Reasons To Be Bullish On Iron Ore

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– Investors have become sceptical about prospects for iron ore prices
– Analysts at BA-ML believe market sentiment has become too negative
– The analysts believe iron ore prices are more likely to surprise to the upside this year
– JP Morgan has reviewed mid-tier producers under coverage

By Greg Peel

With the Chinese economy clearly slowing it would be natural to assume iron ore export prices would be under pressure. Europe is in recession and is the biggest buyer of Chinese manufactured goods while Beijing continues to wage war against Chinese property speculators in its attempts to slow economic growth to a target 7.5%. If copper is considered a commodity peer to iron ore then a decent fall in the copper price since February should imply something similar in the bulk metal.

The analysts at BA-Merrill Lynch believe, however, there are many reasons why the risk on near term iron ore prices is to the upside rather than the downside. Merrills is able to draw on a “myriad of data points” inundating the market in recent days and weeks.

The first is with regard to China's manufacturing purchasing managers' index for March. It showed a surprise jump to 53.1 from 50.8 in February when economists had expected a decline. The problem here is, of course, that HSBC's independently calculated PMI fell to 48.3 in March from 49.6 in February. Beijing's number implies accelerated growth in manufacturing in March and HSBC's number implies accelerated contraction.

There has been much argument in the interim (See: China's Confusing Economy) as to who is right and who is wrong. Beijing's number is weighted to larger companies and is not seasonally adjusted while HSBC's is weighted to smaller companies and is seasonally adjusted. The month of March typically shows a manufacturing rebound following the disruption of Chinese New Year. The right answer remains unclear, but the PMI is not the only reason Merrills provides for iron ore price upside.

Merrills notes that Chinese steel production was impacted, as always, by the New Year break but having rebounded it has continued to trend upwards in the interim. The analysts believe the market has become too bearish on steel expectations and conclude that Chinese production and consumption will increase over the next 3-6 months, thus increasing iron ore demand. One hint is that rebar prices are on an uptrend – rising 11.3% since the October 2011 low and up 4% for the March quarter.

It is well accepted that China is not one for “just in time” inventory management when it comes to raw materials and spends the year building and consuming stockpiles. In eight of the last nine weeks, notes Merrills, iron ore port stocks have fallen in China to the point March saw a 5% reduction from February.

It is hard to believe that with all the expansion in iron ore mining currently underway in Australia and elsewhere that there could be supply issues, but Merrills notes BHP Billiton's ((BHP)) expansion work has been disrupting existing production such that the analysts see iron ore production in the second half of 2012 falling 13% below that of the first half.

Perhaps the biggest threat to iron ore demand is a collapse of the Chinese property market – that which many an economist fears. There appear to be equally as many who don't, mainly because earlier price rises were all about property speculation and cheap money while mortgages are at a low ratio, thus implying no US-style foreclosure-driven price drop. Either way, Merrills notes property prices in Shanghai have actually risen this year, showing a 12.3% rise from a index low in January through to the end of March. Property sales volumes last week in the 14 cities Merrills tracks were up 68% from the same week last year as lower prices, lower mortgage rates and greater mortgage access are encouraging more Chinese to enter the property market.

Finally, the iron ore price itself has remained robust. There has been a rebound in recent weeks but the analysts note the iron ore price has been pretty stubborn around the US$140/t mark since the end of last year. Throw in the above mentioned factors and Merrills sees scope for prices to rise further.

How best for the Australian investor to play iron ore price upside?

The obvious answer is the two big diversifieds, with Rio Tinto ((RIO)) the bigger producer of iron ore than BHP. But both have major capex investments planned over several years across a spectrum of commodities and will offer no earnings growth in the near term. Pilbara pure-play Fortescue Metals ((FMG)) is also hellbent on funding its own ambitious expansion plans.

JP Morgan has this week updated its outlook for the iron ore mid-caps under its coverage.

Grange Resources ((GRR)) is JPM's preferred exposure, and the analysts rate the stock Overweight. A 2012 PE of only 5.8x supports the broker's rating with the development and funding of the company's Southdown project providing the bulk of the risk. JP Morgan has assumed a $500m capital raising in 2013 on this basis but notes Grange management is leaning towards an asset sell-down instead to provide required funding given the low PE ascribed by the market, implying a low stock price. A sell-down avoids dilution but reduces earnings potential. The analysts have set a target of 95c (last trade 57c). The FNArena database shows a Buy/Hold/Sell ratio on GRR of 5/1/0 and a consensus target of 83c.

JP Morgan has today upgraded Gindalbie Metals ((GBG)) to Overweight. The market is clearly nervous over the commissioning and ramp-up phases of Gindalbie's Karara project given the stock is trading at a 20% discount to JPM's net present value calculation. This is enough to prompt the upgrade, with Karara presently on track and on budget. Karara provides GBG with the highest iron ore price leverage of the five mid-caps JP Morgan covers and the analysts have set a target of 82c. (Last trade: 61c; consensus 6/6/0 and 98c)

Atlas Iron ((AGO)) boasts the lowest risk operations of the five, as well as the most proven management and highest level of liquidity. The market is nevertheless in agreement, and with limited upside from Atlas' unvalued projects JP Morgan remains on a Neutral rating with a target of $3.20. (LT: $2.82; consensus 6/2/0 and $3.69).

Mt Gibson Iron ((MGX)) suffers from its own unique problems irrespective of how much iron ore it can mine. The recent boardroom hullabaloo and turnover of senior management caused the market to lose confidence, and new management's taste for mergers and acquisitions increases risk. JP Morgan would rather wait to see strong direction from new management and a cash return to shareholders to crystallise value for the patient before reconsidering its rating. JPM rates MGX Neutral with a target of $1.45. (LT: $1.04; consensus 2/4/2 and $1.49)

The last stock under coverage is Aquila Resources ((AQA)), but JP Morgan is advising on some part of Aquila's 50% sale of its Isaac Plains project and joint venture with Sumitomo on Aquila's West Pilbara project meaning the broker is restricted from offering a rating or target. Macquarie is also restricted, leaving Credit Suisse (Neutral, $6.00) and RBS Australia (Sell, $4.64) as the only other brokers covering the stock. And RBS has not updated its view since February. (LT: $5.00)

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