Material Matters: Forecasts And Ratings Revised; Metals, Coal And Oil

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 – Commodity price forecasts revised
 – Changes impact on broker ratings
 – Nickel and zinc prices under pressure
 – Evidence of some coal production cuts
 – Oil price forecasts trimmed

By Chris Shaw

Having enjoyed solid increases in the early part of 2012 commodity prices have since given back those early gains, recording double-digit declines from highs. The weakness in recent weeks comes as the northern summer demand lull is approaching, but RBS suggests now could be the time to accumulate positions as prices are likely to bottom in coming weeks supported by cutbacks in production.

RBS's expectation of production cuts stems from the fact weaker prices are now cutting into industry cost curves. Evidence of production cutbacks are already emerging in the aluminium and platinum sectors and RBS expects further mine closures, with the zinc market a strong possibility given its large supply surplus.

To reflect recent price movements, Morgan Stanley has reviewed its estimates across the sector, the result being all commodity prices have been revised lower. Adjustments range from cuts of around 3% for iron ore to 12-13% for thermal coal, while base metal price forecasts have been lowered by 5-8% for copper to 12-16% for nickel.

The changes to commodity price forecasts have impacted on earnings estimates and price targets across the sector, with Morgan Stanley pointing out estimates for nickel and gold plays were the most severely impacted. Even with new earnings forecasts factored in, the broker suggests valuation upside exists given stocks are trading 40% below below a simple average of net asset values. 

In particular, Morgan Stanley sees value in the copper and iron ore sectors, which also reflects the fact the underlying commodities in both cases have proven to be more resilient. An upgrade to Fortescue Mining ((FMG)) to Overweight from Equal-weight highlights this view, supported by signs of resilience in iron ore prices and more attractive earnings multiples for the stock given recent share price weakness.

In terms of ratings, Morgan Stanley retains Overweight recommendations on BHP Billiton ((BHP)), Rio Tinto ((RIO)), Gindalbie ((GBG)), Equatorial Resources ((EQX)) and Atlas Iron ((AGO)) in the diversified and iron ore space and PanAust ((PNA)) and OZ Minerals ((OZL)) in the copper sector.

In nickel Morgan Stanley rates Western Areas ((WSA)) and Panoramic Resources ((PAN)) as Overweight, while in gold the broker is positive on Newcrest ((NCM)), Alacer ((AQG)), Gryphon Minerals ((GRY)) and Medusa Mining ((MML)). Whitehaven Coal ((WHC)) is rated Overweight among the bulks. 

The changes in commodity price forecasts by Morgan Stanley has also impacted on models for Australian steel plays. The sector has also struggled in share price terms, with the major names – BlueScope ((BSL)) and Arrium ((ARI)), formerly OneSteel – underperforming the market by an average of 23% over the past two months.

For BlueScope the revised earnings forecasts mean price target falls to $0.33 from $0.47, but there is no change to Morgan Stanley's Equal-weight rating. This reflects the broker's view the stock remains vulnerable to steel price movements as this impacts on earnings for high margin value added products.

In contrast, Morgan Stanley is more bullish on Arrium, rating the stock a Overweight. This is because the likelihood iron ore prices remain above US$130 per tonne implies strong free cash flows for Arrium from FY13 as iron ore exports are expanded. 

While the balance sheet is a risk, the stronger cash flows should act as an offset and so a more positive rating is justified in the view of Morgan Stanley. Revised price forecasts see the broker's price target for the stock fall to $1.06 from $1.55. 

As stainless steel industry consultant MEPS points out, transaction prices in the stainless steel market are heavily influenced by the value of raw materials. As part of this process, mills in Europe and North America issue monthly alloy surcharges based on the published prices for the main ingredients of the product.

These surcharge effects can be significant, as MEPS notes the June alloy extra of 1,418 euros per tonne is 59% of the transaction value. The main contributor to these input costs is the nickel price, which in grade 304 stainless steel represent more than 50% of the transaction cost.

