Material Matters: Base Metals, Bulks, Oz Energy Stocks And Oil

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-Improved base metals outlook
-But Merrills cautious on steel, bulks
-Chinese upturn positive for copper
-PNG LNG update key to Oz energy stocks
-JP Morgan upgrades oil price forecasts
 

By Eva Brocklehurst

Strategists at BA-Merrill Lynch continue to be constructive about base and precious metals, as global growth gathers momentum and supply curtailments begin to impact. The broker upgrades aluminium, copper, nickel and zinc price forecasts but retains a cautious outlook for steel and bulk commodities. The pivot point, as usual, is China. Despite the challenge for bulks, opportunities still exist as the broker observes the trend for iron ore re-stocking, combined with temporary lulls in supply growth, is expected to continue through the second half of 2014. The strong Australian dollar continues to magnify the impact of weak commodity prices on most companies' earnings and the diversified miners are the ones showing value, says Merrills. Rio Tinto ((RIO)) remains Merrills' number one pick, despite negatives relating to coal and the currency.

The broker's best equity ideas within base metals are those with exposure to growing supply constraints, such as nickel, and the least preferred are those with growing market surpluses, such as alumina. Usher in Western Areas ((WSA)), which the broker rates as Buy, given its quality exposure to nickel. Alumina ((AWC)) is highly exposed to deteriorating fundamentals and the broker retains an Underperform rating. The perfect storm is apparent for leveraged bulk names and the broker has materially lowered earnings forecasts across the board for those stocks.

Price forecasts from 2014-2018 have been reduced for iron ore and coal. However, the broker emphasises these downgrades, apart from thermal coal, have been made for medium-term pricing, not long term prices or currencies, and this is why valuations are not greatly affected. A Buy rating remains in place for Fortescue Metals ((FMG)), the best placed of the pure-play iron ore miners with the broker seeing value at current prices, with an Underperform rating for Atlas Iron ((AGO)), which has a high cost position and a lack of economies of scale.

One of Macquarie's favourite indicators, the HSBC Markit Purchasing Managers' Index (PMI) for China, is rising from the trough seen in March. Macquarie observes an upturn in China is not automatically positive for all commodities. Iron ore once had a strong positive correlation with China's PMI but now the link has broken, because of the rise in seaborne supply. Copper, on the contrary, is rising in tandem with the PMI in the current cycle. The broker believes stronger second half growth in China would be positive for sentiment, as it would mean a more synchronised global expansion. This should provide support for equities and copper.

Macquarie believes investors should remain bullish while the PMI is rising. That said, the analysts think the bear market in commodities is not yet over and expect further displacement in the iron ore market. Still, there is enough marginal iron ore supply to keep prices at US$110/t. In contrast, they think it would be unwise to expect lower copper prices, despite fears over warehousing. A developed world recovery is also positive for copper even though China is the world's number one consumer of the metal.

UBS is looking for updates from the large cap stocks on the ramp up of PNG LNG when the production reports from Australia's energy sector start rolling in. This is the issue for Santos ((STO)), although the broker expects the warm start to winter will dampen demand for Cooper Basin gas. Oil Search ((OSH)) is expected to reveal production of 3.7mmboe for the June quarter. Now PNG LNG is on line UBS expects production and revenue will be harder to forecast during the ramp-up phase. Woodside Petroleum ((WPL)) is expected to reveal lower production in the quarter, because of planned outages at the North West Shelf and Pluto LNG as well as natural decline from Vincent.

In the smaller caps the broker is looking for confirmation that the Western Flank oil production continues to be delivered at plateau rates from Beach Energy ((BPT)) and Drillsearch ((DLS)). The broker expects these two, as well as AWE ((AWE)), to hit the top of their respective production guidance ranges. Roc Oil ((ROC)) and Horizon Oil ((HZN)) are expected to provide news on the Beibu Gulf production decline.

JP Morgan has made changes to its 2014 and 2015 oil price forecasts. The broker has introduced a forecast for 2016 and effectively deferred to 2017 the point at which it reverts to the long-term assumption of US$90/bbl for Brent. The revised 2014 Brent price deck of US$110/bbl represents a 6% increase on former forecasts. 2015 Brent is at US$115/bbl, a 15% increase on the former forecast. The 2016 forecast is US$120/bbl. Previously, JP Morgan's forecasts had assumed a fade to long-term pricing, but a combination of Iraq and Libya supply reductions and stronger demand means prices now increase.

The changes signal earnings upgrades for the major Australian oil producers. The broker has upgraded 2015 earnings for Woodside, Oil Search and Santos by 17%, 23% and 26% respectively. The impact of the higher oil price deck is only slightly moderated by higher Australian dollar assumptions over 2014-16. JP Morgan retains an Overweight rating for Santos, Neutral for Woodside and Underweight for Oil Search. The broker has decided Santos offers a strong free cash flow yield and limited downside, even if GLNG disappoints. Woodside offers strong free cash flow, distributions to shareholders, but a long-dated and challenging growth pipeline. Oil Search offers less upside compared with Santos or Woodside, based on JP Morgan's evaluation. The broker thinks the stock will struggle to outperform on a sector-relative basis.

JP Morgan carries an Underweight rating on Beach Energy, on a relative basis compared with other Cooper Basin players, and prefers Senex Energy ((SXY)), with a Neutral rating. The broker thinks a fundamental gap is persisting for AWE between its share price and fair value and identifying specific catalysts is difficult. The broker was surprised that the farm-out at Ande Ande Lumut to Santos did not result in a more permanent re-rating of the stock and retains an Overweight rating. Buru Energy ((BRU)) is now the broker's preferred exposure among ex-100 oil stocks, with 2014 shaping up as a critical year. The broker thinks the Canning Basin is one of the most prospective in Australia and Buru Energy offers a pure play in both oil and wet gas.
 

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