Material Matters: Oil, Coal, Bulks And Contractors

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Upcoming OPEC meeting; coal price rally; outlook for bulks; de-rating ahead for contractors.

-OPEC production freeze may help sentiment and put a floor under the oil price
-Will Chinese government boost thermal coal supply to cap prices this winter?
-Citi expects Chinese steel prices will lose momentum
-Ord Minnett recommends taking profits on highly leveraged contractors
 

By Eva Brocklehurst

Oil

Iranian officials have expressed tentative support for a freeze on oil production. The country's energy minister has said that any measure that helps stablise the oil market will be supported. The country's outright refusal to consider capping output was a reason Saudi Arabia backed out at the Doha meeting but RBC Capital Markets suggest a compromise could occur at the upcoming meeting in Algiers.

OPEC producers do not want oil prices to fall further. While a production freeze may end up being just optics rather than action the analysts suspect, at a minimum, it would put a floor under the market and remind all of OPEC's capacity to co-operate. It would also signal that remarks regarding the cartel's demise are premature, the analysts contend.

Coal

The recent rally in coal prices has been instigated by China's industry reforms and Morgan Stanley queries what will happen now. Does the Chinese government boost supply to cap prices or maintain its reform agenda?

The government has met with the country's large coal miners and many expected a removal of the constraints that were instituted to deal with persistent surplus and safety issues, given the inflation in coal prices that has eventuated. Nevertheless, the government has signalled the reform process continues and has allowed for temporary increases in coal supply in periods of under-supply.

The broker believes the government is concerned about the rally in prices as thermal coal is still China's primary source of energy. If supply is not boosted by October-November a significant portion of coal-fired power generation may be forced to shelve loss-making capacity. Morgan Stanley suspects a pre-winter surge in supply will be allowed and this will undermine Chinese demand for imported coal.

Macquarie observes there are initial measures focused on thermal coal which appear to consist of 74 mines being allowed to produce up to a combined 500,000 tonnes per day. The broker acknowledges details of the measures are inconsistent and information is based solely on media/trader reports.

Macquarie agrees the supply expansion will be incrementally bearish for seaborne prices. The implication is that RMB450/t is considered by the government to be around the price that it can maintain. The broker calculates this relates to a seaborne price of around US$60/t FOB Newcastle and not the current US$70/t price.

Bulks

Despite marking to market upgrades for 2016, given the stronger-than-expected performance of bulk commodities, namely iron ore and coking coal, Citi still expects bulk prices will decline in the next few years, with the exception of manganese, particularly as increasing iron ore supply is delivered into a flat/declining demand outlook.

The broker flags relevant stocks that have been outperforming on the back of these price rises, namely South32 ((S32)), Fortescue Metals ((FMG)) and Whitehaven Coal ((WHC)) and prefers the diversified players such as BHP Billiton ((BHP)) and, secondly, Rio Tinto ((RIO)).

The broker also notes a call for bulk prices to fall is, in part, a call against the Chinese government, given bulk/steel prices have surged in 2016 and this is largely attributable to either stimulus measures or capacity cuts being implemented in China.

Citi acknowledges sentiment may be as much of a driver of the market as anything else. If China's steel production expands in 2017 then this may, alone, support iron ore prices at current levels. Yet, the broker does ultimately believe Chinese steel prices will lose momentum later this year and into 2017.

Citi prefers base metal players over the bulks and copper stocks such as OZ Minerals ((OZL)) and Sandfire Resources ((SFR)). The broker has Sell ratings on Independence Group ((IGO)) and Western Areas ((WSA)) driven by its bearish view on nickel.

Contractors

Ord Minnett suspects the small and mid cap contractors segment is likely to experience a de-rating. The stocks which have performed the best this year are those exposed to gold mining and have high debt, as investors purchase the riskiest businesses, which in turn have the most equity leverage. Some high quality stocks have also performed well such as Mineral Resources ((MIN)) and Service Stream ((SSM)).

De-rating expectations are supported by the decline in capital expenditure, in Australia with the latest statistics for FY17 predicting a 17.4% decline, mostly in the resources sector. Moreover, the broker believes FY16 results quality was poor. Work in progress increased 6.8% yet revenue was down 10% and EBITDA (earnings before interest, tax, depreciation and amortisation) fell by 21%, indicating margin pressure is an issue.

Most companies are basing FY17 guidance on improving conditions, albeit not materially so, the broker notes. Those with oil & gas exposure remain bearish. Ord Minnett does not believe guidance matches with the run-up in price the sector has enjoyed recently, although arguably stocks were previously oversold.

The broker accepts it is difficult to predict the turning point of a sector with such strong momentum and recommends taking profits on highly leveraged stocks, sticking with those that are leveraged to growth. The broker's top picks are Mineral Resources, Service Stream and RCR Tomlinson ((RCR)).
 

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