Material Matters: Metal Demand, Indian Coal And Oz Energy Stocks

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-Metal demand grows in emerging markets
-Reason to be upbeat on Indian coal demand
-Indonesian coal exports more affordable for India
-Best performers among Oz energy stocks
-Impact from FX changes on materials stocks 
 

By Eva Brocklehurst

There are signs that global demand for metals is synchronising. US economic data over the past two months has been generally strong and Europe appears to be finally leaving recession behind. Developed economies are steering towards making a positive contribution to global growth. China has avoided the hard landing and manufacturing is accelerating. The third segment of the global pie, emerging market demand, looks to be also growing.

Copper, zinc, and lead are the metals most sensitive to any further improvements in the economic growth outlook and JP Morgan finds relatively modest increases in demand would be enough to shift those markets from moderate surpluses into balance. In aluminum and nickel, strong production amid hefty inventory levels will continue to pressure cash prices, even with a significant rise in demand. The analysts project global aluminum demand will be 6.4% in 2014, already the highest growth rate among the base metals. It appears this will still not be sufficient to offset a 6.5% increase in global production. In nickel, the ramp up of three major laterite operations in 2014, combined with strength in Chinese pig iron production and low probability of an outright ban on Indonesian ore exports, should keep that market in surplus.

What about this emerging markets story? Slower growth in these countries has been driven by falling corporate profits, limiting spending, as well as by tightening of bank lending standards. JP Morgan's economists believe cyclical support is now building for these nations. This is predicated on more competitive currencies for the likes of Indonesia, India, Brazil and Turkey and lower interest rates in Thailand, Philippines and Mexico. The demand pull from recovering developed economies is also expected to support emerging market exports.

JP Morgan finds the emerging market share of global metal demand, ex China, has been relatively constant since 1976, averaging 29%. It accounted for 26% of global metals demand in 2012. On an absolute basis, this 26% is a smaller share of global demand than developed nations at 31% but, as a share of forecast metals use, incremental growth in this emerging segment will account for 23% and 28% of 2014 and 2015 growth respectively. What this suggests to JP Morgan is, although the global growth case rests predominantly with China, the relatively low urbanisation, ongoing demand for electrification and infrastructure and supportive demographics in many of the emerging market nations will ensure their share of global metals demand continues to increase.

Taking a closer look at thermal coal demand in India, Macquarie thinks there's reason to be upbeat. Imports fell 22% in August as buyers pushed back on tonnage because of a weak rupee, high inventories and monsoon-related factors. The number for September may be even weaker, but Macquarie suspects demand-side pressures are abating. Full year imports look set to reach 135m tonnes, exceeding the broker's forecast of 132mt. There needs to be a pick up in shipments in the final quarter of the year to fulfill this estimate but Macquarie finds signs that this is materialising. If so, India looks likely to become the world's second largest thermal coal importer, overtaking Japan.

At the same time the rupee was under pressure, the Indonesian rupiah suffered even larger declines. In reaction Indonesian producers slashed prices and this means Indonesian coal is becoming more affordable for Indian buyers. If there is a pick up in Indian demand then Indonesia is likely to be the source. Macquarie has received anecdotal feedback about mine closures at current pricing but is yet to see cuts in aggregate production. The regulatory stance taken by the Indonesia government on royalties and export taxes could be the major swing factor for coal production in 2014, given up to 54% of production permits would be pre-tax loss makers in the event of both higher royalties and coal export taxes. From discussions with attendees during the recent commodities conference in Jakarta, Macquarie expects pricing expectations to remain muted, with the consensus appearing to be pricing a continuation of current levels over the near term, largely on supply concerns.

Morgan Stanley has reviewed energy stocks to look at what's driving the sector. The Australian energy sector has rallied 13% in the year to date, against 12% for the ASX200. That may not be greatly different, but it betters the situation in 2012 when the sector retreated 2% in a market that rallied 15%. The drivers are, of course, oil prices and exchange rates. The additional drivers are the progress being made through the capex cycle, de-risking of major LNG projects and the domestic gas market dynamics, with the pursuit of new sources of supply. Morgan Stanley finds hard evidence of future higher, oil-linked prices in recent supply deals and expects this theme to remain an important driver, given an assessment that future supply shortfalls have not been addressed. In  the case of major LNG developments the broker thinks there's further value to be captured.

Morgan Stanley characterises the better performers by their declining capex with safe passage to completion of projects, LNG in particular, as well as their exposure to domestic gas prices and volumes. Those underperforming are those that need more capex to fund exploration and development and have impoverished balance sheets.

So, what's the choice? Of the larger cap stocks the broker's favourite, and only Overweight recommendation in this group, is Oil Search ((OSH)). Morgan Stanley thinks over the next 3-5 years production growth will outdo peers and drive value. Those that are rated Neutral (equal-weight) are the bulk of the major players, Woodside Petroleum ((WPL)), Origin Energy ((ORG)), Santos ((STO)), Caltex ((CTX)) and Beach Energy ((BPT)). Among smaller stocks an Overweight rating is applied for varying reasons. ROC Oil ((ROC)) is trading with a large discount to profitable, developed assets. Karoon Gas ((KAR)) has favourable geology and large upside to exploration outcomes but funding remains an issue. Horizon Oil ((HZN)) offers production growth leveraged by debt but production plans are taking longer than expected to reach fruition. Senex Energy ((SXY))  is liked because of its exposure to Cooper Basin growth.

Following changes to Deutsche Bank's foreign exchange assumptions, the broker has reviewed materials stocks. Earnings estimates remain broadly unchanged apart from Amcor ((AMC)) where earnings estimates are raised by 2-3%. Amcor's earnings are highly sensitive to movements in the currency and Amcor does not hedge its translation exposure. Deutsche Bank estimates every EUR1c move affects net profit by $5m and every US1c move by $3m. For Orica ((ORI) the broker estimates a 1% move in the Australian dollar against a basket of currencies (USD, EUR, GBP and NZD) impacts pre-tax earnings by $4m on the hedged component and $8m on the unhedged component. Incitec Pivot's ((IPL)) earnings are also sensitive to movements in the currency, given the translation of the Dyno earnings and the sale of DAP and urea in US dollars. IPL hedges its transaction exposure but not its translation exposure. The broker estimates every US1c move impacts pre-tax earnings by $10m. DuluxGroup's ((DLX)) sensitivity primarily comes from the translation of offshore earnings, particularly from New Zealand and Asia.
 

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