Material Matters: Mining Stocks, Bulks And The Oz Economy, Gold And Nickel

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-JP Morgan moves to Overweight miners
-It's prices not volume, says Goldman Sachs
-Gold to remain subdued in 2014
-Demand destruction likely in nickel
 

By Eva Brocklehurst

JP Morgan's European equity strategists have upgraded the mining sector to Overweight from Underweight, believing an improvement in free cash flow and potential for capital returns is imminent. The strategists expect Rio Tinto ((RIO)) will generate a free cash flow yield of 9% in 2015, among the highest in the market, and be in a position to augment a 4% dividend yield with capital return. The broker also expects BHP Billiton ((BHP)) to make a capital management announcement at its FY14 results.

The strategists have been structurally bearish on mining for over two years. The rest of the June quarter could still lack momentum but JP Morgan thinks it is an opportune time to build exposure ahead of a better second half performance. The broker recognises the risk of further iron ore price weakness but has become more positive on the second half, given improving Chinese steel indicators. Valuations also look attractive, even if the iron ore price trades at US$80/t into perpetuity.

Goldman Sachs has crunched some numbers on what is really driving Australia's economy in terms of commodities. The broker cites no shortage of economists who believe that rising mining volumes will overturn any negative impact of falling prices. The broker thinks they fail to acknowledge the downside risks to iron ore prices. To Goldman, it's prices and margins that provide the real leverage in Australia's economy, not volume growth. The resource sector is unable to alter its cost base as quickly as its revenue stream moves and this drives a compression of profitability via fixed cost leverage.

With such a heavy concentration of the Australian economy in iron ore and coal the broker thinks the next wave of compression is set to commence, after a break at the end of 2013 while commodity prices were broadly steady. This could also coincide with renewed focus on savings from a government perspective, to witness a multi-year decline in mining investment. Goldman considers the recent positive employment data is a fillip from nine months of stable commodity prices and fiscal stimulus in 2013/14, and the boost in sentiment following the change in government in 2013. Looking ahead, the broker expects disappointment to flow over the winter months, as there are indications the economy has slowed since January, and the summer's employment growth could stall.

Gold demand is subdued and indicators suggest to JP Morgan the potential for higher prices is limited in the short term. Headwinds include sluggish US economic recovery, low inflation and ongoing reductions in the US Federal Reserve's bond buying program. Still, gold prices are up more than 7% this year, stemming mostly from fears over the Ukraine conflict. Seasonal demand is a positive catalyst that is likely to strengthen late in the September quarter and there is also the chance that Indian import restrictions will be relaxed after the elections. The broker thinks this should lead to an increase in demand. Anecdotal evidence suggests to the broker that Chinese market has plenty of gold and the weakness in the currency, which depreciated by just over 3% since January, has further deterred gold imports.

This softness in Chinese demand is expected to continue, until picking up in the December quarter in preparation for Chinese New Year. Despite the weakness in demand, JP Morgan still expects 2014 will be second only to 2013 in terms of gold use. It seems the sudden drop in prices in 2013 brought forward purchases, which cannibalised demand in 2014. The broker retains a price forecast for US$1272/oz in 2014 and US$1275/oz in 2015.

Nickel demand may adjust lower from the prospect of higher prices but Deutsche Bank believes, ultimately, the construction of processing capacity in Indonesia is necessary to balance the market. This will take at least two years to reach critical mass and another two to create a more balanced market. The broker forecasts prices to run higher for longer, and upgrades nickel estimates by 11% in 2014, 21% in 2015, 50% in 2016 and 64% in 2017. Now, all indications are that the Indonesian ban on ore exports will be enforced. Many operators lodged plans for the building of downstream processing when Indonesia's permit rules were changed in 2012, ahead of the 2014 ban. Nevertheless, until the ban was actually enforced there was little progress being made. Moreover, the broker had estimated that mid 2015 was the soonest that the Indonesian political process would facilitate a change to exports, but this has proved not to be the case.

There may be other ways to account for the supply shock, in that some demand destruction for nickel is likely, such as a switch to ferritic grades (chrome only) from austenitic (nickel and chrome) in the case of stainless steel. Deutsche Bank also increases the proportion of scrap in ratios for stainless steel forecasts. At the start of the ban, the broker estimated that China had roughly 320,000t of contained nickel in ore and this should sustain nickel pig iron production for eight months. Deutsche Bank now thinks this may be optimistic, noting port stocks have fallen by 13% in the first three months of the year.

Can The Philippines, the second most important exporter of saprolite ore to China, supply the shortfall? Deutsche Bank notes the ore is of lower grade and it is unlikely it will fill the breach left by Indonesia. Nickel exports from The Philippines could increase by 100-120,000t by 2017, a third of the gap left by Indonesia. Nickel projects that could ramp up or re-start to capitalise on the higher price are limited. The broker notes Falcondo in the Dominican Republic is one and there are some marginal operations in Australia such as Avebury, Sinclair and Silver Swan.
 

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