Material Matters: Oil Implications, Nickel And Miners’ Cash

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-Oz mid cap oils hard hit
-Lower level for supply response
-Run down in nickel stocks
-Cash backed miners oversold?
 

By Eva Brocklehurst

Oil

Several brokers believe the going will get tougher for the oil & gas sector before it improves. Macquarie has lowered 2015 and 2016 Brent oil forecasts by 31% and 23% respectively. Despite a long and painful re-balancing, crude oil markets are expected to revert back to a price range that justifies reinvestment economics. The broker's normalised long-term price assumption is US$95/bbl. Oversupply is forecast to peak at 1.7mmbpd in the second quarter of 2015, which should suppress near-term price recovery. OPEC is expected to maintain product quotas so a re-balancing relies on a supply response from the producers outside of OPEC, with slowing of growth in the sector from the US, Russia, North Sea and Latin America. Macquarie does not expect to witness a measurable slowing until at least the third or fourth quarter of 2015. 

Macquarie suspects changes in oil prices will take $4bn in operating cash flow out of Australia's large-cap energy sector over 2015 and 2016 and reduce free cash flow yields by 4.9% in 2015. Mid cap sector earnings and valuation are particularly hard hit by the downgrades but while the weaker oil prices are a headwind, stock specific news is expected to dominate investment cases. Santos wears the largest valuation downgrade for Macquarie in the large caps as it has the most marginal production base and is perhaps the most financially leveraged ahead of executing on GLNG. Still, it appears to the broker that share prices have over-reacted to the deterioration in oil prices and Macquarie retains a preference for Santos and Oil Search over Woodside, given the leverage. In mid caps, the broker prefers those with high operating margins and low sustaining capex, solid balance sheets and a high proportion of developed reserves.

Implications for Bulks, Metals

Sharp falls in global oil prices are expected to accelerate deflationary forces among miners. Bulk commodities are likely to suffer the most, given current pricing is already impacting on cost curves in oversupplied markets. Morgans expects the base metals will fare better with supply/demand more finely balanced. The broker has made large cuts to iron ore and oil price forecasts, decreasing 2015 earnings estimates for BHP Billiton ((BHP)) and Rio Tinto ((RIO)) by 30% and 22% respectively.

Macquarie evaluates what a lower oil price means for metals prices. Historical price correlations suggest the immediate impact is negative but the medium term is harder to call. Separating out the particular metals provides little insight, with external factors such as local economies or currencies being the main drivers. Those that have had the highest correlation with crude oil in recent years, such as platinum, silver and aluminium, have seen that correlation become less significant in the last year. Longer term the relationship looks clearer, with platinum and copper the two strongest correlations and tin a close third. The broker notes the main impact from lower oil prices is on the supply side, as cheaper energy inputs mean lower production costs. In oversupplied markets, currently the case in many metals, this means the fair value price of the stock and the level at which decisions are made to cut excess capacity move lower.

Nickel

Indonesia's ban on exports of unprocessed minerals has now been ruled on as final by the Constitutional Court. Bell Potter observes, since the ban was put in place last January, nickel laterite ore exports from the Philippines to China have increased 15-20% year on year. Chinese nickel pig iron producers blend this lower grade ore with their stockpiled Indonesian ore, extending the life of inventories. The onset of the monsoon in the Philippines is now expected to curtail exports for around three months which could lead to nickel laterite ore stockpiles being depleted by early to mid 2015. Bell Potter has upgraded Sirius Resources ((SIR)) to Buy following a pull back in its share price. Western Areas ((WSA)) now tops the broker's nickel pecking order followed by Sirius, Independence Group ((IGO)), Panoramic Resources ((PAN)) and Rox Resources ((RXL)).

Value Versus Cash

Morgans observes the market has reached an unusual point where the value of some resource companies is at a level where the cash at the bank is greater than the market capitalisation of the company. The broker asks whether at least some nominal value should be attributed to operations and the sums invested in infrastructure. Morgans concedes the decline in valuations is reasonable, given the weakness in commodity prices, but pricing a company below value of the cash at the bank seems over the top. Morgans takes the view that such companies are highly leveraged to significant upside once sentiment and prices turn.

An example is Mount Gibson ((MGX)), which holds 33c per share in cash versus its current share price around 20c. Mount Gibson has insurance to help cover operational losses as a result of suspending its Koolan Island activities, but investors appear to Morgans to be discounting the stock greatly. Alacer Gold ((AQG)) is another company with significant cash reserves which, given the weak gold price, Morgans believes could be used, along with delaying the expansion of Copler sulphide, for acquisitions to broaden the asset base. BC Iron ((BCI)) holds around $78m net cash but has an enterprise value of around $14m. With capacity to ramp up production to around 11mtpa by adding in Iron Valley when prices recover makes the stock's leverage to higher prices quite significant.
 

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