Material Matters: Bulks, Large Caps, Gold & Copper

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-Bulk miners may disappoint further
-Copper, zinc Macquarie's pick in metals
-Morgan Stanley advises to stick to quality
-Enhanced M&A activity likely in gold, copper
 

By Eva Brocklehurst

?Mining Cycle

Short term volatility is exacerbating the cycle but Morgan Stanley observes that, looking back in 2016, the market may find that now was the wrong time to capitulate to the pressure that is dominating the resources sector. The broker recommends exposures to companies with quality assets and sound balance sheets should be increased.

Lower energy costs and a weaker Australian currency should boost margins but this may not be apparent until the August reporting season, and should be more so for the bulk miners. Moreover, Chinese demand may be softer, but it is not collapsing, and stimulus should result in better demand in 2015. Specifically, property is improving, bauxite inventory is depleting and copper financing is no longer an overhang.

The broker acknowledges not all its Overweight ratings have worked. Miners to own at this point in the cycle are Iluka Resources, Rio Tinto, Whitehaven Coal, BHP Billiton, Western Areas ((WSA)), OZ Minerals ((OZL)) and PanAust ((PNA)). Morgan Stanley's list of those to avoid include Newcrest Mining ((NCM)), Regis Resources ((RRL)), Resolute Mining ((RSG)), Medusa Mining ((MML)), Mount Gibson ((MGX)) and Atlas Iron ((AGO)).

Bulks

Is there light at the end of the bulk commodities tunnel? Citi suspects the downturn has further to run but the right commodities combined with the right currency exposure can deliver relative outperformance. Citi has lowered 2015 price forecasts for iron ore to US$58/t, thermal coal to US$55/t and metallurgical (coking) coal to US$113/t.

Having run updated oil & gas prices through its models, Citi's 2016 price forecasts are also being reduced on the back of a dramatic fall in US dollar supply costs. The broker continues to prefer base metals to bulk commodities. Expectations of excess cash being returned, already reduced, may still be disappointed while dividend cuts are on the horizon for smaller companies with bulk exposure, further supplemented, potentially, by impairments. The broker is still bullish on the bulks sector but expects a slow grind higher over the next few years.

Large Cap Miners and Metals/Bulks Outlook

Macquarie has downgraded the outlook for the majority of its metals and bulk prices. Base metals are considered the best of a bad lot as raw material constraints, a lack of high quality products and medium-term market deficits favour zinc, nickel and copper. While the producers have done significant work in dealing with oversupply, there remains more work to do to balance the market and the need to cut immediate supply persists, in the broker's opinion. Macquarie has reduced medium term forecasts for iron ore, thermal coal and coking coal by 27%, 19% and 9% respectively. The only metals where the broker has upgraded long-term forecasts are copper and zinc.

The revised forecasts mean the broker's valuation for BHP Billiton ((BHP)) falls by 25% and earnings reductions of 30% are implemented for the next two years. Revised oil prices weigh. BHP's progressive dividend policy appears increasingly onerous, in Macquarie's opinion, and is likely to be funded by debt or at the expense of long-term growth, should commodity prices stay at current levels. Rio Tinto's ((RIO)) valuation falls 29% while Fortescue Metals ((FMG)) falls a more significant 44%. Macquarie finds the risk/reward for FMG "uncompelling".

Among other large cap miners Macquarie scores Alumina Ltd ((AWC)) a top pure play exposure which offers free cash flow yields of 10% at spot pricing. Iluka Resources ((ILU)) is also favourably affected by Macquarie's updated FX forecasts for 2015 and 2016 and a more balanced zircon market is expected. Still, with significant sustaining capital commitments required over the next two years the valuation upside is not considered compelling. The weakening Australian dollar provides little respite for Whitehaven Coal ((WHC)) and, while optimistic on the operations and asset quality, Macquarie believes expectations need to be reset and the stock is unlikely to return to profitability before FY17.

Gold and Copper Equities

Credit Suisse continues to expect a focus on cost reductions this year but considers the peak cycle for costs has now passed, with the world operating under a lower oil price environment while a lower Australian dollar reduces the reported US dollar costs. These external factors should provide real savings for Australian gold and copper producers. Credit Suisse notes a stabilisation in the gold price has occurred with the precious metal finding a floor at US$1,200/oz. The broker's gold stocks indicate higher gold pricing are being factored in for the longer term and this indicates the emergence of value opportunities for companies where the gold prices factored in are trading at a discount to spot.

This is not the case for the copper price, which has plunged 10% this year on top of the moderate declines witnessed in 2014. The main concern appears to be the outlook for China, which takes 45% of global copper demand. Credit Suisse expects the copper price will recover this year amid a tighter market. The broker believes the market's anticipation of lower prices indicates value opportunities, or mis-pricing, occur where the equity sell off has been de-linked from the underlying value.

The environment lends itself to enhanced M&A activity in the broker's view and a divergence in paper value between mid tier producers and junior explorers may facilitate activity as mid tiers capitalise on market premiums.

UBS observes the good start to 2015 for gold stocks, with analysis suggesting an average implied price of US$1,103/oz. The broker's team is forecasting US$1,190/oz in 2015 and a small lift to US$1,200/oz in 2016. This price deck may be flat but the broker envisages downside risks associated with expected US rate hikes this year. The upside risk is from safe-haven perceptions, amid uncertainty in Europe.

UBS has a negative stance on Australia's leading gold stock, Newcrest, despite the stock's size and liquidity. The reason is the lack of disclosure about Lihir. UBS is drawn to low-cost producer Alacer Gold ((AQG)) and the turnaround story at Regis Resources.

JP Morgan believes the spot scenarios continue to favour Sandfire Resources ((SFR)) and OZ Minerals in copper. These two mid cap copper miners remain the best placed in terms of balance sheet and earnings metrics, in the broker's view. JP Morgan is less enthused about PanAust as net debt increases under spot pricing, given lower revenue and near-term spending at Frieda. It also has no exposure to a weaker Australian dollar.

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