such expectations and would imply weaker raw material demand in both economies.
With respect to China, Goldman Sachs continues to expect a relatively soft landing for the economy. This implies existing commodity demand expectations are already conservative, but for the sake of the analysis Goldman Sachs has factored in weaker demand as part of the potential downside scenario.
Under such a scenario all of the base metals would be in surplus in 2012 and 2013. While fundamentals remain strongest for copper, the metal has been trading a long way above cost support, so in a worst-case scenario there is potential to close what is still a US$1.50 per pound gap.
The mineral sands markets would remain in notional deficit, but Goldman Sachs suggests these markets would offer only muted potential for further price gains. Among the bulks, iron ore should remain in a notional deficit, while Goldman Sachs expects solid support given marginal production costs in China of around US$140 per tonne.
Similarly, Goldman Sachs expects thermal coal to remain well supported from a cost perspective, but there would be greater downside for metallurgical coal barring any fresh supply disruptions.
For the precious metals, Goldman Sachs expects gold to outperform thanks to its traditional safe haven role, while it appears unlikely platinum would trade at a sustained discount to gold. Palladium would likely perform worse than platinum as the market would be more likely to treat this metal as an industrial commodity rather than a precious metal.
This leaves Goldman Sachs's preferred commodities for the shorter-term as gold, mineral sands, iron ore and thermal coal. Medium-term, and assuming no major downgrades to 2012 growth expectations, copper, metallurgical coal, the platinum group metals, oil, zinc and the rare earths could be added to this list as these are among the more supply-constrained commodities.
Goldman Sachs continues to suggest avoiding pure play investment exposure to aluminium, alumina, nickel and uranium, as all of these commodities are seen as oversupplied in the market.
UBS has undertaken a similar analysis, comparing the current sell-off in commodity markets against what occurred during the GFC. Current price moves are modest in comparison to 2008 but UBS suggests GFC-lows offer an extreme floor scenario.
Marginal costs of production are also a key variable, as while spot commodity prices at present are still 75-180% above the GFC floor they are about 30% above the range of marginal costs of production.
Investors seeking a defensive position in the resources sector should look at the thermal coal, aluminium and gold sectors in the view of UBS, as downside appears most limited for these commodities.
Corresponding equity exposures include the diversified miners such as BHP Billiton ((BHP)) and Rio Tinto ((RIO)), Whitehaven Coal ((WHC)), Alumina Ltd ((AWC)), Newcrest ((NCM)) and Alacer Gold ((AQG)).
Assuming a recovery scenario then UBS prefers the commodities China seeks, which means copper, iron ore and zinc. Favourable equity exposures under this scenario include PanAust ((PNA)), Rio Tinto, Fortescue Metals ((FMG)) and Perilya ((PEM)).
One important point noted by UBS is resource company balance sheets are in much better shape now than was the case during the GFC, with many companies now enjoying net cash positions. Even allowing for scenarios of flat commodity prices going forward, the likes of Rio Tinto and BHP Billiton would still be on relatively attractive multiples.
The reduced downside risk seen for thermal coal prices would be expected to support earnings for Whitehaven, while earnings for Fortescue would fall more significantly given the company's current cost base and finance costs.
Given the sharpness of the recent falls in commodity markets, Macquarie has assessed the market to see how much of the price declines can be attributed to US dollar strength and how much is due simply to weakness in a particular commodity.
The analysis is timely as during most of August and September currency markets had been relatively stable, but in recent sessions the commodity currencies have weakened and there have been ever sharper falls in emerging market currencies.
For copper, Macquarie notes commodity currencies haven't been able to offset the price declines experienced since the start of August. Currencies have had some impact though, as the decline in Australian dollar or Chilean peso terms has been around half that seen in US dollar denominated prices.
It is a similar story in the gold market, as while the price has started to fall in US dollar terms, Macquarie notes prices have been relatively stable in Australian dollar terms and have actually risen in South African rand terms.
While iron ore prices are now looking more vulnerable given a weaker outlook for Chinese construction activity, Macquarie points out prices in Australian dollar terms are 10% higher since the start of August and almost 20% higher in Brazilian real terms over the same period.
This leads Macquarie to suggest if exchange rates were to hold around current levels iron ore prices would need to fall to US$161 per tonne for Australian producers to be worse off now than at the start of August. If such a price fall was to eventuate, Macquarie expects there would also be an impact on Chinese domestic supply.
Macquarie's finding is while looking at currency prices in this way makes little difference in the near-term given poor market sentiment, movements attributable to currency markets and the US dollar in particular relative to weakness in a specific commodity will be important once the market settles down.
