Cashing in on commodities

Summary: 2017 was a boom year for many mining stocks, but this year is likely to be completely different. As always, everything depends on demand and supply.

Key take-out: Strong demand for minerals was a key theme for last year, but whether that will continue in 2018 is keeping many analysts guessing. The challenge for miners will be balancing their investment and shareholder demands.

Recovery from a severe downturn is complete for Australia's mining industry, but with strong cash generation from operations, and capital flowing freely, the focus for investors switches to how well the miners can manage success.

If past bust-to-boom cycles are a guide, the early days are likely to be the best thanks to the double benefit of high commodity prices and low costs leftover from the downturn. But, after that comes the challenge of reinvesting wisely, something that doesn't always happen either with project development or asset acquisition.

Right now, it's the best of times for the miners, as is likely to be demonstrated next month, first when Rio Tinto reports its 2017 profit on February 7, with a 75 per cent increase over 2016 to $US8 billion being forecast, followed by BHP's half-year report on February 20, with a similar increase expected.

There is also an expectation that BHP, and its diversified rival, Rio Tinto, will reward shareholders with increased dividends and share buy-backs now that debt levels have effectively been normalised.

It's the promise of a higher payout, which largely explains why BHP's recent share price has been slightly above the consensus maximum price tip over the next 12-months of $31.58 of eight leading investment banks. Some, such as Morgan Stanley and Deutsche Bank, are forecasting a price this year of more than $34.

Investor enthusiasm for Rio Tinto also appears to be getting ahead of the company's underlying performance, with the recent price higher than the consensus price forecast of $79.67. Only Macquarie Bank has a price tip ($85) which is above the current market.

Sweet spot is one way of describing the financial position of Australia's biggest mining companies, and as good as it gets is another for a small group which also produces the lion's share of the country's minerals and metals.

The cash challenge for miners

Overall, commodity prices are at their highest in four years, and if history is a guide there is likely to soon be a slowdown in the pace of recovery.

With the best of the improvement embedded in share prices, cash will be the single biggest factor in determining future values, in terms of incoming cash flows, outgoing cash payments to shareholders, and in the critical test of how wisely management deploys spare cash in project reinvestment – an essential step for all resource companies as their asset base depletes.

Away from the leaders, small-to-medium mining companies become a lot harder to value. A lot is riding on commodity-price forecasts (notoriously slippery), shifting patterns of supply and demand, and the great uncertainty of hot new minerals which this year will be dominated by the “battery family”. These include lithium, graphite, cobalt, and a number of other possible players in the electric vehicle revolution such as vanadium and manganese.

Exploration, picking up after the downturn, will become a key factor in share-price moves. Discoveries, critical to future mine development, are likely to see increased interest from speculators as the sector leaders revert to their status of “rock factories”.

Gold and the dollar

And then there is the metal which is also a currency: gold. Always tricky to forecast, I got gold wrong just before Christmas when forecasting a gold-price correction. Fortunately, that tip started with the opening comment that “Gold needs a crisis” – which is exactly what's happened with the US dollar tumbling amid talk of a trade war with China.

Since the outbreak of the latest US vs China spat, and ongoing concern about the US President, Donald Trump, the gold price has risen by $US100 an ounce, or 8 per cent, in just five weeks.

Interestingly, the Australian dollar gold price has not kept pace, rising by $50/oz, or 3 per cent, over the same five weeks, a direct reflection of the declining value of the US dollar.

The falling US currency has played a significant role in lifting all commodity prices, because most are traded in US dollars and a weak dollar means commodities cost less for consumers in other countries.

Watching currency moves, especially on a possible recovery in the US dollar, will this year be as important for investors in the resources sector as watching commodity prices? These have been boosted over the past 12 months by a single, and totally unexpected event: China's environmental clean-up. This has seen local mines and mineral processing plants closed, triggering stronger demand for imports.

Liquefied natural gas and iron ore have been the two biggest beneficiaries of the Chinese clean-up. LNG because of a shift from coal-fired power generation to gas powered, and iron ore thanks to a switch from low-grade material to high-grade ore, which has fewer impurities and generates less waste. BHP and Rio Tinto have been the iron ore winners thanks to their premium-quality exports. Fortescue has been less fortunate because of its low-grade ore.

