Material Matters: Coal, Gold, Nickel, Oil & Gas

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-Coal looks forlorn
-Gold costs loom large
-Nickel's awful trading range
-Oil & Gas pays dividends
 

By Eva Brocklehurst

Memories are short it seems. Goldman Sachs calls coal the forgotten sector. The strength of the Australian dollar and increasing costs have narrowed profitability and reduced the sector's competitive ability. Goldman notes thermal coal unit costs in Australia are up 110% since 2006 in US dollar terms and 51% in local currency terms. The Australian free-on-board cash cost is now in the top quartile of the cost curve at $85/t on average and this has caused Australia to cede incremental volume growth to lower-cost regions such as Indonesia, Colombia and South Africa.

The news is still not good. Thermal coal prices are likely to face continued pressure from slowing import demand in China, increasing infrastructure capacity and lower domestic electricity growth rates, Goldman maintains. The broker forecasts thermal coal prices of US$98/t in 2013 and US$100/t for 2014-15. Amid local coal stocks, Resource Generation ((RES)) is Goldman' preferred exposure. The company has all mine approvals in place as well as its infrastructure requirements and there's better project economics in South Africa where the company has its Boikarabelo mine nearing go.

Goldman finds little value elsewhere in the sector, believing Coalspur Mines ((CPL)) is not likely to deliver on cost expectations and Whitehaven Coal ((WHC)) remains constrained by high costs and delays in the development of Maules Creek. Yancoal ((YAN)) is Australia's largest coal producer but the broker is neutral on the stock because of low liquidity and high debt levels.

There's nothing consistent about gold stocks. Deutsche Bank notes investors are disappointed with gold companies being unable to translate strong gold prices into profits. Profit expectations are driven by the C1 cash cost measure but the broker suspects this does not reflect the true cost to produce an ounce of gold. There's moves afoot to replace C1 with an "all-in cash cost" to better reflect profitability, particularly in a falling price environment. So where does this put the gold stocks under this broker's coverage? Deutsche Bank expects a peak in all-in cash costs in 2013 and puts Regis Resources ((RRL)) and Medusa Mining ((MML)) at the lowest all-in cash cost level. Alacer Gold ((AQG)) and Newcrest Mining ((NCM)) are seen to have the greatest potential for improvements in 2014.

To measure all-in cash costs the broker includes C1 operating costs, royalties, sustaining capital costs, near-mine exploration, evaluation and corporate costs. So, there's a lot of costs to consider. All-in costs among the producing companies should average $1,208/oz in FY13. What! Where have these costs been lurking in the past? Deutsche Bank says operational cost inflation was hidden throughout 2011/12 as gold prices surged. Average all-in cash costs across the broker's covered stocks were at $799/oz in 2011 so that's a 40% increase to the $1,108/oz recorded for 2012. The culprits? Again, a higher Australian dollar and increased operating cost inflation attacked profit margins.

So, FY13 should produce the peak in expenditure while an easing gold price could drive industry changes. Further afield? Cost control and production growth should drive down all-in cash costs in FY14. The broker expects the higher capital spending in previous years will translate into stronger gold output in FY14, with gold production lifting 27% for the seven gold stocks covered. Average all-in cash costs are forecast to decline 25% to $908/oz.

Much of this reduction will be driven by Newcrest, as significant production growth comes from Cadia East and Lihir. Deutsche Bank also expects Alacer will experience 25% lower all-in costs for 2014. Regis, meanwhile, has a strong cost profile, with FY13 all-in cash costs of $767/oz despite commissioning of Garden Well. On a final note, Medusa is the market leader when looking at costs ($584/oz in FY13), benefiting from high grades and low labour costs. The broker is cautious on the stock, nonetheless, because of the operational unpredictability and country risk.

