Material Matters: Iron Ore, Gold, Oil And The AUD

This story features SANDFIRE RESOURCES LIMITED. For more info SHARE ANALYSIS: SFR

– Higher production and lower costs can offset low prices
– Lower LT Brent forecasts take some shine off oil plays
– Iron ore to stabilize then soften
– Low AUD lifting valuations and earnings

By Andrew Nelson

Yesterday, analysts at Deutsche Bank reviewed their outlook on the Australian mining sector. The broker noted that despite increasing global demand for metals, overall growth rates are decelerating if anything. The question now is: can stocks go up on declining commodity prices?

The short answer is Yes. The broker believes shares can push higher as miners increase free cash flow via lifting production and cutting costs, which in turn will increase returns. This is despite the broker forecasting prices near current spot prices, with nothing but a modest pick-up in demand expected in 2014.

The broker notes many of the stocks it covers are currently discounting flat commodity prices around or even below the broker’s long term forecasts. This tells Deutsche Bank that the market is now pricing in a faster return to long-run pricing. The broker thinks a price arbitrage may be forming.

Under this scenario, the stocks worth looking at include BHP Billiton ((BHP)), which is discounting a US$71/t CIF iron ore price and Rio Tinto (( RIO)), which is sitting at US$67/t, well below the broker’s long term US$80/t. The entire copper sector is also trading at a discount to the broker’s long term US275c/lb copper price, while pretty much the entire gold sector is trading at a discount to spot. Both Alacer Gold ((AQG)) and Regis Resources ((RRL)) are trading significantly under the broker’s long term gold price of US$1,300/oz.

The broker likes companies with strong free cash flow and a deep discount to NPV the best. These would include Rio Tinto, BHP, Sandfire Resources ((SFR)), Alumina ((AWC)),Regis, Alacer and Independence Group ((IGO)). The broker notes both Rio Tinto and BHP are blessed with a number of re-rating prospects. These are the potential for increased production, the ability to cut costs and the ability to increase dividends via asset sales and reduced capex requirements.

Deutsche Bank also took a look at the Australian energy sector, with reduced long-term Brent forecasts seeing 2%-7% cuts to target prices for large-cap Australian Energy plays. The broker expects Brent oil prices to lift from current levels to average around US$101/bbl in 2H13 on the back of improving global economic growth. However, the broker’s long-term Brent forecast has been trimmed to US$100/bbl after taking US oil supply forecasts into account.

Given the broker sees little earnings assistance from oil prices in the near term, it will be the stock specific drivers that deliver share price performance. Thus, stocks offering earnings growth via production growth or those that are positive prospective news flow with the potential for re-rating opportunities are the ones the broker likes best.

Oil Search ((OSH)), Woodside Petroleum ((WPL) and Santos ((STO)) are the broker’s preferred exposures. Oil Search should see some upside from news about PNG LNG Train 3 developments and from drilling in the Gulf of Papua and the Taza field in Kurdistan. Woodside offers Pluto-1 re-pricing upside into 2014 and a strong dividend yield, while Santos offers near-term production growth and 18% upside to the broker’s target price. There are still plenty of risks with GLNG, but the broker thinks they are more than in the price at current levels.

JP Morgan has taken a fresh look at iron ore, noting prices seem to have stabilized after what turned out to be a 31% correction after hitting a peak in February. Demand remains solid despite the weaker prices and while the broker sees a little bit of short term help coming from this, ultimately JP Morgan expects supply-side dynamics will start to drive down iron ore prices.

But for the near term, the broker suspects prices have likely bottomed and should recover a little into the 3Q along with a pick up in steel prices and restocking demand. Chinese steel production growth remains robust despite all of the soft China talk and this is more than offsetting ex-China weakness. In fact, the broker expects demand to grow 4.6% in 2013 and 4.0% in 2014.

The problem is, new supply will soon be outstripping what are admittedly decent demand levels. JP Morgan expects ex-China supply growth to lift to 7.2% during the 2H, which will certainly keep a cap on prices. It’s not just a short term issue either, the broker forecasting ex-China supply to grow by 9.1% in 2014 and 6.9% in 2015.

The broker also took a fresh look at the Australian coal market, noting last year’s production shortages from flooding and industrial action have given way to a market that is now well-supplied. This has pushed the broker to lower its 2013-14 hard coking coal price estimates to US$156/t and US$160/t respectively.

The broker expects coking coal pricing will remain weak in Q3 and Q4, but by 2014 we should be looking at a more balanced market that should allow prices to recover. The broker does note steelmakers have been moving to use more PCI coal and other lower cost alternatives, which could limit the upside for the best quality coals.

The thermal coal market is also well supplied, says JP Morgan, but the broker points out that with US utility inventories currently falling, the outlook for 2014 is pretty good.

UBS recently took a look at the falling AUD and the broader impact it is expected to have on Australian resources. The broker notes the Australian dollar has suffered more than most during the US dollar’s recent rally. The outlook for the AUD has fundamentally changed, seeing the broker cuts its 2013 forecast to US97c from US$1.04, while 2014 is cut to US92c from US$1.03 and 2015 is now US90c from US97c.

Given commodities are generally priced in USD, the weaker exchange rate will help to lift AUD revenues and also deliver some decent earnings upside. This is especially so in coal, where margins are thin given the recent drop in prices. BHP, Rio and Fortescue Metals ((FMG)) will also enjoy increased earnings despite reporting in USD given substantial AUD cost bases. The broker also notes there are even a number of marginal companies that will return to profitability on the weaker AUD.

On the other hand, UBS thinks the outlook for commodity prices in general remains soft and if protracted, could wipe out the current AUD upside and more. The two best placed plans are, as always, Rio Tinto and BHP given low cost asset bases. Alumina is a big beneficiary of the current AUD and is one of those companies that moves into profit on the broker’s new forecasts.

Morgan Stanley has come out a cut its gold price forecasts, citing not only the recent pullback, but also the evident decline in appetite for gold as an investment asset. 2014-15 gold price forecasts are dropped by 16% and 10% to US$1,313/oz and US$1,300/oz. The broker’s long term forecast remains unchanged at US$1,348/oz.

This has had a negative impact across the sector, seeing wholesale cuts to earnings, valuation and price targets across the broker’s gold stock universe. As you can guess, the producers boasting the lowest costs are the least affected and are thus the broker’s preferred exposures.

The top two? Perseus Mining ((PRU)) and Medusa Mining ((MML )), as they offer the best margins and solid upside to current price targets. Given the broad and seemingly panicked sell off across the sector, the broker thinks these two will fare well given they will also remain reasonably profitable during these times of softer gold prices.
 

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