The metals mix

The outlook for the major conventional minerals and metals, looks like this:

Iron ore: A substantial slide in the iron ore price has been a feature of predictions about the steel-making material for the past two years, but has failed to arrive. This year started with fresh forecasts of a fall in the price of high-grade ore from around $US78 a tonne to $US66/t, and down again to $US58/t in 2019. If that happens profits fall for all iron ore miners, but could fall faster for low-grade exporters such as Fortescue. It is being forced to incur a hefty discount applied by Chinese customers keen to comply with the new government environmental rules.

Copper: The second-most important commodity for BHP and Rio Tinto has been rising since late 2015, a point which effectively represents the turn in the metals market. But, at a recent price of $US3.24 a pound, copper is stretching the envelope. Strong demand from traditional markets such as construction, power generation and electronics will underwrite the outlook for copper, along with concern about a lack of major new mines. But, at its latest price, copper is already trading above most price forecasts such as the $US2.65/lb average for 2018 from Credit Suisse.

Zinc: A star of the past two years, but mainly for an unsustainable reason: producer cutbacks and mothballed mines. From a low of less than US70c a pound at the end of 2015, zinc hit a 10-year high of $US1.57/lb earlier this week. The outlook is for a slide back to $US1.45/lb by the end of 2018, and then a steady decline to $US1.27/lb next year, and $US1.11/lb in 2020 as mothballed projects come back on line. The price trajectory should be manageable for existing producers, but a test for proposed new mines.

Nickel: Another metal which might have already done its best work in the current cycle, rising by 55 per cent since hitting a bottom at $US3.70/lb in early 2016, a price which forced a number of mines to close. The latest price of $US5.71/lb might encourage some mothballed projects to restart, though most price projections point to nickel already being above its forecast 2018 average of $US5.25/lb. Even nickel's use in batteries, which has encouraged BHP to stick with its marginal Nickel West business, might not help the metal get anywhere close to the $US10/lb price of four years ago.

Coal: The mineral that frightens governments, banks and most investors is having a wonderful start to 2018. That's thanks to strong Asian demand for thermal (used to produce electricity) and China's clean-up, which has boosted demand for Australia's high-quality coking coal (used to make steel). Winter can be a deceptive period for coal, but a recent spot (short-term) price for thermal coal of more than $US100/t the material is more than 40 per cent higher than the price-forecast for the year. Spot coking coal at $US250/t is more than double the long-term contract price – which explains why Whitehaven Coal is trading at a five-year high of $4.80.

Oil and gas have also been recovering strongly, but because they are in a different investment category, and deserve a close look, they will be covered in a future report on the resources sector.

Arguably of greater interest to some investors, and certainly to speculators, is the outlook for the battery metals family. While it is bright, the reality could be that most of the heavy lifting was done last year for materials such as lithium, cobalt and graphite.

Graphite: Companies in this sector will face the challenge of absorbing major new sources of the material, especially from one of the ASX leaders in the battery metals business, Syrah Resources.

With an ability to produce 20 per cent of the world's graphite from its Balama mine in Mozambique, Syrah's first full year's output of 270,000 tonnes could have a profound effect on the price. That might explain why it remains Australia's most heavily short-sold stock, with 20.5 per cent of its capital reported as being shorted.

Lithium: A similar picture of looming oversupply threatens the lithium market as a number of new mines start production. They include two named Pilgangoora, though owned by different companies working adjoining tenements, Pilbara Minerals and Altura Mining.

Both stocks were lithium stars in 2017, soaring by 200 per cent in the case of Pilbara to a price of $1.25, and 300 per cent in the case of Altura to 50c.

Pilbara and Altura have been losing height since the start of 2018 as they move closer to exporting lithium into a market which analysts at the investment bank UBS and the commodity forecasting firm, Roskill, expect to decline sharply from around the middle of the year, falling from $US20,000/t to $US11625/t over the next three years.

Cobalt: The third leader of the battery family could also be heading for a slowdown as production rises, largely through mine restarts which include Glencore's Katanga mine in Africa. It was the world's biggest source of cobalt until mothballed two years ago.

There is a theme running through the minerals and metals sector, and that's one of a sparkling recovery which has run its course.

Higher prices, when combined with costs that fell sharply between 2011 and last year, are delivering strong profits today. This means most mining companies have been able to retire debt and are now amassing substantial amounts of cash.

What happens to that cash is the big issue for 2018. Shareholders want most of it, and probably deserve it. Management needs it to build the next portfolio of mines.

Attempts to satisfy both objectives at the same time will be a challenge worth watching.