Material Matters: China, Resources Sector Preferences, And Tin

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 – RBS sees some positives from China
 – Brokers update sector preferences
 – Macquarie revises commodity price forecasts
 – Tin market outlook reviewed

By Chris Shaw

As noted by RBS Australia, headline manufacturing and growth indicators for China softened further in August, as industrial production growth for the month weakened to 8.9% in year-on-year terms. Weak export demand from Europe in particular and poor confidence levels thanks to excess inventories continue to drag on conditions, but RBS sees evidence of destocking and an improved outlook for the property sector as positives with respect to the outlook for 2013.

An example of the former is port stocks of iron ore, which have declined from a post-GFC peak of around 40 days last November to about 35 days now. In the property market there are signs of a pick-up in activity ranging from land sales to floor space final sales.

RBS still suggests the People's Bank of China (PBoC) will need to ease monetary policy further to deliver a meaningful increase in credit growth. But with policy-making continuing on a cautious path, RBS doesn't see a sudden pick-up in Chinese resources demand. This implies cost-curve support will remain a key through the rest of 2012.

Relating this to the Australian resources sector, RBS sees valuations as attractive given near-record discounts to net present value (NPV). At the same time, the growing gap between commodity prices and the AUD/USD continues to pressure the outlook for earnings in FY13. 

Under current conditions and expectations RBS continues to prefer BHP Billiton ((BHP)) among the diversified plays, along with copper, energy and gold exposures. The broker's model portfolio holds BHP, Santos ((STO)), Oil Search ((OSH)), PanAust ((PNA)), Newcrest ((NCM)) and Alacer Gold ((AQG)) as its resource exposures. 

Macquarie has also reviewed its resource sector models, this to account for changes to commodity price forecasts. A revised outlook for Chinese steel demand has resulted in cuts to iron ore forecasts of around 25% over the next few years, though short-term the risk appears to be to the upside for spot prices.

For 2013 Macquarie is forecasting an iron ore fines price of US$130 per tonne, while prices should remain above US$110 per tonne through 2016. Met coal estimates have also been lowered by 5-18% in coming years, Macquarie now expecting a hard coking coal price of around US$200 per tonne in 2013.

Changes to base metal forecasts were mixed, with little change to copper and nickel estimates but aluminium and zinc price forecasts cut 6-16% in coming periods. Gold price forecasts were trimmed slightly, while Macquarie's long-term uranium price has been lifted to US$55 per pound from US$50 per pound previously.

In general, Macquarie's review indicated many core themes in the resource sector remain unchanged – long run prices continue to move higher and demand remains on track for another record year this year. At the same time, price falls add to the likelihood supply growth falls short of expectations in coming years.

As well, cyclical supply from the likes of China continues to act as a balancing force for markets, leading Macquarie to suggest a drop to the long-term commodity price environment will only come about when enough of this cyclical supply is replaced by new, lower cost material to force cyclical supply to react to demand swings. 

Applying revised commodity price estimates to resource stocks under coverage has meant changes to earnings estimates and price targets across the sector. On average, net profit after tax estimates for BHP Billiton have been cut by 24% through FY17, while estimates for Rio Tinto ((RIO)) have been lowered by an average of 34% through 2016. While Macquarie retains an Outperform rating on both stocks, valuation suggests Rio Tinto is slightly preferred even accounting for potentially lower risk to earnings for BHP in coming years. 

The cuts to iron ore prices have meant cuts to price targets across the sector of 10-40%, while both Atlas Iron ((AGO)) and Grange Resources ((GRR)) have seen ratings downgraded to Neutral. In both cases this reflects not only the changes to forecasts and targets but recent share price gains. In the iron ore sector Macquarie's top picks remain Fortescue Metals ((FMG)) and BC Iron ((BCI)), both of which are rated Outperform.

Gold equities have outperformed bullion in recent weeks and valuations for producers have increased from near-record lows, but Macquarie suggests a further re-rating for the sector will require operational improvements and better performance with respect to delivering on growth options. Alacer is Macquarie's preferred exposure, while Newcrest should benefit from incremental production improvements. Both stocks are rated as Outperform, along with Evolution Mining ((EVN)) and Azimuth Resources ((AZH)).

With changes to copper price forecasts limited there has been only a minor impact on valuations in the sector. Production growth potential sees Macquarie favour PanAust among copper plays, while OZ Minerals ((OZL)) also appears to offer value at current levels. Both are rated as Outperform by Macquarie.

A weaker outlook for the Australian dollar against the US dollar has provided a marginal valuation uplift for AUD-exposed nickel stocks under coverage. In the sector Macquarie prefers Independence Group ((IGO)) and Western Areas ((WSA)) and rates both as Outperform.

Valuation for Iluka ((ILU)) has also risen slightly but given recent share price gains Macquarie suggests the stock is now trading in line with valuation. As a result rating is downgraded to Neutral despite a slight increase in price target.

The increase in long-term uranium price forecast has boosted valuations and target prices for both Paladin ((PDN)) and Energy Resources of Australia ((ERA)), though in both cases Macquarie's ratings are unchanged at Neutral and Underperform respectively. 

Macquarie has also adjusted estimates in the energy sector, this to account for changes to medium-term currency forecasts. The changes are most significant for the Australian dollar, with forecasts now standing at US$1.04 in 2013 and US$1.02 in 2014, down from previous estimates of a rate of US$1.07 through 2015.

Given it reports in Australian dollars, Santos is a major beneficiary of the changes, with earnings forecasts lifted by around 5% by Macquarie. Santos again is the big winner on a cash flow basis as the likes of Woodside ((WPL)), Oil Search, Roc Oil ((ROC)) and Horizon Oil ((HZN)) are again impacted by reporting in US dollars. 

The changes to estimates have not impacted on Macquarie's bullish stance towards the energy sector, driven by stocks trading at an average discount to underlying net asset value of 26%. In the large caps Macquarie favours Santos and Oil Search, while Origin Energy ((ORG)) is also rated as Outperform against a Neutral rating for Woodside.

Elsewhere in the sector, Macquarie has Neutral ratings on Caltex ((CTX)) and Nexus ((NXS)), while AWE ((AWE)), Beach Energy ((BPT)), Horizon, Roc, Molopo Energy ((MPO)), Carnarvon Petroleum ((CVN)), Tap Oil ((TAP)) and Karoon Gas ((KAR)) are also rated as Outperform.

At the start of August, falling tin prices caused Indonesian producers to announce production cuts and sales limits. Citi notes when similar moves were made in 2011 tin prices did find short-term support, rallying until export and production discipline again broke down.

This time around tin prices also rallied, before Indonesian smelters announced exports would resume in September. While previous periods when Indonesian supply discipline ended such as 2008 and 2011 saw prices reverse significantly, Citi sees reasons why this won't be the case in 2012.

As Citi notes, the level and availability of LME tin inventory is very limited at present, with as little as 4,195 tonnes of inventory available to the wider market in recent weeks. As well, Citi notes supply from other markets, in particular China, has been weaker this year than was the case in 2011.

Lower Chinese output has seen Chinese tin imports increase strongly this year, Citi noting refined imports are up 172% in year-on-year terms for the year to July. Citi expects positive arbitrage margins will support Chinese import demand through the balance of this year, as it currently appears cheaper for tin consumers to buy metal from overseas than from domestic producers.

At the same time tin demand weakened through the first half of 2012, though not enough in Citi's view to remove the tightness in the market overall. Citi continues to forecast a market deficit of around 11,000 tonnes this year, which it expects will offer price support. The US$23,000 per tonne level is the next price target for tin in Citi's view. 

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