Material Matters: Commodity Strategies, Precious Metals, Iron Ore, Gas

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– Commodity markets positioning for further deterioration in economic outlook
 – Barclays offers some strategy options for the June quarter
 – Updated precious metal market views
 – RBS offers its preferred Australian gold exposures
 – Iron ore prices may weaken further
 – East Africa a growing threat to Australian gas projects

By Chris Shaw

As noted by Barclays Capital, the phase of upward commodity price movement seen from January to early April is now breaking down. This is due primarily to a less supportive macro environment thanks to ongoing concerns over the European debt crisis and contagion effects.

As Barclays points out, markets are clearly positioning for a further deterioration in the economic outlook, this despite what has in general been mildly encouraging data of late. Buying June quarter lows in commodity markets has been a good strategy in each of the past two years and Barclays sees scope for the pattern to play out again this year. 

With this in mind, Barclays has its highest conviction views in long copper, soybeans and aluminium positions, as well as a long position in fuel oil given rising Saudi demand and lower Iranian exports. 

This breakdown in prices has meant simple price directional strategies in the commodity markets have underperformed alpha or market structure based strategies in the second quarter to date. So far in the period, liquidity and curve risk premium strategies have been the best performed, while value strategies that were the strongest in the first quarter have fallen sharply. 

In terms of how to best play the commodities space in coming months, Barclays suggests alpha strategies are most likely to be successful, backwardation strategies in particular. Such strategies reflect outperformance of a long investment in a portfolio of backwardated commodities against a short position in the nearby indices.

In recent weeks the gold price has fallen to its lowest levels since the end of last year, something Deutsche Bank suggests can at least in part be explained by the gold to EUR/USD correlation rising to almost 70%. This has pushed down the gold price as the US dollar has strengthened.

In Deutsche's view the increasing speculation of a Greek exit from the eurozone and the associated short-term negative implications for the euro will sustain downward risks for the gold price. At the same time, the recent weakness has seen stagnant inflows into physically-backed gold ETFs.

Even with this, Deutsche notes speculative length in gold remains at elevated levels. Looking forward, Deutsche suggests if Greece exits the eurozone and any contagion can be contained, the move would be positive for the euro. Any weakness in US real economic data would also be a potentially positive catalyst for gold, though Deutsche cautions any measures that keep the Fed's balance sheet largely unchanged would see a rally in the metal quickly unravel.

Further on gold, RBS notes the sector has significantly underperformed the broader market over the past few months as a weaker gold price has seen stocks in the sector punished even more severely. For RBS this doesn't justify a shift from a market-weight position on gold stocks, though now the broker suggests high quality names are looking likely to outperform their peers.

For the gold price, RBS suggests the market currently has a number of potential positive catalysts, including QE3, the ongoing eurozone crisis and inflation hedging, but overall the broker retains a broadly neutral view on the metal. 

In RBS's view investors in the gold sector should focus on long-term growth, exploration upside, low cash costs and valuation. On such a basis and on a 12-month view RBS's preferred plays are Alacer Gold ((AQG)), Medusa Mining ((MML)) and Perseus Mining ((PRU)).

For Alacer the attraction is the high quality of the Copler asset in Turkey, which will help the company grow production to around 700,000 ounces per year. Another positive is near-term cash flows should be enough to fund these expansion plans, while exploration offers potential upside to valuation going forward.

Medusa offers an attractive valuation at current levels and the upside of expected production growth from around 59,000 ounces this year to 200,000 ounces by FY15, as well as strong operating cash flows and the ability to fund growth plans.

Perseus continues to ramp up the Edikan project and will bring the Sissingue project on-line in 2014, which RBS notes should lift group production to around 400,000 ounces per year. This significant growth is enough to justify a Buy rating in the broker's view.

Also in the sector RBS has Buy ratings on Newcrest Mining ((NCM)), OceanaGold ((OGC)) and Kingsgate Consolidated ((KCN)), while Hold ratings are ascribed to Regis Resources ((RRL)) and Resolute Mining ((RSG)). 

With respect to platinum, Macquarie notes a review by Johnson Matthey increased the size of the platinum market surplus last year to 430,000 ounces, while the specialty chemicals company expects 2012 will offer similar market conditions.

The revision reflected deteriorating growth in the final quarter of 2011 as well as an increase in the estimate for South African supply and strong recycling activity. Looking forward, Macquarie notes the latest Johnson Matthey update suggests China is an area of potential consumption upside this year, this following what was a broadly flat consumption performance last year.

For platinum overall, Macquarie's view is while demand is currently somewhat mixed, supply is falling and falling quite quickly. In large part this reflects pressure on high cost producers in South Africa. 

This supports the expectation of the platinum market eventually shifting into a deficit position, which would be supportive for prices longer-term. Near-term Macquarie retains a cautious view, this reflecting the risk the market may weaken further in the coming weeks and months. 

RBS notes with prices for platinum falling to near US$1,420 per ounce and platinum below US$600 per ounce in recent weeks, the market is again arguing whether or not such prices are unsustainable given ongoing and increasing cost pressures. At current prices around half of current platinum producers are estimated to be making losses.

Economically therefore arguments exist for production cutbacks, as not only would some higher cost supply be taken off the market but a market closer to balance would be more supportive for prices. Longer-term the current market pricing should reduce the appetite for investment in the sector, which in turn should mean slower production growth. In RBS's view this should drive sustainably higher platinum prices. 

As with Johnson Matthey, RBS remains more bullish on palladium given superior market fundamentals, with demand increasing and the expectation of a collapse in Russian sales that should push the market into deficit this year. In contrast, Platinum appears unlikely to be in deficit this year according to RBS's estimates.

Turning to the bulks, Commonwealth Bank notes iron ore prices have fallen 3% in the past week and 9.5% to US$135 per tonne over the past month. CBA attributes the recent weakness in part to a large influx of spot cargo from Brazil, which has prompted Chinese buyers to hold off from making purchases.

The other factor according to CBA has been falling steel prices, which has come from a combination of lower imports in April, reduced iron ore port stocks and increased domestic output creating an imported iron ore inventory de-stock. If this continues prices could push lower, leading CBA to suggest there is downside risk to iron ore price expectations in the short-term.

Deutsche Bank agrees, expecting iron ore prices could fall further given some downside risks to materials demand in China. As Deutsche notes, the usual high demand spring period has disappointed in China and the market is now moving into the summer slowdown period. This suggests falling demand volumes and production cutbacks by Chinese steel mills.

This is prompting a correction in global steel prices and leads Deutsche to suggest iron ore prices are at risk of correcting further. Prices could potentially drop below US$120 per tonne in the broker's view, while the forward curve for iron ore is likely to flatten as prices move closer to the marginal industry cash cost. Deutsche's long-term iron ore price forecast is unchanged at US$80 per tonne.

In the gas market, JP Morgan notes a large discovery in Mozambique offers scope for Mozambique's and East Africa's gas reserves to overtake those of Australia in coming years. At present the East African gas resource base is estimated to be close to 100 trillion cubic feet, which compares to Australia at 103 trillion cubic feet and Indonesia at 108 trillion cubic feet.

The issue for Australian gas plays in the view of JP Morgan is the rising resource base in East Africa offers a competitive threat to slow-moving projects here such as Browse and Sunrise. If East African projects were advanced quickly some of the Australian plays could be pushed off the market as they are quicker to off-take and the potential for a cost advantage for the African plays. 

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