Material Matters: Strategy, Oil, Iron Ore, Zinc And Gold

This story features EVOLUTION MINING LIMITED, and other companies. For more info SHARE ANALYSIS: EVN

-Miner value improves, somewhat
-Will OPEC's quota tighten?
-Iron ore miners more efficient
-Zinc upside hard to define
-NAB analysts bearish on gold
 

By Eva Brocklehurst

Strategy

The latest mineral exploration report from the Australian Bureau of Statistics reveals significant reductions in expenditure on exploration, for both minerals and petroleum. Nonetheless, Morgans observes the extent of area explored has increased, reflecting much cheaper going rates for hiring contractors. The broker notes some well-funded exploration is occurring, despite the downturn.

Evolution Mining's ((EVN)) FY16 exploration budget of $24m rates the company as one of the larger explorers in the domestic gold sector. In the energy sector the broker likes FAR Ltd ((FAR)) for its US$190m free carry on the Senegal portfolio. Thirdly, Mitchell Services ((MSV)), a drilling service provider, is a pick with strong leverage to grade control and exploration drilling across coal, precious and base metals.

Credit Suisse observes the mining sector sell-off continues in the wake of the earnings results. Price-to-book and price-to-sales figures suggest the large cap miners are nearing historical lows in pricing yet earnings estimates are still at risk, given the moves in commodity prices.

Credit Suisse also notes risk appetite has turned lower. Hence, while valuations are starting to provide support, earnings forecasts are possibly still too high. The broker maintains valuations may have improved, but only as long as option value is included and spot commodity prices are ignored.

The broker prefers the mid cap stocks over large caps. At spot, Fortescue Metals ((FMG)), Whitehaven Coal ((WHC)), Western Areas ((WSA)), Independence Group ((IGO)), New Hope Coal ((NHC)) and Alumina Ltd ((AWC)) screen well and the dividend yields remain attractive for BHP Billiton ((BHP)) and Rio Tinto ((RIO)), in the broker's view.

Oil

Oil prices suffered during August, with National Australia Bank analysts observing market risk aversion was heightened on the back of the sharp corrections in the Chinese equity market as well as devaluation of the renminbi. After a prolonged period of low prices even the larger OPEC producers are feeling the strain.

The analysts suspect Saudi Arabia will be able to withstand the low prices for longer but the smaller producers such as Algeria, Ecuador and Venezuela are under pressure to revive discussions on strategy. The NAB analysts suspect an emergency meeting may be called prior to the next scheduled date in December, and for the output quota to be tightened as a consequence.

Iron Ore

China remains the key economy for iron ore demand but this has weakened. The NAB analysts suggest China's apparent steel consumption fell around 5.0% year on year in the first seven months of this year. Hence, steel production is expected to contract in 2015, which directly impacts demand for iron ore, and the analysts envisage little scope for improvement in 2016.

Citi has analysed major miners' realised iron ore prices and compared these to the benchmark/reference price over the four years 2011-14, finding a wide divergence. In general, the analysts found the quality discount and penalties for impurities have been increasing, partly explaining the discrepancies. Fortescue Metals suffered the largest discount in 2014, on the back of an oversupply of low-quality ore.

Miners are increasingly supplying higher grades and the broker suspects this trend will continue, particularly among Brazilian suppliers, because of their additional costs and higher freight charges.

UBS has calculated anew the break-even price an iron ore miner would need to re-evaluate its operations. The broker observes, within its coverage, the producers have managed to lower break-even prices over the past three months. The break-even range across these producers is now US$28-51/dmt CFR. The broker observes Fortescue Metals' break-even has fallen US$2 to US$38/dmt CFR and Brazil's Vale by US$4 to US$37/dmt CFR.

The iron ore price has stabilised recently, defying expectations it would fall back below US$50/t. UBS suspects the market is balanced at this point in time. As Australian producers are operating at capacity the only new supply to consider near term is that from Roy Hill, due in October.

Zinc

The zinc market has been in deficit for three years, resulting in some short-term supply response and increases in mine supply. Strong demand from late 2014 has not continued, the NAB analysts observe, with galvanised steel output growth slowing in line with the Chinese economy. With closure of some big mines imminent in 2016 the analyst expect the deficit to remain in the medium term, with an average price of US$2,100/tonne.

Macquarie observes demand has indeed been weak for zinc but asks if there are any bulls around, given the mine closures. The biggest regional reduction this year was in South America and Russia's domestic concerns are compounded by the loss of export market share in Turkey to rival exporters.

Macquarie trims assumptions for full year demand for zinc in China to 3.1% growth from around 4.0%. Elsewhere, demand growth is absent except for North America, which is forecast at an "unexciting" 2.5%. The broker still expects the zinc market to shift into a raw materials deficit towards the end of this year. However, metal stocks are known to be high ex China, although difficult to quantify.

Hence, the central thesis of price upside for zinc rests on raw material shortages turning into refined metal shortages and forcing market participants to raise their bids.

Gold

The yellow metal may have attracted some safe haven interest in August but this was driven by market volatility and the NAB analysts did not expect it would last. The analysts suspect gold has become increasingly more of a hedge against currency risks rather than economic or geopolitical risks.

Bearish sentiment was demonstrated by a resumption of the downward trend in the June quarter in exchange traded fund holdings. Jewellery demand from emerging countries also fell sharply in the quarter. The NAB analysis forecast gold prices to fall below US$1,000/oz by the second half of 2016. Gold prices are seen entrenched in a bearish cycle which will not turn unless sustained uncertainty translates into slower global economic activity.
 

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