Material Matters: Seasonal Weakness, Aluminium, Copper And Gold

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 – Northern summer seasonally weak for commodities
 – Prices expected to improve later this year
 – Aluminium market conditions remain difficult
 – Copper market expectations updated
 – Gold stocks de-rating

By Chris Shaw

The northern summer is typically a seasonally weak period for commodities, as the holiday period affects demand for the industrial metals and capacity is closed accordingly. Demand also tends to fall for the precious metals according to RBS, this given the Indian monsoon period and limited gifting demand from China and the west.

Lead excepted, RBS notes inventories for the industrial metals tend to increase or remain broadly unchanged in month-on-month terms in August, so any increase in inventories this time around should not be assumed to equate to weaker market fundamentals in the broker's view.

Such increases may keep prices under pressure, but RBS suggests further downside for industrial metal prices is limited. 

Looking further ahead, RBS notes the final quarter of the year tends to be accompanied by a seasonal upswing in demand. When the possibility of QE3 is added to the equation, RBS suggests a healthy recovery in commodity prices is on the cards for later this year. Given this, RBS suggests the next few weeks offers an opportunity to gain commodity exposure to take advantage of this expected upswing in prices in the final quarter of 2012, one that is expected to last into 2013 for most commodities.

Looking more closely at the base metals, Citi suggests aluminium smelters are facing a tough 2012 given the year-to-date weakness in aluminium cash prices. At the June low of around US$1,810 per tonne, Citi estimates close to 50% of smelters in the non-Chinese world would have been losing money.

But in China, Shanghai aluminium prices have averaged between US$2,450-$2,500 per tonne so far this year, which Citi notes is supporting higher cost smelters in the Chinese market. This implies a market with two cost curves, one for the Chinese smelters and one for rest of the world smelters.

In contrast to aluminium prices, aluminium premiums have risen so far this year, Citi attributing this to growing investor demand for physical metal to tie up in LME and non-LME warehouse-based financing deals and the restrictive operating nature of LME warehousing. One impact of the increase in premiums according to Citi is it has enabled many smelters to continue production, so adding to the market's oversupply.

As most smelters typically operate for a number of months before reacting to prices, Citi expects significant over-production and depressed prices will continue to weigh on aluminium through the summer.

Weak prices and rising costs have pressured Australian aluminium smelters, as Citi notes around 9% of Australian capacity has been shutdown permanently so far this year. The carbon pricing scheme is expected to further increase costs for Australian smelters. 

While alumina refineries in Australia are also experiencing higher costs, Citi notes they are being helped by higher alumina prices. This leads Citi to suggest the alumina space appears a more attractive space in Australia when compared to aluminium smelting.

Turning to copper, ANZ Banking Group has cut its price forecast for the metal for the second half of 2012 by 4%, while its full year forecast has been lowered by 3.9% to US$8,156 per tonne. This reflects a less tight market than previously expected, due largely to slower demand growth from China in particular.

Revised demand assumptions see ANZ cut its projected deficit for copper in 2012 to 63,000 tonnes from 170,000 tonnes previously. A swing to a surplus of around 420,000 tonnes is expected in 2013 and for next year ANZ is forecasting an average copper price of US$8,598 per tonne.

Longer-term, ANZ's best case scenario is for a global copper market surplus of around three million tonnes in 2020, a figure based on expected demand of 28.4 million tonnes. If based solely on approved projects however, ANZ notes the copper market in 2020 would likely be in deficit of around 2.9 million tonnes. 

This implies copper prices will need to remain elevated at levels above US$6,062 per tonne to ensure enough concentrate can be delivered to the market. This is reflected in ANZ's long-term average price forecast of just over US$6,170 per tonne in 2012 dollar terms.

Macquarie has also reviewed the global copper market and concludes the market is fundamentally tight, meaning another annual deficit this year. Fundamentals are expected to improve through the second half of 2012, as Macquarie notes Chinese stocks are now being drawn down and demand from key sectors in China such as the power grid is improving. 

As well, Macquarie points out mine supply growth has again disappointed the market this year, as all major miners have underperformed relative to planned increases. 

At present the copper price is around 2% lower than at the start of the year, yet as Macquarie notes ASX listed copper producer values have fallen far more significantly. PanAust's ((PNA)) share price has fallen more than 30% this year, while OZ Minerals ((OZL)) has lost more than 25%.

This leads Macquarie to suggest any improvement in market sentiment should be a benefit to ASX listed copper plays. PanAust is Macquarie's preferred producer thanks to it having the greatest leverage to a recovery in market sentiment and/or higher copper prices. 

OZ Minerals is oversold and offers value at current levels in Macquarie's view, so both it and PanAust are rated as Outperform. Macquarie also rates Discovery Metals ((DML)) and Blackthorn Resources ((BTR)) as Outperform, the former for significant leverage to the copper price from output expansion potential and the latter from scope to significantly add to resources at the Mumbwa project.

Macquarie also covers Sandfire Resources ((SFR)) among ASX-listed copper plays and rates the stock as Neutral given the shares are trading broadly in line with valuation. 

The FNArena database shows Sentiment Indicator readings of 1.0 for Blackthorn, 0.8 for PanAust, 0.4 for OZ Minerals, 0.2 for Discovery and 0.1 for Sandfire.

Turning to gold, analysis from Citi suggests while all resource stocks have de-rated from an earnings multiple perspective in the past several years, gold stocks have de-rated by 10-20% more than the broader resources market.

As evidence of this, Citi notes in 2004/05 gold equities traded on an earnings multiple of around 30 times and at around twice the earnings multiple of the broader resources sector. The earnings multiple for gold stocks has since fallen to around 12 times, which is a 50% premium to the broader mining market.

While much of this reflects higher commodity prices and therefore higher earnings, Citi suggests that given gold's allure appears to be fading there is a risk the de-rating in gold equities continues. Potentially, Citi sees scope for multiples to move to the same single-digit range as resource stocks such as BHP Billiton ((BHP)) and Rio Tinto ((RIO)).

Changes to weighted average cost of capital (WACC) assumptions could drive a further de-rating, particularly in price to net present value terms, as Citi notes for some time gold stocks have used a quasi default WACC of 5% to reflect the quasi cash nature of gold.

But if the market is moving away from assuming such a WACC for gold stocks and towards a discount rate reflecting the inherent risk in gold companies, the average multiple for gold stocks will likely fall in Citi's view. 

As well, Citi suggests performance for gold equities from now will be driven by not only the gold price but by what the companies do operationally. This includes measures such as reducing costs and growing production volumes.

In terms of the impact of gold exchange traded funds or ETFs, Citi notes while the emergence of such ETFs has caused gold equities to underperform the gold price, this is not a unique scenario in the resource sector.

With the upwards momentum in commodity prices having ceased, Citi suggests it is difficult to see how investing in commodities can generate outperformance. At the same time, it is likely the period of outperformance of commodities versus equities may be over in a stagnant price environment. For Citi this implies the right equity exposure, with good cost control, volume growth and positive cash flow, should be enough to outperform ETFs in coming years. 

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