Material Matters: Commodity Indices, Bulks Oversupply And Gold

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-Is it time to overweight?
-Bulk prices stay under pressure
-Demand problem for commodities
-Quality not quantity best for gold?
 

By Eva Brocklehurst

It may be time to become overweight in commodity indices. JP Morgan finds seasonal factors are reversing as global growth and inflation rates turn upward. The analysts believe the bear market in commodities began in late 2011, not early 2013. They consider prices have fallen far enough and for long enough to force cuts in production and spur fresh demand. This is the broker's first Overweight call on commodities since September 2010, having turned Underweight for commodities as an asset class in November 2011.

JP Morgan hastens to add that this is not the "all clear" siren. Downside risk remains high, particularly in metals, and liquidity could dry up over the northern summer. Nevertheless, the recommendation is net long, overweight exposure for institutional investors, for the first time in over two years.

Iron ore may be getting some support from re-stocking and a margin squeeze has been observed in coal markets, which seems to suggest prices are approaching their nadir. Nevertheless, National Australia Bank analysts expect bulk commodity price to remain under pressure as concerns mount over China's growth outlook. Steel production has eased in recent months but is still growing in trend terms as Chinese mills attempt to retain market share in the face of a slowing economy and elevated inventories. The average price for iron ore is estimated at around US$102/tonne Free On Board in June, down from US$117/t in May, while spot coal prices, ex Newcastle, slipped below US$80/t FOB late in June. The NAB analysts have revised price forecasts slightly lower, to account for slower growth, particularly in China.

There are a number of factors contributing to the forecasts. Subdued demand is expected to stay in place for longer and cost cutting and US dollar appreciation will add to price headwinds. Rising global supplies are also significant. The analysts believe Chinese authorities will need to address the overcapacity that has emerged in some sectors and this, along with the cooling economy, will affect bulk commodities. Similarly, steel producers and power utilities will need to lower their costs and this may involve greater use of lower quality coals.

On the supply side, bulk exports, particularly from Australia, are expected to pick up strongly over the next two years. This should keep the market balance loose and bulk commodity prices at or below current levels. Coking coal will also feel the pinch from a soft steel market. Thermal coal is expected to become more balanced in 2014 as buyers look for cheaper alternatives to LNG and oil, and exports from the US slow down. Lower currencies for coal producers will also keep more supply viable. The changes to Chinese policy remain the big uncertainty facing the market, particularly those relating to bans on lower quality coals. The analysts expects a shift to alternative energy sources could also limit any potential price gains.

A weakening of growth in emerging markets has become a cyclical demand problem for commodities, in Morgan Stanley's view. Furthermore, the developed economies in the US and Japan, while reinvigorated, hold out the prospect of less commodity-intensive demand. A lagged supply response is expected to extend the cyclical downturn in prices for non-ferrous metals and steel.

As for bulks, the analysts believe coal is plagued by oversupply from expanded capacity in Australia and Canada and a delayed response to low prices from the US, a swing producer. Meanwhile, thermal coal is challenged by increased capacity in Indonesia, Australia and China at the time base load power growth is slowing. The broker's preference in the bulks segment is iron ore. Supply growth has been less than the more bearish market expectations and, of note, China's imports continue to grow despite weak demand for finished steel.

Morgan Stanley sees evidence of growing oversupply and excess capacity in base metals and remains cautious. Despite this, the analysts believe the market is too bearish on the downside risks to copper. This is Morgan Stanley's preferred exposure. The analysts have downgraded forecasts for gold and silver as the quantitative easing in the US looks like ending. The broker's overweight calls are in the platinum spectrum, particularly palladium.

Goldman Sachs has taken a look at gold miners and challenged the conventional wisdom that longer mine life is a better outcome. As the price declines the analysts believe many companies will have to review profitability for later years. The argument is that a shorter life is better if it means bigger margins and, hence, lower risk. Longer mine lives subject the company to many inputs that can affect cash flows. Relying on cash flow predictions five to ten years out to justify the project places importance on factors which are uncontrollable. The analysts hail plans to mine less low-grade material, which have been put in place by miners such as OceanaGold ((OCG)) and Kingsgate Consolidated ((KCN)).

More impairments are expected to come from the sector, based on the assumptions used to calculate reserves as well as carrying values. The broker finds most balance sheets among the gold miners are okay and a few, notably Regis Resources ((RRL)), Medusa Mining ((MML)) and Perseus Mining ((PRU)) are debt free. Teranga Gold ((TGZ)) and Kingsgate are considered the most vulnerable to further price declines.

Goldman's new forecast assumes a US$1,300/oz gold price until the end of this year, then a steady decline to US$1,050/oz by the end of 2014. Continued central bank gold buying is not expected to be sufficient to offset a decline in prices. The ensuing decline in mined output should maintain prices near US$1,200/oz over the longer term and this is the analysts' forecast for 2015 and beyond.

Goldman has introduced the "all-in cost" and "all-in sustaining cost" metrics proposed by the World Gold Council. The analysts are sceptical about the extent companies will adopt such a level of disclosure, as it will require asset by asset results for both expansionary and sustaining capital.
 

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