Material Matters: Base Metal Producers, Silver, Rio Tinto’s Key Assets And Iron Ore

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-Producing stocks matter on ASX
-Gold and copper dominate small caps
-Silver could start to perform
-RIO upside on copper, aluminium
-More downside for iron ore
 

By Eva Brocklehurst

Resources stocks are starting to matter in the ASX Small Ordinaries Index. They may only form 20% of the index compared with 45% back in 2012 but there are some that are making Goldman Sachs sit up and take notice. The broker notes production is replacing speculation. Recent acquisition announcements from PanAust ((PNA)), Aquila Resources ((AQA)) and Karoon Gas ((KAR)), and upside in Western Areas ((WSA)) from nickel price appreciation, show that resource exposure can still affect the performance of the index. At its peak in 2011, 40% of the small cap resources exposure was from non-producers but this has now halved. The likes of producers such as PanAust, Whitehaven Coal ((WHC)) and OZ Minerals ((OZL)) are replacing development companies and this reduces the level of risk in resource weightings.

Gold and copper remain the main commodities in the small cap index. Gold used to dominate more than it does now, at 15% of weightings versus 36% for resources overall. That percentage has fallen to 5% with energy taking 5% and copper 3%. The broker's preferred exposures in the ASX small cap resources space are Alacer Gold ((AQG)), Beadell Resources ((BDR)), Sandfire Resources ((SFR)) and Drillsearch ((DLS)).

Silver has underperformed gold in the past few years but this could be changing, in Deutsche Bank's view. Silver's decline may have reflected aggressive liquidation among speculators over the past few months. From a valuation perspective the metal is moving into territory that may be considered cheap, in the broker's opinion. The speculative community may be ignoring silver but Deutsche Bank observes electronic trading fund flows reveal more support, with silver enjoying inflows of US$116m in the year to date. Deutsche Bank is reluctant to become outright long on silver but believes the underperformance of silver relative to gold over the past three years is becoming inconsistent with a rebound in US economic activity, and from a position and valuation perspective.

Rio Tinto ((RIO)) should reveal upside from its North American copper and aluminium assets. Morgans anticipates this potential ahead of the investor site visit next week. Despite higher iron ore production, the broker estimates a combination of lower iron ore prices and material improvements in the aluminium and copper divisions will lead to their combination accounting for more than 25% of group earnings in 2015, up from 15% in 2013. The broker expects aluminium earnings will increase by 75% in 2015, as the full benefits of cost cutting and a turnaround in the Gove operations boost the profitability of the business.

The broker also thinks the market may be underestimating the amount of value the company has been able to extract from efficiencies. Copper is being targeted for US$500m in cost savings over two years with Kennecott alone expected to provide more than US$300m. Morgans believes the most value accretive option for the diamond business is a trade sale or as a separately listed vehicle.

Deutsche Bank has downgraded forecasts for iron ore, expecting iron ore fines to decline by 10.3% to US$89.3/t in FY15, against a previous forecast of US$99.5/t. The broker's mining earnings forecasts are reduced 45% for FY15 and 50% fro FY16. In making these downgrades to forecasts the broker increases profit forecasts for BlueScope ((BSL)) but reduces profit forecasts for Arrium ((ARI)) and Sims Metal Management ((SGM)). Arrium has been downgraded to Sell from Hold because of significant iron ore price and balance sheet risk associated with reduced earnings. Sims retains upside potential from further improvements in US economic activity while BlueScope has strong exposure to the Australian housing recovery.

Commonwealth Bank analysts are also downgrading iron ore price forecasts, by 10% to US$104/t for 2014 and by 8% to US$100/t for 2015. The analysts note the wet season did not affect Australia's Pilbara production much this year and this allowed for strong volume growth. Brazilian supply was also relatively unaffected by the wet season. Chinese domestic supply usually ramps up after winter as warmer weather in the north allows increased mining activity. These seasonal factors should run their course over the next month or two and support a recovery in iron ore price from current levels, in the view of the CBA analysts.

There are other weakening factors which are coming to bear, they acknowledge, such as the lift in supply. Fortescue Metals ((FMG)), BHP Billiton ((BHP)) and Rio Tinto have all lifted run rates in the past three to six months. This should weigh on the market for the rest of 2014. The analysts do not expect another major step up in export supply until the second half of 2015.

On the demand side, very weak property construction forward indicators point to growing downside risks for Chinese steel demand and output from the second half of 2014 and into 2015. The CBA analysts downgrade 2014 Chinese steel output growth to 2% from 3%. All up, the risks imply a faster transition to long-run iron ore prices of US$90-100/t and the analysts believe, with property construction demand looking like retracing in China, the balance of risk seems tilted to the downside.
 

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