Material Matters: Copper’s Supply Issues, Oil Price Expectations, Oz E&C Sector

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– Supply side issues persist in copper
– Oil prices expected to range trade
– Updates on Australian developers and contractors

By Chris Shaw

The current focus in the copper market is on downside demand risks in China, the US and Europe but Macquarie suggests it is important to remember ongoing poor supply performance has also been an important contributor to market tightness.

On Macquarie's numbers, global mine production growth has averaged only around 1.5% per year since the copper price began to boom in 2005. The current year is not expected to be any exception, as mine production is likely to show little growth in 2011 thanks to nearly 600,000 tonnes of supply losses.

Much of the lost supply can be attributed to a strike at the Escondida mine, but Macquarie notes Chinese production was down 8.7% a year in August and total Chilean production has fallen 5% in year-on-year terms for the first eight months of the year.

Challenges to supply increases such as declining grades and project delays are expected to continue, so there is no change to the forecast of a small deficit between global supply and demand in 2012. The size of the deficit will depend on both supply performance and the extent of any Chinese re-stocking.

In oil, JP Morgan sees a number of factors potentially impacting on the path of the oil price into 2012. On the supply side these include the return of supplies from Libya, with scope for output from that country to reach 1.3 million barrels per day by the end of next year. 

As this is coming at the same time as rising supply from Iraq and non-OPEC producers, JP Morgan sees scope for supply to increase by about 1.9 million barrels per day relative to current levels.

At the same time, weaker global economic growth expectations lead JP Morgan to suggest oil demand growth next year may come in at around one million barrels per day, meaning the market would need to re-balance by an amount of around 0.9 million barrels per day from current levels.

This suggests to JP Morgan prices for Brent crude should remain in a range of US$100-$120 per barrel, even as the market re-balances. As an example of this re-balancing, JP Morgan notes there are proposed refinery closures of 700,000 barrels per day in the US and 200,000 barrels per day in Europe expected in the coming year, offset by an addition of 810,000 barrels per day of capacity in Asia.

This re-balancing process is likely to increase the pull on Atlantic Basin crudes from Asian refineries by around one million barrels per day. JP Morgan expects this will increase the pressure on a potential narrowing of the sweet/sour crude spread.

At present JP Morgan suggests short-term risks for the oil price are skewed to the upside, this due to North Sea production issues and the fact it will be several months before significant additional supply from Libya hits the market. But moving into the second half of 2012 JP Morgan suggests the Brent/Dubai spread could compress, to the extent that Dubai prices might trade at a premium occasionally. 

Similar to JP Morgan's view, Barclays Capital also sees little in base case assumptions to imply any large changes to oil price estimates are required at present. This base case assumes an 80-85% chance economic policy failure is avoided.

In 2011 Barclays notes oil prices have been capped on the upside by supply fears and macroeconomic issues, while downside protection has come from strong fundamentals in the physical market, narrowing spare capacity and disappointments in non-OPEC supply growth.

This means assuming only an economic slowdown, the oil market should stay relatively tight. The 15-20% chance of a different outcome remains the major concern, Barclays noting this is resulting in the market currently behaving in an irrational manner by reacting to headlines falling in the 80-85% scenario as strongly as those relating to the 15-20% scenario.

In terms of market fundamentals, Barclays notes the degree of excess demand in 3Q11 has been so large even the release of significant government stockpiles has not been enough to balance the market. With space capacity also low, market volatility has increased.

Given the more likely outcome of an economic slowdown, Barclays expects Brent crude prices should comfortably average more than US$100 per barrel this year. West Texas Intermediate is expected to remain at lower levels given an expected 3Q11 average of about US$90 per barrel.

Returning to the Australian market, Deutsche Bank has attempted to assess current and expected conditions with respect to labour supply in the Australian resources sector. Deutsche suggests a labour shortage is likely if planned resources capex plans proceed.

Assuming these shortages eventuate, Deutsche suggests project delays and low industry growth rates are likely. Most likely to be affected are smaller projects and the oil and gas sector, as both have disadvantages in terms of attracting labour.

This potential for labour shortages has the potential to impact on resources sector industry growth rates and Deutsche has lowered its forecasts to reflect this view. While industry forecasts are for growth of 12-24% annually over the next few years, Deutsche now expects growth of 5-10%.

Added to this have been changes to Deutsche's foreign exchange forecasts, the end result being adjustments to earnings forecasts for the major developers and contractors listed on the Australian market.

The changes to forecasts flow through to modest adjustments to price targets, though Deutsche's ratings on the stocks are unchanged. Buy ratings are ascribed to Leighton Holdings ((LEI)), WorleyParsons ((WOR)) and Boart Longyear ((BLY)), while the broker rates UGL ((UGL)), Downer EDI ((DOW)) and Transfield Services ((TSE)) as Hold.

By way of comparison, the FNArena database shows Sentiment Indicator readings for the stocks of 0.9 for Boart Longyear, 0.7 for UGL, 0.5 for Transfield, 0.4 for both Downer EDI and WorleyParsons and 0.1 for Leighton Holdings.

Goldman Sachs has also looked more closely at the engineering and construction sector, maintaining a positive view given record levels of planned resources capex spending. At present, planned capex projects total $210 billion, while less advanced projects suggest additional capex of around $170 billion.

Dominating the expected work is the LNG sector, accounting for around 70% of definite projects over the next few years. The sheer magnitude of this pipeline suggests a solid scope for work levels for Australian engineering and construction companies.

This elevated level of work should allow companies in the sector to achieve improved project pricing, which should also boost margins. At the same time, Goldman Sachs expects an improvement in earnings visibility in the sector.

In terms of how best to play the sector, Goldman Sachs prefers Boart Longyear, UGL and WorleyParsons among the larger cap plays. Among the small to mid-cap plays, the broker's preferences are Sedgeman ((SDM)), Imdex ((IMD)) and Ausenco ((AAX)). 

In ratings terms, Goldman Sachs has Buy ratings on UGL and Boart Longyear among the larger cap plays and Hold ratings on Leighton, WorleyParsons, Transfield and Downer EDI. At the smaller end of the market Goldman Sachs rates Ausenco, Bradken ((BKN)), Imdex, Norfolk ((NFK)) and Sedgeman as Buy, while rating Monadelphous ((MND)) and WDS ((WDS)) as Hold.

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