Material Matters: Oil, Thermal Coal, Base Metals And Gold

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-Time to buy Australian oil stocks
-Indonesia potential winner in thermal coal
-Zinc, nickel in line with fundamentals
-Copper, aluminium likely oversold
-US dollar not that bearish for gold
 

By Eva Brocklehurst

The oil price slipped off its US$100-plus per barrel pedestal recently and UBS is reminded of the sensitivity of ASX-listed energy stocks to both the oil price and Australian dollar. The oil price has fallen by 16% since mid June for Brent crude, to US$97/bbl. This is only the third time in the past 4-5 years that Brent has slipped below US$100/bbl. UBS suspects there are a number of reasons why the price is lower. Oil demand growth forecasts have been cut by the global energy agencies and, on the supply side, disruptions in Iraq and Russia have not eventuated. Despite the fall, the broker observes top Australian producer Woodside ((WPL)) has held up well, while Santos ((STO)) is down 1.4% and Oil Search ((OSH)) down 6.4%.

Small caps have been hit even harder by the fall in the price of oil, with Horizon Oil ((HZN)) down 25%, Beach Energy ((BPT)) down 14% and Drillsearch Energy ((DLS)) down 13%. Admittedly, Horizon Oil was also affected by the merger with Roc Oil ((ROC)) falling over. UBS continues to expect a long-term oil price of US$100/bbl is needed to encourage exploration and to balance OPEC budgets. The broker considers Oil Search, Drillsearch and Horizon are oversold.

Morgans believes now is the time to buy these oil stocks, with prices expected to rise again from year end. At the same time the Australian dollar will fall against its US counterpart. These two factors combine to make investment attractive for producers and for market sentiment to turn positive for explorers. Morgans notes top performers in the sector include those with recent exploration success, corporate activity, or those with upcoming catalysts. The broker highlights Oil Search, AWE ((AWE)), Drillsearch, New Standard Energy ((NSE)) and IPB Petroleum ((IPB)), which have near-term involvement in hot spots such as Texas, Africa and Western Australia. Morgans' word of caution to investors is to remain active, as high impact exploration wells typically have a higher chance of failure than success and are considered high risk. These include the offshore WA well being drilled by IPB in late October and FAR's ((FAR)) FAN-1 in Senegal.

The new thermal coal restrictions announced by China's National Development and Reform Commission (NDRC) are creating some uncertainties. Wood Mackenzie estimates as much as 39mt of high ash thermal coal from Australia may be affected, while the Bureau of Resources and Energy Economics estimates 20-25mt. By the end of 2014, Chinese authorities are targeting production cuts of 150mt and a fall in imports of 40mt. This should help reduce an oversupplied domestic market, in JP Morgan's view. The broker finds analysis of the impact on Australian coal exports varies widely, citing the Minerals Council of Australia which does not expect a major impact, given imports of black coal destined for northern cities relate to small scale coal use and not large-scale power plants. What most analysts agree on is that Indonesian coal exports should benefit, given almost all that country's coal meets the required new specs for ash and sulphur content.

Commonwealth Bank analysts also observe some confusion about the application of the new regulations. Some participants have claimed that power stations may get exemptions if they have sulphur/ash treatment while others have highlighted the NDRC's reference to "scattered" coal or direct coal consumption, which accounts for 22% of thermal coal use in China, as evidence the regulations won't apply to coal for power stations or cement manufacturers. The analysts focus on the strict regulation banning the use of coal with ash over 16% and sulphur over 1% in coastal provinces and large cities, as this is where most of China's thermal coal imports are consumed. Based on this sample, Colombia and Indonesia are the least affected by the new regulations followed by Australia and South Africa. The coal exporting countries with the highest rates of non compliance are Russia and, potentially, Mongolia.

All up, the analysts observe picking winners is difficult. China is moving to replace direct coal consumption with reticulated natural gas/LNG. Moreover, the domestic coal industry may increase output of higher quality coals to fill the gap as the bans on low quality take effect. Finally, will Indonesia allow increased coal exports? CBA analysts understand the Indonesian authorities are proposing to make coal exporters pay royalties up front and register export eligibility. If regulatory risks restrict Indonesian thermal coal exports, and there is some switching of non-compliant Australian coals to different markets, Australian miners could protect and increase market share by directing more compliant coal to China.

The metals complex has been sold off over the past week on the back of weaker-than-expected Chinese data and the continued appreciation of the US dollar. JP Morgan believes, in nickel and zinc, the price has aligned with relatively weak fundamentals, but in copper and aluminium the selling has overshadowed anecdotal evidence of physical market tightness. In terms of precious metals, the appreciation of the US dollar has historically been a negative while the currency's impact on base metals is more ambiguous.

JP Morgan does not find any sign of improved refined copper availability outside of the US, while European demand is still quiet. Tight credit conditions are also significantly reducing buying interest in China. Outside of China aluminium demand is also outpacing supply. In the US strong demand and tight supply have led to another leg up in MW aluminium premiums this month. JP Morgan continues to expect upside to prices in aluminium for the next five quarters.

Zinc deliveries into the LME are expected to increase in the next few months, as Chinese domestic refined zinc production recovers and demand growth outside of China remains soft. Nickel prices are also trading on news out of the Philippines, where a bill has been introduced that proposes banning unprocessed mineral ores. The price has retraced by almost 10% as it emerged it would probably take two years for the bill to be enacted and, even if enacted, producers would likely receive a five year period of grace. As a result, JP Morgan believes nickel ore exports from the Philippines are secure for the medium term. The bill has also raised an interesting point, the broker notes, about the feasibility of building nickel pig iron smelters in the Philippines, given a lack of high-grade lateritic ore in the country, infrastructure challenges and relatively high taxes.

Gold sold off over September but has more recently sustained some buying interest. To JP Morgan, the market was discounting the geopolitical tensions and economic weakness in Europe and focusing more on the strength of the US economy, strong US dollar and US Federal Reserve policies. The analysts expect short-term gold price support at US$1,220/oz, as physical buying is triggered by lower prices and a shortage of scrap. Asian consumers and investors are expected to step back into the market at current prices. While the appreciating US dollar is bearish for gold, JP Morgan suspects it is not as outright bearish as headlines sometimes imply. In India, gold demand is picking up, although not as strong as at the same time in 2013. Still, buying is occurring at the consumer level and JP Morgan expects Indian gold demand to improve further, boosted by a lower price.

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