Commodities: Smaller, Shorter Excitements Until 2016?

This story features GRANGE RESOURCES LIMITED, and other companies. For more info SHARE ANALYSIS: GRR

By Rudi Filapek-Vandyck, Editor FNArena

Think about it. It's quite ironic the country that until recently was thought to have access to an unlimited pool of cheap labour is currently wrestling with a tighter than forecast labour market and companies on the ground are reporting growth limits and project delays because of it.

It's not the only misconception about China that has unravelled in recent times, but it certainly is one of the important ones. In particular for share market investors in Australia where hopes for another round of infrastructure stimulus by the newly chosen leaders in Beijing have been one of the motivations for owning resources stocks, and for expecting a swift turnaround in the sector's fortunes.

Alas, all speculation about a pending stimulus program to kick Chinese growth in line with global expectations has proven somewhat of a pub joke. You know, the one where the publican promises to serve free beer for everyone "tomorrow". Of course, come again the next day and the same promise still shows prominently on the wall behind the bar. In the same vein, tomorrow has proven one day too far off for the next round of Chinese demand stimulus.

So why hasn't Beijing re-opened the stimulus tap in the face of slower than expected growth?

Nobody really knows the answer as China very much remains the source of a thousand dreams and guesses, even to many experts with on the ground contacts and experiences, but a tight labour market certainly is one of the plausible explanations. Nobody wants to see wage inflation taking off, while on the other hand low unemployment undermines the case for more stimulus.

A second, equally convincing argument, is high debt among Chinese companies and regional governments. There comes a point when high debt levels undermine further stimulus attempts because private companies will simply use new liquidity to pay off old debts, not to make further investments. Has China reached this critical point? Yet another matter for public debate.

One obvious legacy from the last big round of stimulus, in 2009, is that many industries in China are now faced with structural over-capacity. The Chinese steel sector, for example, and aluminium smelters. This implies that further investments probably won't generate anything in terms of a commercial return. They might even worsen the current over-capacity. Taken from this point of view, China's dilemma about further private investments looks pretty similar to the dilemmas that are currently a hot topic during board meetings at Woodside Petroleum, BHP Billiton, Rio Tinto, and others.

Will there be a high enough return, if any?

The good news is China has seen it all before, and mistakes have been made in the past and subsequently corrected. The scenario was not fundamentally different in the late nineties and Chinese banks had to be bailed out en masse by the central government in the early noughties. Which is probably why the new leadership in Beijing has to date held off on genuine further stimulus and instead is concentrating on structural reforms. UBS economists recently compared today's misalignments inside the Chinese economy with the late nineties and concluded that virtually on every aspect the situation today appears less severe than back then.

This implies any reform/adjustments should have a less negative impact too.

UBS economists are the latest to re-calibrate their expectations for Chinese growth in the short to medium term, to 7.7% for this year and to 7.8% next year. Note how the 8 has virtually disappeared from experts' projections. Their peers at Citi informed their clientele Chinese GDP growth is on its way to 6.5% by 2020.

Before anyone raises that other widely quoted misconception, that these lower numbers come with a larger sized Chinese economy and thus they are good news, economists at Goldman Sachs again spelled out what the true problem is for commodities this year: supply is catching up and Chinese growth at lower pace means markets will remain well supplied, if not over-supplied.

Goldman Sachs decided to cancel its long copper trading position last week, at a loss. This may serve as an indication of the in-house conviction behind the move.

To be fair, one of the additional factors that is predicted to keep a lid on the price of copper this year is the Chinese crackdown on all things shadow financing, i.e. outside the regular banking channels. As every investor should know by now, many a Chinese company has used materials such as copper as collateral for financing deals when faced with more scrutiny from Beijing and local banks. Goldman Sachs sees the unwinding of such trades as a major impediment for the price of copper, whereas previously supply problems at Rio Tinto's mine in Utah and at Grasberg in Indonesia would have translated into a less tight market, and thus potential for higher prices.

However, when it comes to base materials, nothing is ever written in stone. Macquarie analysts observe how, in the absence of more stimulus through infrastructure investments, the Chinese property sector appears poised to contribute more to overall growth this year. This is good news, explain the analysts, because the property sector is more resources intensive than infrastructure, implying demand from China may well surprise to the upside later in the year, despite its growth numbers no longer reaching above 8%.

Regardless, and as I have argued since last year, the most important feature for commodities markets this year is what is happening on the supply side, not what is happening in China. It should be noted this conclusion is popping up in more and more sector updates as 2013 matures. Consider the following title above the latest sector update by analysts at Goldman Sachs, published on Friday: "The balance of power shifts further away from iron ore producers".

