Commodity Stocks Need Sentiment Lift

This story features BCI MINERALS LIMITED, and other companies. For more info SHARE ANALYSIS: BCI

By Rudi Filapek-Vandyck, Editor FNArena

It's not how our investment minds are wired, but share prices of commodity producers do not always move in synch with commodity prices.

Anyone who had the prescience and courage to get on board the BC Iron ((BCI)) shareholder register at some point since the company listed in late 2006 is today sitting on a healthy gain and with the promise of some hefty dividend payments in the years ahead; 9.8% and 7.1% respectively on consensus forecasts. It hasn't been different for shareholders in Oil Search ((OSH)), except that those hefty dividend payments to Oil Search shareholders won't happen for another year or two.

Overall, however, the sector has disappointed many over the past years, again bringing home that same message too often forgotten: only a few are left standing as viable investment propositions when prices fall for an extended period. And prices have pretty much been caught in a relentless downtrend since late 2010/early 2011. Some commodities started weakening earlier than others, but ultimately even iron ore, copper and crude oil had to succumb to the same downward pressures. If it wasn't for the sudden upheaval surrounding the struggling regime in Syria, the price of oil would already have been closer to US$100 barrel (Brent), or worse.

The good news is commodity prices are no longer falling. In fact, there are quite a number of analysts around who would be willing to bet that many prices are bottoming right now.

What really excite investors is that the term "global synchronised growth" is making a comeback this year, albeit with a firm bias towards the developed world (USA, UK, Europe and Japan) and with a more sedate, but still positive, role for China. Things are looking better for 2014, growth-wise, and some analysts are responding by lifting prospective prices for basic resources.

The current slew of price updates for iron ore -stronger for longer- is attracting the most media attention, of course. There is a whole lot of symbolism to deal with here as virtually nobody has been lifting price forecasts for iron ore for at least the past two years. Also, while price forecasts are rising, they are doing so from earlier estimates that assumed a much quicker and steeper fall in price than has eventuated to date. But prices are still expected to drop from current level of around US$132/tonne for the high quality 62% Fe grade.

Commodity analysts at CommBank, for example, recently returned from a site trip in China saddled with the conclusion the iron ore market overall is likely to remain better balanced for years to come. The result, predict the analysts, is that US$100/tonne will likely prove a solid floor under the price. Plus CommBank now believes both 2014 and 2015 will see the price average around US$110/tonne, much better than what most had been predicting only a few months ago.

Add more weakness for the Australian dollar and it is not difficult to see how share prices for BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)) -all heavily leveraged to iron ore- can still turn into profitable investments even if the price of iron ore will continue to trend lower (underlying).

Most producers in Australia are now producing at all-in costs that are well below US$110/tonne, implying they will stay in business, generate sufficient cash flows to pay all the bills and reduce debt and possibly reward shareholders with annual dividends. Those that are able to also increase volumes should prove the better investments.

Things should potentially turn out even better for (most) other commodities as they have already gone through the down-cycle that is now happening for iron ore. Few analysts would have anticipated that nickel futures are still trading below US$14,000/tonne today. Or that uranium is priced at US$35/lb. Or that aluminium still does not command a higher price than circa US$1,800/tonne.

It does not require too much imagination to assume that the coming "global synchronised growth" is going to heal all the wounds that have opened up in the sector since late 2010, but that, alas, is not going to happen. Ask analysts at Macquarie and Citi, among others, and they will firmly point into the direction of what is too often forgotten by the optimists: the outlook for commodity prices is (to a large extent) dependent on both demand and supply and right now many markets are facing ample supplies.

As per usual, the precise outcome of predicted demand and supply estimates leads to a wide range of price forecasts, yet the common factor in most research updates is unmistakably clear: investors better not position for significant price increases in the short to medium term. In layman's terms this becomes: there is a lid on the upside potential for commodities prices this year and next.

The good news is, as I pointed out in the opening sentence of this story, sometimes share prices outperform commodities. Given most valuations in the metals and mining sector (more so than in the energy space) are still relatively cheap-looking compared to historical references and compared to the broader market in general, the fact that commodity prices are no longer falling, or falling slower in the case of iron ore, should open the door to further share price gains for those companies who can reasonably be expected to grow profits and dividends for shareholders.

This, I think, lays down the framework for those investors looking to piggyback on the growing realisation there is yet another global growth acceleration in the making, even without all the accolades that surrounded similar events pre-2007 and post March-2009. Playing the commodities theme, in a sustainable, longer term fashion as opposed to the volatility-trading approach, thus becomes a matter of either picking the large cap producers, because they can cut costs, reduce spending, increase dividends and ramp up production, or picking the next successful emerging producer.

The two examples I mentioned at the top of today's story -BC Iron and Oil Search- provide proof that successfully picking the next emerging producers can be a profitable exercise even during times of distress for the sector overall, but since we are talking commodity stocks we also have to take into account above average volatility.

It is my view that equities feel quite "heavy" in September. This view has been reinforced by my own Never Fail Market Indicator (banks share prices versus consensus price targets) which signals the market is a little bit overstretched (as I reported in weeks past). Combine this signal with repeated warning signals from technical analysts elsewhere, plus heavy falls for the local share market on Monday, and it is probably best for anyone who wants to add exposure to commodities to wait until more clarity emerges about how exactly this market "correction" is going to play out.

After all, buying shares in BHP Billiton has only been a profitable exercise for everyone who purchased at price levels lower than today's. Those investors who bought at the start of the new calendar year are only just above water, thanks to two dividend payments. In line with my earlier analyses, and with everything above, I remain of the view that BHP shares will find support at around 4% forward looking dividend yield. At the present share price and FX values, the prospective yield is 3.7%, which means BHP shares can easily revisit the low-$30s.

The next level of technical support is likely at $35 (simple 200 moving average).

Such is the nature of investing in commodity stocks that in order to help share prices outperform their underlying price leverages, we need a boost to investor sentiment, but we may instead see the lack of exactly that first.

(This story was written on Monday, 30 September 2013. It was published in the form of an email to paying subscribers on that day).

(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)

Previous Weekly Insights that might be of interest:

– Big Banks And Big Resources

– BHP At $25?

– Diversified Resources Turning Into… Banks!?

– Investing In Commodities: A Mini-Guide

– Investing In Commodities: A Mini-Guide (vol 2)

And for those who are as yet not familiar with my personal market indicator (banks share prices versus consensus targets):

– Banks Now Overpriced – What Does That Mean?

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July this year forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet was released in January this year and is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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Rudi On Tour

– I have accepted an invitation to present to ATAA members in Canberra in late November

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