Treasure Chest: UBS Turns Positive On Commodities

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By Greg Peel

What?

UBS analysts have now become more “constructive” on the outlook for particular commodity prices and related mining stocks after being bearish for most of 2011.

Why?

Markets began to turn sour in April and fear accelerated on a combination of European sovereign debt issues, US deficit and potential recession issues, and concern over a hard landing in China. Prior to the downturn, large volumes of “carry trades” were implemented by speculators who looked to profit on commodity prices rising on the back of a structurally weak US dollar. When the European situation began to outweigh all others, the US dollar turned and began to rally leaving commodity prices vulnerable.

That these positions needed to be unwound meant the UBS analysts maintained a bearish view on commodity prices and the prices of related mining stocks, and that view was still in place up to August. But September has brought rapid and substantial unwinding of these carry trades, so while there may remain a couple more months of downward pressure, UBS is looking ahead to upside potential once the overhang is cleared.

Background

September saw carry trade unwinding “with a vengeance”, UBS notes. This has gone some way to reducing positions and has also begun to force supply chain inventories towards unsustainably low levels. While the analysts suggest there may be two or three months more of unwinding to come, the panic lows hit by global markets at the beginning of October priced in a large proportion of fundamental deterioration, they believe.

UBS also believes that inventory patterns in China are driven much more by monetary policy than any trends in actual end-demand. End-demand is now weakening sharply at the margin which may well be a trigger for Beijing to consider its first policy easing after two years of tightening. UBS suspects this will take the form of stimulus for social housing. The lengthy tightening period has impacted heavily on Chinese copper supply chain inventories, the broker notes, so the subsequent potential for restocking is significant.

Add Chinese stimulus to the likely geared-up EFSF and commodity prices have the potential to rally. It won't be a full-blown commodity bull market – that would also require QE3 from the Fed. The trigger for QE3 will not come as easily as that of QE2, but the potential is there if the Fed believes deflationary pressures are building in the US.

UBS suggests BHP Billiton ((BHP)) is a proxy for the global commodities sector. BHP shares were sold down into October to a 40% discount to the UBS analysts' fair value at which point they see a compelling margin of safety for investors looking to buy. With QE3, that discount gap could close completely, UBS suggests. Without QE3, a rise to a 20% discount is the target.

The analysts preferred commodities are thermal coal (Chinese and Indian buying, speculators have had no access), iron ore (reduced Indian exports, seasonally restocking in China), and gold (broad appeal in uncertain markets). Least preferred are those commodities with very large inventory surpluses, being aluminium and nickel.

Special positive mention also goes to copper (China is “desperately” short), metallurgical coal (recent price falls have been seasonal, China restocks in November), platinum/palladium (cost and supply pressures in South Africa) and alumina (the switch to spot pricing is still running its course).

China has already restocked zinc, so upside would require Chinese stimulus and QE3. Uranium has found a floor and appears stable. Silver has been very volatile and reminds investors, UBS suggests, that it really is “gold's poor cousin”.

UBS has listed ten global mining stocks it most prefers. The Australian inclusions in that list are Rio Tinto ((RIO)) and Fortescue Metals ((FMG)).

Note: the change in view at UBS comes at a time when other market experts have either grown more positive on resources stocks or have remained positive all the way through the recent correction. Both Macquarie and Credit Suisse have been issuing positive reports on the sector as well.

For more background information: see the Weekly Broker Wrap, published earlier today on the FNArena website as well as the next Materials Matters story, to be published on the website later today.

For further research on individual companies: FNArena subscribers have access to Stock Analysis on the FNArena website, as well as R-Factor and the Icarus Signal.
 

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