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Material Matters: Analysts Turn Positive On Commodities Exposure

Commodities | Sep 13 2012

 – Standard Chartered turns more bullish on commodities
 – UBS also moves to an Overweight position in resources
 – Some grounds for an iron ore price recovery
 – Coal could also enjoy some gains
 – CBA updates mineral sands outlook

By Chris Shaw

Despite poor price performance in commodity markets so far this year, the view of Standard Chartered is the market is now in the early part of a more bullish phase for commodities. Since June 21st, 14 of the 16 key commodities have risen in price and the commodities basket used as a general reference has gained 10% over the period.

June may prove to be a turning point, as Standard Chartered notes history shows turning points in the market usually come when the outlook is weakest. As well, there remains potential for significant price rallies from any pick-up in demand as consumers are currently operating on hand-to-mouth inventory levels and supply remains constrained for many commodities. 

An example is copper. While inventories in China are low, as much as one million tonnes of the metal has been taken out of the market and is in bonded warehouses where it remains tied up in financing agreements. Yet, observes Standard Chartered, the price has been rising. This is seen as a bullish sign, as higher prices mean consumers are running out of stock, traders have become short and supply remains constrained. 

The analysts are also bullish on gold given the industry is building limited new mine supply each year at the same time as Chinese and central bank buying continues to increase. Gold also stands to benefit from continued loosening in monetary policy globally.

While bulk prices have been far weaker than Standard Chartered expected, this is now in the price and the falls in recent weeks could in fact be a positive longer-term as low prices may discourage new capacity additions. 

While factoring in lower commodity prices has caused Standard Chartered to cut earnings forecasts and price targets across the sector, this has not detracted from the newly bullish outlook as the weakness in resource equities is regarded as having been overdone.

Among the major stocks under coverage, Standard Chartered continues to rate Rio Tinto ((RIO)) as Outperform, while BHP Billiton has been downgraded to In-Line from Outperform. The attraction of the former is solid production growth as new world-class projects are brought on-line on top of a possible recovery in iron ore prices. For BHP, Standard Chartered suggests lower capex and a lack of major project approvals means the stock could trail peers in a period of recovering commodity prices.

Outside of stocks with an Australian listing, Standard Chartered rates Glencore International and Xstrata as Outperform, the latter involves an upgrade from In-Line previously. Anglo American, Vale and CITIC Pacific are rated as In-Line, the former having been downgraded from Outperform previously and the latter upgraded from Underperform.

UBS similarly has moved to an Overweight position in resources stocks, given the view further Quantitative Easing could drive up commodity prices and as a result mining equities. The broker likes Rio Tinto relative to BHP Billiton, suggesting Rio Tinto is cheaper on forward earnings and better placed with respect to free cash flow allowing for additional capital management.

Reviews of the earnings models for both companies have generated some changes to earnings estimates, the change enough for Rio Tinto's price target to be lifted to $93.00 from $90.00. UBS notes under current spot prices, earnings for 2013 for BHP and Rio Tinto would fall by 30% and 47% respectively. Under such a scenario Rio Tinto continues to trade on a cheaper multiple. 

As noted by Goldman Sachs, after several days of declines, iron ore prices have recovered somewhat so far this week. Given domestic iron ore production is falling and weak prices make further production cuts likely, the broker suggests there are some grounds to expect further price recovery in the market.

Chinese domestic supply appears to be responding to lower prices and this leads Goldman Sachs to suggest the Chinese iron ore cost curve may yet reassert itself. This would also be a positive for prices in the broker's view.

In coal, Goldman Sachs suggests a supply response is underway given increasing evidence of production cuts in both thermal and metallurgical coal. Further production cuts are expected in the final quarter of this year as miners roll off fixed price contracts and become fully exposed to spot prices.

At present, Goldman Sachs suggests met coal prices are around US$30 per tonne below the marginal cost of production. Such a price is unsustainable and the broker expects the 4Q contract price will be settled at a premium to spot prices. 

In the mineral sands market, Commonwealth Bank suggests supply concentration in the face of falling demand will likely be enough to support titanium and zircon prices near peak levels both this year and next. But longer-term, higher prices are inducing new supply and this should pressure prices beyond 2013.

An issue for zircon in particular is growth in the industry is being leveraged on growth of the Chinese economy, meaning there is little diversification in the industry overall. Given Chinese GDP growth and investment are likely to slow over time, the longer-term outlook for zircon demand is thus less bullish.

Supporting this view is the fact both zircon and TiO2 are susceptible to substitution and thrift as they are non-essential quality additives. Zircon offers hardness and low thermal expansion but can easily be substituted to lower quality alternatives, while Titanium is more robust to higher prices as consumers are already paying a premium to use the metal. 

CBA's forecasts reflect a more conservative view, as zircon prices are forecast to fall to US$1,525 per tonne by 2014 from US$2,500 per tonne now, while rutile prices are forecast to decline to US$1,538 per tonne by 2014 from US$2,300 per tonne now.

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