Material Matters: Iron Ore, Oil And Stock Preferences

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By Andrew Nelson

The state of iron ore prices and demand levels from China remain a major driver of both Australian economic and commercial success, whether we like it or not. Over the last few months iron ore prices tanked before settling a little higher over the past few weeks, temporarily avoiding what were very damaging levels. Yet the question remains: can we bank on more help from iron ore prices and iron ore demand from China?

Analysts at ANZ reassessed the iron ore market last week and while their outlook isn’t fantastic, at least the bank expects prices to remain at or above economic levels.

First, it’s important to note that the see-sawing in the iron ore price we’ve had to deal with over the past two months has done a bit of damage, causing increased levels of concern, caution and uncertainty over the direction of the price. And uncertainty is never the market’s friend. However, the team from ANZ believe that over the past few weeks, calmer heads have started to prevail, with much of the speculative activity now wound out of the market.

The problem is we’re still left with fundamentals that have certainly deteriorated, with Chinese steel mills continuing to pump out product despite the weakening demand outlook. On the bank’s numbers, output from China is running about 15% above required demand, with the team thinking 40-50 million tonnes of steel has been stockpiled over the last 4-5 months. Normal levels are closer to 10 million tonnes, notes ANZ.

Given the current demand outlook, the team thinks we could be looking at up to six months to clear the excess inventory, which will keep a cap on iron ore prices in the meantime. Thus while ANZ believes the recent 25% relief rally in iron ore was justified, it also believes this is not likely to be the first step of a stronger recovery.

The bank has cut its iron ore price forecasts by an average of 16% for the next 12 months and by an average of 7% over the corresponding two years, noting that the faster closure of high cost Chinese iron ore supply has lowered the industry floor price by at least US$10/t. 

If there’s good news to take from this it’s that at least iron ore prices are settling down and this should provide a bit of clarity and confidence. ANZ predicts iron ore will trade in a US$100-$110/t range over the next 3-6 months, while steel stockpiles and uncertain demand from China remain the main factors in the market. Things should start to pick up in the second half of 2013, but the team thinks pricing power will end up being more balanced, which translates to a more sustainable trading range closer to US$110-$130. Getting back to the US$130-$150 is far less likely.

Analysts at Macquarie Group are also of a timidly optimistic view on the outlook for iron ore prices, noting data from its September survey of steel mills, steel traders and iron ore traders continues to show that while the market remains difficult for steel industry, at least production has started to be scaled back.

The broker believes that things are starting to look a little better than they have in previous months, with infrastructure orders rising, while iron ore destocking has just about finished and steel inventory at both mills and held by traders is finally starting to fall.  

Given current market uncertainty, however, the general outlook consensus within the industry remains mixed. Macquarie notes that while traders are a little more positive, mills remain cautious. The broker believes that some sign end-user demand has started to improve could lead to a decent restocking rally, but as to when, the broker simply doesn’t know yet.

Switching our focus to oil sees us take a look at a report out yesterday from Deutsche Bank. The broker has turned a bit more positive on the outlook for oil prices and stocks, seeing help arriving in the form of supply concerns, given the current geopolitical mess in the Middle East and the implications this has on steady supply.

The improved outlook sees the broker lift its Brent oil forecasts for 4Q12 and for CY13 to US$113-$115/bbl , up from US$100-$104/bbl. As a result, Deutsche’s CY12-13 EPS forecasts for large-cap Australian Energy plays have increased by 6%-14% on average.

If anything, the broker sees upside risks to its 2013 oil forecasts given the likelihood of continued supply risks, with Iran and Syria remaining at the core of the issue. In such an environment, Oil Search ((OSH)) remains the broker’s top sector pick, followed by Woodside ((WPL)) and Aurora ((AUT)).

The thing that unites all three of these stocks is less LNG news flow risk, more visible earnings growth, the expectation of positive news flow in the near-term and valuation upside. The broker also points out that all three also enjoy a USD denomination, meaning they are less at risk from the persistently high AUD. Given the broker has also revised its AUD assumptions, predicting a slightly stronger outlook for longer, USD denomination is quite a helpful trait.

Goldman Sachs also took the chance to update its earnings estimates to account for actual changes to spot Brent oil prices and FX rates over the September quarter. The end result is not quite as upbeat as Deutsche Bank's assumptions, with CY12/FY13 earnings estimates cut across the sector due to a lower than expected A$ oil price.  

Caltex ((CTX)) is an exception, however, given it actually benefits a little from the lower oil price by way of lower working capital. The broker has also lifted its price target for Roc Oil ((ROC)) a little on the back of progress being made at Beibu Gulf, which is nearing production.  Price targets for the other stocks in the sector remained unchanged.

Lastly, Deutsche Bank has reviewed its 4Q12 commodity price assumptions and precious metals have come out the winner. Forecasts are lifted by 5%-10% from 2013-2015. The broker expects gold will deliver the best returns over the next 18 months, with US$2,000/oz expected to be breached some time in 1H13 on the back of a cocktail of expanding monetary conditions, South African supply constraints, negative real interest rates, a weak USD and central bank purchases.

In the meantime industrials metals, while able to derive some benefit from government policies, will still need to see the start of economic recovery in China before we see significantly higher prices. Deutsche likes copper given slow supply growth and demand support, with nickel next and then aluminium.

For gold exposure, the broker likes the look of Alacer ((AQG)) given valuation upside and St Barbara ((SBM)) given better leverage to rising gold prices. On the broker’s numbers, every 10% lift in gold prices increases its valuation for SBM by 35%

In industrial metals, Deutsche’s top pick is PanAust ((PNA)) given the low capital intensity growth options at Phu Kham and a 35% exposure to precious metals. Rio Tinto ((RIO)) and BHP Billiton ((BHP)) also feature given attractive valuations, strong margins, and growth flexibility. Of the two, Deutsche likes RIO better, as the broker sees a more compelling valuation story and stronger 2-year earnings growth.

The broker also thinks Whitehaven Coal ((WHC)) has some decent valuation appeal despite some shorter term challenges in the coal space, while Alumina ((AWC)) is looking allright given the broker is starting to see some upside potential for alumina prices.

 
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