Commodities | Sep 28 2011
– Chinese property a risk for commodity demand
– Orders of preference in commodity markets
– Differing views on base metals
– Alumina prices expected to remain firm
By Chris Shaw
Chinese property stocks have fallen 33% this month, performance that highlights the concern of JP Morgan the sector has become over-extended. This implies some meaningful downside risk for demand for commodities, argues the stockbroker.
JP Morgan's research shows private sector housing sales are falling behind target levels, cash conversion is falling and gearing is rising. The likely response is developers will cut production, which could translate to an 8% fall in steel demand if starts drop to the current level of sales. JP Morgan notes in 2010, 35% of Chinese steel consumption was housing related.
Other drivers of demand appear unlikely to fill up any slack resulting from lower residential construction levels in JP Morgan's view. The infrastructure sector faces balance sheet issues, capex for the railway sector appears to have peaked and credit restrictions are also hitting commercial real estate activity levels.
While stocks exposed to Chinese metal demand have pulled back during the recent correction, the falls have not been by much more than markets generally. In JP Morgan's view, if Chinese demand softens it is hard to see how mining shares could outperform. As a result, JP Morgan continues to recommend an Underweight position on the Australian resources sector.
Further on its analysis of the potential impact of lower global economic growth on commodity markets, Goldman Sachs has run some numbers on a scenario assuming global GDP growth forecasts are downgraded to below 3.5% in 2012.
Under such a scenario Goldman Sachs sees gold stocks as beneficiaries, as gold would be expected to outperform in the event of a sustained period of economic weakness. In contrast, base metal stocks would see earnings and valuation downgrades to varying degrees, the differences depending on the currency in which earnings were reported and what levels of by-product credits were produced.
The impact on mineral sands stocks would be varied, with Iluka ((ILU)) a beneficiary from the weaker Australian dollar assumptions of such an economic scenario. In general, Goldman Sachs would expect mineral sands equities would outperform those of the base metals in a lower growth scenario.
In terms of how this impacts on the commodities' order of preference, gold and mineral sands would continue to be Goldman Sachs's top picks. From a longer-term perspective those commodities where there is structural tightness, which includes rare earth metals, copper, zinc and the platinum group metals, would be next in line, while nickel and aluminium should continue to be avoided in the view of Goldman Sachs.
RBS Australia has updated commodity and foreign exchange forecasts, trimming base metal estimates by 2-8% in the near-term while lifting precious metal estimates by 7-29%. Long-term forecasts have increased by 13-20%, these changes reflecting the view ongoing unit cost inflation and growing capital costs for new projects will need higher long-term incentive pricing.
The changes impact most on the mid-cap base metal stocks covered by RBS. Targets have been reduced, with the target for PanAust ((PNA)) falling to $4.32 from $4.82, for Discovery Metals ((DML)) to $1.30 from $1.43, for Mirabela Nickel ((MBN)) to $2.03 from $2.21 and for Intrepid Mines ((IAU)) to $1.62 from $2.70.
Ratings are unchanged, RBS ascribing Buys to PanAust, Mirabela and Intrepid and a Hold rating to Discovery. PanAust is offering value at current levels in RBS's view as the current market cap implies a flat copper price into perpetuity of US$2.40 per pound and means no value is being priced in for development or exploration upside.
Operationally Mirabela appears to be achieving a turnaround, a trend RBS suggests could help avoid potential balance sheet stresses. Intrepid's joint venture structure at the Tujuh Bukit project remains an issue but the risk/reward metrics are considered compelling at current levels, while commissioning at Boseto is some cause for concern at Discovery.
Given current market conditions, Macquarie takes the view the order of preference among the base metals should be aluminium and zinc ahead (!) of copper. This partly reflects price performance over the past few years, as while base metal prices in general are up by less than 90% since the GFC, copper prices have risen by more than 150% higher over the same period.
Copper's gains are not such a surprise given the metal offers the most compelling investment proposition from a fundamental perspective according to RBS, as the market is in deficit and is likely to remain so through next year. Helping this is copper supply continues to fall short of expectations.
But at the same time RBS suggests the copper price presents the most significant fundamental downside risk, as prices remain far above the industry's marginal cost. This means prices could fall further without impacting the supply-demand balance of the market.
In contrast, prices for both aluminium and zinc are already below the marginal cost of production. At the same time, the two markets are showing some positive signs such as solid demand, a moderation in production and positive physical market price signals.
As well, RBS notes while aluminium and zinc stocks are high they are not easily accessed given ongoing carry trades are keeping metal in storage and de facto limits on withdrawals from LME warehouses. This is keeping physical markets closer to balanced.
In RBS's view, if aluminium and zinc prices continue to sink there are likely to be cuts to production, so tightening market balances. This should provide support for a price recovery, making both metals look increasingly attractive from a fundamental perspective.
US based Hallgarten and Company has also looked at zinc as well as lead, noting recent weakness has both metals trading below recent highs. This suggests some unappreciated potential for zinc in particular, as prices remain reasonably well supported as at levels under US70c per pound most producers are losing money.
Prices are unlikely to stay at such levels according to Hallgarten, as zinc production is falling as few new mines are appearing on the horizon. At the same time, Chinese import demand for the metal is expected to continue to increase as domestic output remains inadequate.
When diminishing supply from ongoing mine closures is added to the equation, Hallgarten expects the zinc price will soon trade above US$1.00 per pound level on a consistent basis. From a 12-month perspective the forecast is US$1.10 per pound or higher, while from a 2-3 year perspective Hallgarten expects prices of better than US$1.50 per pound.
While lead prices have been more resilient than zinc in recent years, Hallgarten sees scope for lead's price lead over zinc to erode over time. This reflects the fact an expansion in zinc demand could come from a number of sources but there are less price motivators for lead.
ANZ Banking Group's commodities research team has turned its attention to alumina, taking the view prices should remain firm in coming years even though there will be limited demand growth from outside of China.
China itself is largely self-sufficient in alumina and should remain so even as smelter expansion drives demand increases. They key factors for ANZ are ongoing bottlenecks in bauxite and high Chinese marginal costs, which together should support alumina prices well above long-term averages. The spot price is currently around US$400 per tonne, which compares to a long-term average price of around US$307 per tonne.
The pricing mechanism for alumina has seen a shift away from benchmark prices, even as consumers have been slow to accept the change to index-based pricing. In the view of ANZ, alumina and aluminium will maintain their price relationship going forward, even as traditional pricing methods are abandoned. As the pricing environment changes, ANZ expects both consumers and producers will be able to develop new hedging alternatives in the alumina market.
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