Material Matters: Weak Outlook Shaping 2015

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-Bulk risks heightened into 2015
-Gold tops downside risk in metals
-Weak copper vs strong aluminium
-Uranium outlook revives
 

By Eva Brocklehurst

The fourth quarter of 2014 is shaping up with weaker commodity prices and the earnings risk for most exposed equities, particularly for bulk commodities such as iron ore and coal, will become more significant if this weakness is sustained into 2015. BA-Merrill Lynch compares mark-to-market estimates for FY15 against long-term averages and expects downside risks to accelerate if commodity prices do not rebound from current levels during the December quarter. Iron ore will be the hardest hit but, apart from a beneficial move in the Australian dollar and higher alumina prices, most commodities are now trading below 2015 estimates.

The diversified miners, BHP Billiton ((BHP)) and Rio Tinto ((RIO)) trade at premiums to longer term multiples which suggest to the broker the market anticipates a rebound. Leveraged names, such as Fortescue Metals ((FMG)), appear cheaper. Valuations aside, the rapid decline in commodity prices has implications for dividend growth and Merrills finds there is particular risk when it comes to expectations for Rio Tinto and Fortescue Metals, where higher debt could potentially curtail higher payments (RIO) or reduce payments (FMG).

When it comes to pure play metal stocks, the broker considers the biggest downside risk to FY15 earnings and cash flow is with gold miners such as Kingsgate Consolidated ((KCN)) and Perseus Mining ((PRU)) or nickel producer Western Areas ((WSA)), given their high costs. Upside risk resides with Alumina ((AWC)), given the Australian dollar's weakness and alumina price strength. The main catalysts for a turnaround will be further Chinese economic stimulus and re-stocking of iron ore.

JP Morgan raises questions about the demand for metals, given variations across regions in terms of the growth outlook. Demand in the US construction sector appears weak, even though the housing market is in a recovery phase and this has tempered the broker's view of metal demand going forward. This view is exacerbated by weakness in the Chinese real estate market. Chinese banks are also reportedly tightening lending standards for distributors of aluminium extrusions. Across Europe demand for aluminium extrusions and flat rolled products is also depressed.

Chinese copper demand in the second half of 2014 has so far disappointed the analysts and JP Morgan estimates it could be down by 3-5% on the first half. European demand for copper is weak, with consumers well covered and some destocking occurring. US copper demand has also missed expectations so far this year. JP Morgan notes aluminium/zinc demand in the US automotive sector has resumed and this may explain the discrepancy between weak copper and strong aluminium/zinc fundamentals in the US, as the automotive sector outperforms the construction sector.

It is either feast or famine, in Morgan Stanley's view, as the global economy is out of sync and lower growth is a burden on demand. That said, an overly bearish scenario is not the broker's base case. The fourth quarter appears to be either significantly oversupplied or running into deficit. Amid a rising US dollar and mounting concerns over the Chinese economic trajectory the broker favours exposures to those commodities possessing compelling supply-side fundamentals. In this case it is base metals, despite being caught up in the sell-off in September, that are likely to outperform other metals amid a continuing narrative of constrained supply.

In bulks, new low-cost iron ore is flooding the market well above the rate of demand growth, while coal is abundant and demand is waning. Morgan Stanley believes these markets need producer discipline to come to their aid. Precious metals, meanwhile, appear structurally challenged as indicators are weighted against positive returns on gold, while the platinum group may recover as investment flows reverse.

Morgan Stanley's preference is for alumina, as Chinese smelters seek to ensure security of supply while aluminium production expands. The broker's other more relatively bullish outlook is for uranium. Prices have revived following supply cuts and the broker notes mine supply growth will decline 3.8% over 2014, which was inevitable given more than two thirds of production lies above the spot price on the cost curve. The broker believes upward momentum in the price will gather pace as Japan restarts its reactors, with early in 2015 considered the most likely timeframe. The broker is slightly more bullish on copper, nickel, palladium and platinum compared with zinc, lead, coal and iron ore. At the bearish end of the spectrum the broker finds it very hard to get excited about gold.
 

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