This implies stainless steel market participants should monitor nickel prices. MEPS suggests the nickel market is likely to be in surplus both this year and in 2013, while growth in stainless steel consumption will be held back by moderate demand.

An expected surplus is likely to see nickel miners attempt to redress the market balance by delaying or reducing the size of new projects or by cutting back on existing projects. At the same time the need to meet environmental guidelines could see reduced nickel output from China. If this occurred and the global economy took a turn for the better, MEPS suggests the outlook for long-term nickel prices would improve.

Shorter-term Macquarie suggests the focus in nickel markets is turning away from supply and back to the demand side of the equation. This is because the supply adjustments experienced in the market in recent months have been too small to make much of an impact on the market balance.

This has seen prices continue to weaken to levels last seen in July 2009. While the market has entered a seasonal slowdown, Macquarie notes reports in the market are the slowdown has been even more severe than usual for this time of year.

The weaker nickel prices have generated falls in stainless orders and production and to reflect this Macquarie has cuts its forecasts for global stainless steel production this year to 35.4 million tonnes, which would be year-on-year growth of 4.1%.

This impacts on Macquarie's forecasts for the nickel market, the broker now expecting lower demand offset by production cuts in various markets. A nickel market surplus of around 49,000 tonnes is expected in 2012, though achieving this surplus will require some reductions in Chinese nickel pig iron output. Macquarie expects speculative buying in the nickel market will emerge if prices fall below US$16.000 per tonne.

Elsewhere in the base metals, Macquarie notes the zinc market is also struggling and there remains the risk prices fall further in coming months. This reflects weak market fundamentals as demand is declining, premiums are under pressure, carry trades are now losing money and treatment charges are rising.

Zinc demand now faces some seasonal headwinds, as typically demand for the metal falls sequentially from the first half to the second half of the year. This seasonal slowdown is expected at a time when zinc stocks remain very high at around 48 days of global consumption.

In Macquarie's view it appears an increasing probability that any rebalancing in the zinc market will need to come from supply side adjustments, meaning prices will have to fall further. This is because any rebalancing from the demand side of the market is unrealistic given the current economic environment.

Turning to the coal sector, Macquarie points out there are signs heavy equipment sales for mining for the likes of United Tractors have grown modestly through the first five months of this year despite strong growth in the total overall market.

In Macquarie's view this suggests weak coal prices are impacting on equipment demand, a trend consistent with the broker's assessment there are production cuts underway at the smaller end of the market. 

Such a supply response is critical for the pricing outlook according to Macquarie, as it should generate a tighter supply/demand balance. Such a tightening in the market should prove to be supportive to prices. 

In the oil market, UBS has adjusted near-term oil price forecasts lower to reflect recent price falls in the market. While making the changes the broker continues to expect oil's fundamentals are likely to tighten from the third quarter of this year given rising seasonal demand, reduced macro uncertainty, the return of a higher risk premium and lower OPEC supply expectations.

The changes see UBS cut US$5 per barrel from its forecasts for the final two quarters of 2012, leaving the broker's forecasts at US$105 per barrel for Brent crude and US$93 per barrel for West Texas Intermediate. There is no change to UBS's longer-term view US$95 per barrel will be a floor for Brent prices and WTI will converge to this level over time.

The changes to oil price assumptions causes UBS to adjust its models for stocks in the Australian energy sector. This has seen some upgrades in ratings, with the broker lifting recommendations for Australian Worldwide Exploration ((AWE)), Beach Energy ((BPT)) and Roc Oil ((ROC)) to Buy from Neutral previously. 

Other Buys in the sector for UBS are Aurora (AUT)), Horizon Oil ((HZN)), Karoon Gas ((KAR)), Oil Search ((OSH)), Santos (STO)), Tap Oil ((TAP)) and Woodside ((WPL)). The only Neutral rating is ascribed to Caltex ((CTX)). UBS has made only minor changes to price targets as a result of the adjustments to oil price estimates. 

 

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