Goldman Sachs analysts have thus reiterated their negative view for iron ore prices in the years beyond 2013, expecting the price will be back at US$80/tonne by 2015. Note also the analysts have a bullish outlook for the months ahead, but they remain steadfastly negative beyond what they see as one final push higher.

Recent updates on commodities by the likes of Macquarie, Goldman Sachs, JP Morgan and Credit Suisse reveal just how price expectations have flattened for the years ahead. Certainly, there's still room for prices to rise from present levels, on the conditions that supply does not positively surprise and demand does not disappoint even more, but any rises, so it appears, shall remain benign and certainly not register to the same extent as to what investors have become used to in the decade past.

This outlook can have even deeper ramifications than is currently reflected in the industry's capex intentions. Economists at National Australia Bank probably summarised it best: "While the investment pipeline remains enormous, there is a real risk that the rate of decline in capital expenditure will be more pronounced than previously anticipated, having a more severe impact on the Australian economy than currently forecast".

Don't rush out to snap up beaten down pick and shovel services providers. They might yet be facing even more dire news.

The more pleasant side-effect of all this is that today's slump in demand growth, prices and investments is creating a fertile base for the next upswing. But investors might have to be patient, with commodity specialists at Macquarie suggesting the next up-cycle might not announce itself with sustainable gusto until 2016.

Meanwhile, and again proving there's always some reason to inject some excitement into (some) resources stocks, recent sector updates inspired by adjustments for the Australian dollar are revealing any further AUD weakness has the potential for large consequences for a selection of smaller mining companies. JP Morgan analysts believe AUDUSD is poised to average around parity for the years ahead, which is well above most revised expectations elsewhere, but despite lower for longer prices for most commodities the net impact on certain companies is still calculated to be substantial, if not spectacular.

Earnings forecasts for Atlas Iron ((AGO)), for example, have risen 13%, 56% and 57% respectively for 2013-15. For Grange Resources ((GRR)) the increases are 87%, 156% and 111%. Whitehaven Coal ((WHC)) registers minus -14%, up 112% and 43%. Also, consider the projected impact on Alumina Ltd ((AWC)): up 46%, minus -151% and minus -76%. OZ Minerals ((OZL)): up 22%, then minus -78% and minus -51%. PanAust ((PNA)): minus -24%, minus -30%, minus -25%.

Note all these percentage changes reflect JP Morgan's adjustments to estimates, not the actual earnings estimates. Most of the heavily hit companies such as Alumina, OZ Minerals and PanAust are still projected to grow their profits, but at much slower speed than previously assumed. Ironically, most of the heavy beneficiaries, such as Atlas Iron and Grange Resources, seem to have only minimal growth on the agenda for the years ahead. But that's still a lot better than what prospects looked like earlier.

Analysts at Credit Suisse, on the other hand, believe AUDUSD will be back at 0.85 in twelve months' time and this leads to a whole different set of outcomes. On CS's projections, Western Areas ((WSA)) should benefit to the tune of 90% in FY14, with Atlas Iron second on close to 80%. Alumina Ltd and Evolution Mining ((EVN)) should benefit more than 60% each, while for Yancoal Australia ((YAL)) the gain should be 50%-plus.

And THAT is why resources stocks will always remain on the radar of day traders and speculators in the share market. Investors with less appetite for extreme risk, and more focused on capital preservation and income, should have learned a few valuable lessons by now.
 

(This story was written on Monday, 27th May 2013. It was published on the day in the form of an email to paying subscribers).

Equity Market Pullback A Buying Opportunity?

According to our recent Investor Sentiment Survey (results will be released shortly) many among you are considering allocating more funds to equities as pullbacks occur. I strongly recommend the three groups of stocks identified in my eBooklet from earlier this year: Make Risk Your Friend. Finding All-Weather Performers (see also below).

DO YOU HAVE YOUR COPY YET?

At the very least, my latest e-Booklet "Making Risk Your Friend. Finding All-Weather Performers", which was published in January this year, managed to accurately capture the Zeitgeist.

All three categories of stocks mentioned in the booklet are responsible for the index gains post 2009 and this remains the case throughout 2013.

This e-Booklet (58 pages) is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

****

Rudi On Tour in 2013

– I will present and contribute during the 2013 National Conference of the Australian Technical Analysts Association (ATAA) at the Novotel in Sydney's Brighton Beach, June 21-23

– I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm

Click to view our Glossary of Financial Terms