Material Matters: Iron Ore, Merger Speculation And Gold

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-Iron ore surplus by year end
-Buy cycle for iron ore stocks?
-WSA-SFR-SIR merger potential?
-Gold? Must be high grade/low cost
 

By Eva Brocklehurst

Iron ore's day in the sun is coming to an end, according to Goldman Sachs. This year prices have fallen by 21%, while Chinese port stocks have risen to a record 109 million tonnes. The June quarter has started with an inventory overhang and limited upside is expected for demand over the rest of the year. Yet the relentless upward momentum in seaborne supply continues. The Goldman analysts believe the structural surplus will become increasingly pronounced this quarter and rise to around 145mt in 2015. Lower seaborne prices are expected to eventually affect Chinese domestic prices, forcing the closure of marginal supply that comes mainly from small mines near the coast. The analysts believes this time these closures are likely to be permanent.

Even so, they believe the level of cost support that high-cost mines in China provide, once the market shifts into oversupply, has not been properly tested. Hence, a wide gap in expectations for iron ore prices exists. The analysts tend to think that the closures of the small Chinese mines will be offset partially by new projects in inland regions as well as improved mechanisation and higher productivity. The analysts do not think the level of cost support in China will stop seaborne prices from dropping through US$100/t in 2015. How low does the broker suggest prices may go? Goldman reiterates a US$80/t price forecast for 2015.

The analysts think it highly unlikely that iron ore demand from the Chinese steel sector will surprise greatly on the upside this year. Indeed, such demand needs to grow by 10% both this year and next to absorb the expected surplus. The analysts believe the steel intensity of the Chinese economy is falling and demand for iron ore will decelerate out to 2018.

Citi is taking a more positive cyclical view on iron ore stocks, although remains a structural iron ore bear, with price forecasts of US$90/t in 2015 and US$80/t in 2016. The broker has upgraded several stock recommendations on this more positive cyclical call. The supply growth rate in iron ore is expected to slow in the second half of 2014 as Fortescue Metals ((FMG)) and Rio Tinto ((RIO)) hit targeted rates of production. This feature, combined with a continued recovery in Chinese steel production as liquidity conditions improve, means there's some near-term upside for the prices of these two stocks – both upgrade to Buy from Neutral. Mid caps Atlas Iron ((AGO)) and Mt Gibson Iron ((MGX)) are upgraded to Neutral from Sell.

Credit remains the key to China's growth momentum, in Citi's view. Conditions are tight but unlikely to get tighter. Citi also notes the real estate sector has been a big negative for commodity demand and the Chinese government and developers are beginning to react. This signals better demand in the second half. This should provide enough impact to, at the least, stop the slide in the iron ore price and the share price of the stocks, if not lead to a rally once the price of the metal bottoms and rallies back above US$110/t.

To much more speculative matters, and Bell Potter looks at what would happen if Sirius Resources ((SIR)), Western Areas ((WSA)) and Sandfire Resources ((SFR)) were to merge. The broker thinks such a combination would create a company with improving debt and equity financing terms, improved capacity to undertake value accretive corporate activity, diversified metals price risks, overhead savings and, importantly, longevity. All these factors would create value for shareholders. Such a move would create a high-grade, gold and base metals conglomerate and a $2.6bn, top 100 ASX company, in the broker's opinion. Production by FY15 would be around 73,000tpa copper, 26,000tpa nickel and 39,000ozpa gold. Bell Potter thinks the most feasible paths to consolidation is a Sandfire-Western Areas merger prior to a move on Sirius Resources, or a joint bid by the former two for Sirius Resources.

Physical demand has been strong for gold jewellery, coin and bar, with sales topping US$170bn in 2013. DJ Carmichael observes these sales figures are a result of a better outlook for the global economy and the unwinding of global stimulus measures. Also, gold has been sought as a safe haven as tensions mount in Ukraine. The price has rallied 7.2% since the beginning of the year in US dollar terms. China has become the biggest buyer, surpassing India.

So, if the price is higher and demand is strong, DJ Carmichael asks why is it that some gold stocks are not benefitting? The broker notes only 38% of gold companies have had positive returns since the beginning of the year and suspects the reason is because of the negative sentiment in the market towards small resource stocks. DJ Carmichael notes the market is assigning the highest valuation to those companies producing high quality from smaller underground operations. High grade, high margin operations rank highest, as they are able to withstand price fluctuations in the underlying commodity. The market is not paying for companies that are more leveraged, reflecting an increased level of risk aversion.

The broker notes Doray Minerals ((DRM)), Medusa Mining ((MML)), Northern Star Resources ((NST)), Regis Resources ((RRL)), Troy Resources ((TRY)) and Beadell Resources ((BDR)) are all producing high quality ounces at low cost and/or have management premiums.
 

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