Looking specifically at iron ore, Citi takes the view the market is showing the first signs of weakness. This reflects Chinese steel output falling 1% in month-on-month terms in August, which has resulted in iron ore port inventories rising to a record level of 94.3M tonnes or 34 days of cover. This level is the highest since the GFC.
While the outlook for the market remains constructive, Citi suggests the current environment means there is limited upside to iron ore prices for the final quarter of this year. But a still tight seaborne market and macro indicators suggesting a soft landing for the Chinese economy should keep iron ore demand from collapsing.
As a result, Citi has not adjusted its short-term iron ore price target of US$165 per tonne. The broker's 6-12 month target is also unchanged at US$150 per tonne.
Credit Suisse has looked at the iron ore market slightly differently, attempting to assess an appropriate pecking order for the Western Australian pure iron ore plays in the current environment.
From being the most preferred prior to the market downturn Credit Suisse now suggests Fortescue is the highest risk play, as iron ore price weakness could impact on the company's planned aggressive expansion plans. Credit Suisse estimates Fortescue would need to scale back its spending plans at iron ore prices between US$130-$140 per tonne.
On the other hand, while Atlas Iron ((AGO)) is also a growth stock the company does not have similar financing concerns as planned expansion will require low levels of capex. This will allow Atlas to remain net cash rich.
The change in conditions means Mount Gibson ((MGX)) now looks relatively defensive, even with a relatively short mine life, the absence of a growth strategy and corporate governance issues. As Credit Suisse notes, these factors are offset by high cash levels and improved valuation from recent share price weakness. Credit Suisse sees little attraction in Gindalbie ((GBG)) at present, as the company is entering the higher risk ramp-up stage.
This means in order of preference at present, Credit Suisse regards Mount Gibson as probably the safest, followed by Atlas, with Fortescue the highest risk play at present given the potential for a funding shortfall.
Credit Suisse has made no changes to recommendations on the stocks, ascribing Outperform ratings to all four companies. By way of comparison, Sentiment Indicator readings according to the FNArena database stand at 1.0 for Gindalbie, 0.9 for Fortescue, 0.8 for Mount Gibson and 0.7 for Atlas Iron.
Turning to coal, RBS Australia notes feedback from market participants suggests physical trade, pricing and the outlook are still resilient, especially for thermal coal. In contrast RBS suggests a more cautious approach is justified, as it appears only supply constraints in Queensland are maintaining tension in quarterly pricing.
Given an expectation prices will cycle for longer than had first been expected and to account for the view cost escalation will continue in the Australian and Chinese coal sectors, RBS has lifted coal price forecasts.
Long-term price estimates now stand at US$180 per tonne for hard coking coal and US$100 per tonne for export thermal coal. These compare to previous respective forecasts of US$145 per tonne and US$80 per tonne.
In annual average price terms forecasts for hard coking coal have increased by 36% to 68% through 2014, RBS now expecting prices of US$305 per tonne in 2012, US$275 per tonne in 2013 and US$285 per tonne in 2014.
For thermal coal the increases to forecasts have been 18% to 21% over the same period, leaving forecasts at US$115 per tonne, US$105 per tonne and US$100 per tonne respectively.
Factoring in the changes sees RBS adjust earnings and price targets across the sector, with targets increasing for Macarthur Coal ((MCC)) and Aston Resources ((AZT)) and falling for Whitehaven and Gloucester Coal ((GCL)). There is no change to the target for New Hope Corporation ((NHC)).
Recommendations are unchanged, RBS rating all the above stocks as Buy with the exception of Macarthur, which is rated as Hold. Of the Buys, New Hope is regarded by RBS as the most compelling defensive exposure in the sector.
Citi has similarly reviewed the coal sector, continuing to take an optimistic view on Asian demand given Chinese imports should remain high and Japanese demand should improve as the impact of the earthquake in March fades.
While US coal exports are currently weakening Citi suggests this is no surprise, as the US is the swing producer and had lifted exports earlier in the year to fill a void in the market left by the flood induced fall in Australian exports.
Indicators continue to point to strong import demand for met coal in Citi's view, but the current macro environment is likely to weigh on near-term spot prices. The sector's long-term supply issues should help contract prices hold up, so Citi sees limited downside from current levels for quarterly contract prices through 2012.
In dollar terms, Citi expects 4Q11 met coal contract prices to settle at US$280 per tonne, while the broker's 12-month price target is US$270 per tonne.
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