Nickel fundamentals are awful, in Macquarie's view. Prices are increasingly being supported by financing nickel in LME warehouses and the metal appears stuck in a narrow trading range. The broker finds LME stocks have risen almost continuously since the end of 2011 and are now approaching the all-time high level of 166,476t seen in February 2010. Where are the stockpiles? Most of the surplus has either accumulated in China or in LME warehouses outside China. Macquarie notes that part of the problem is non-deliverable nickel – nickel in scrap, ferronickel and nickel oxide – is being offered into the physical market at significant discounts to LME. These forms are first choice for consumers that can use them, mainly in the stainless steel industry, which accounts for at least 65% of nickel usage. Producers of LME deliverable product can achieve the LME price by selling on the LME so LME stocks represent most of the surplus.

The debate in the nickel market centres on supply growth in China. According to Macquarie, this revolves around how much of the nickel ore being imported from Indonesia is being stockpiled, ahead of a possible ban on nickel ore exports from that country, and how much of ore imports from the Philippines is being used as iron ore and not nickel ore. The broker's conclusion is that forecasts for imports in 2013 of 396,000t may be conservative. For the rest of the world, uncertainty still revolves around the estimates of growth in nickel projects.

Based purely on fundamentals, the broker thinks that the price could trade in the US$15-16,000/t range this year, to force the closure of higher cost Chinese NPI capacity. Nevertheless, the resilience of prices since mid 2012 indicates that stock financing demand will limit the downside in the short term. Macquarie thinks it may take an event external to nickel for prices to drop under US$16,000/t and that's not been heralded, yet.

Oil and gas looks a bit better. With the market focused on high yield stocks, UBS had a look at returns from the ASX100 oil and gas stocks and ponders the dividend outcomes. Usually held as growth stocks, the broker concludes that the end of major LNG investment over the next couple of years provides scope for higher dividends. Woodside Petroleum ((WPL)) has been the focus as Pluto is reliably producing LNG. UBS expects the company to generate positive free cash flow and notes investors are looking for a capital return in the second half. Woodside may increase its dividend, the broker warns, but an off-market buyback cannot be ruled out. 

There are three scenarios UBS paints. If the Browse development (at James Price Point) is sanctioned in June, the broker suggests not to expect anything in the way of capital management from Woodside. If the Browse project is not sanctioned then the company is expected to evaluate capital management options. Wildcards, the third scenario, are either sudden progress with Sunrise LNG, or further acquisitions. Either of these could change the strategy in relation to increasing capital returns. Another item: speculation that Woodside will use its franking credits to buy Shell's 23.3% stake. The broker discounts this as it would impinge on the company's growth strategy because of the need to take on large debt.

For UBS, Santos ((STO)) is the oil major that could surprise. A forecast minimum $1.9bn in cash and undrawn debt by 2015 as well as a step change in cash flow once both the company's LNG projects come on line in 2014/15, leads to expectations of a doubling of dividend to 60c by 2015 and a rise to 100c by 2017, fully franked (7.6% net yield). Increasing the dividend soon would send a signal to the market that the company is confident in delivering the projects in hand on time and on budget. In the broker's opinion, this would attract investors seeking yield. The risk to this speculation is that the company may decide to be conservative and retain a larger buffer for potential capex increases.

More dividends to come? Oil Search ((OSH)) may produce a dividend increase in 2015 while Beach Energy ((BPT)) could deliver a special dividend. Oil Search, focused on delivering the PNG LNG, is slated for a big year in 2013. The company may surprise and increase dividends earlier but UBS expects the increase to be more likely in 2015. Beach may entertain the concept of a special dividend or raise its regular payment, UBS maintains, now the Chevron deal is done and as the Western Flank ramps up this year. The key here is what the company plans in terms of unconventional acreage once Chevron has completed the farm-in. The broker thinks Beach could afford to distribute up to 10c, fully franked, by way of a special dividend but may decide to retain cash for future investment in Cooper Basin oil and gas.

The other stock to look out for is Aurora Oil & Gas ((AUT)). UBS thinks the company will start paying a dividend when Eagle Ford is self funding. The company expects to be cash-flow positive by the end of the year and UBS forecasts a 4c dividend payable in 2015.
 

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