Commodity call

PORTFOLIO POINT: There is good news for oil, gold and lead in broker outlooks, coal and aluminium remain attractive, not so aluminium and nickel.

In something of a cautionary note, UBS points out two important indicators for miners and commodities have turned negative. Capital is now flowing out of emerging markets and back to the US and as the European bank deleveraging process promises more credit stress and implies further destocking in commodity markets.

This has been enough for UBS to recommend investors reduce their exposure to the commodity sector as a whole, as better buying opportunities likely await. In the meantime, the broker has proposed three relative value ideas worth considering until market conditions improve.

The first is a preference for gold and gold equities against both the commodity sector and the market as a whole, as gold is a likely beneficiary form an expected move by the Federal Reserve to a third round of quantitative easing (QE3).

UBS also prefers copper relative to nickel at present, as easing of policy in China is providing an incentive to restock copper and should see it outperform relative to the other base metals.

The final relative value idea is to buy Rio Tinto (RIO) and BHP Billiton (BHP) Plc stock against lines of the Ltd shares, this reflecting the expectation Australian credit growth will slow towards the rate currently being achieved in the UK.

In terms of rankings across the commodity spectrum, on a three-month view UBS prefers gold, copper and iron ore as its first tier, followed by thermal and metallurgical coal and then platinum and palladium. Aluminium and nickel are the least preferred commodity exposures across this time-frame.

Looking more than one-year ahead the order is slightly different, with iron ore the top pick given UBS's view that Chinese steel production and a strong demand outlook will underpin prices. Gold comes in second given ongoing uncertainty with respect to the global economy; while copper and zinc make up the next line given supply issues for the former and growing Chinese import needs for the latter.

What hasn't changed over the longer-term time-frame is UBS's view of the least-preferred commodity exposures, which remain aluminium and nickel. For the former a cost push story remains an issue in coming years, while potential increased supply should lead to lower prices for the latter.

In terms of price forecasts, UBS expects copper prices of $US3.60 a pound in 2012, down 10% in year-on-year terms. Prices should be higher in the first half of next year. Aluminium prices are likely to follow an opposite trend and be higher later in 2012 than in the early months, with UBS forecasting an annual average three-month forward price of $US1.06 a pound.

In nickel, UBS sees prices averaging $US8.98 a pound in 2012, a fall of more than 13% relative to the expected average for this year of $US10.38 a pound. Zinc prices should average $US1.03 a pound on UBS's numbers, with prices expected to strengthen post the Chinese New Year.

Having moved to a spot pricing model for iron ore, UBS expects quarterly prices in Australia of $US155 a tonne for the first quarter, $US164 a tonne in the June quarter, $US159 a tonne in the September quarter and $US150 a tonne for the final quarter of 2012.

Met coal prices are expected to average $US203.80 a tonne for hard coking coal and $US160.30 a tonne for LV-PCI coal, while UBS expects semi-soft prices will average $US153.80 a tonne next year and thermal coal $US123.80 a tonne for Newcastle spot.

Uranium prices should be little changed, as from an expected $US56 a tonne average price this year UBS expects only a minor decline to an average of $US55 a tonne in 2012.

Given most of the bullish factors for gold are unlikely to go away next year, UBS sees prices climbing to an average of $US2050 an ounce in 2012, while silver is expected to average $US35 an ounce next year.

Platinum prices are expected to be little changed, UBS forecasting an average price of $US1675 an ounce next year, up $US10 an ounce from its previous forecast. UBS has lifted its palladium forecast to an average of $US725 an ounce, up from $US675 an ounce previously.

In terms of exposure to the sector, UBS's top picks are Goldcorp, Newmont, Barrick, AngloGold, First Quantum, Consol Energy, Sakari, Cliffs Resources and Australian-listed plays Rio Tinto (RIO) and Fortescue Metals (FMG). All of these stocks are rated buys.

The final quarter of 2011 has seen some positive signals emerge in the lead market, Barclays Capital has noted, despite a backdrop of deteriorating macroeconomic conditions. Stocks of lead on the London Metal Exchange have fallen mildly but on a sustained basis, while cancelled warrants have risen significantly.

Barclays also notes recent Chinese data suggests domestic refinery demand continues to strengthen, as lead acid battery production has risen 24% in month-on-month terms. The increase follows the completion of some environmental inspections but also reflects seasonal demand in Barclays' view.

At the same time NBS supply data suggests both mine and refined output has declined in recent weeks, meaning the Chinese domestic market remains in deficit. The SHFE/LME price ratio has hovered close to the import arbitrage break-even level.

This leads Barclays to suggest the lead markets in both China and the rest of the world are in deficit, which is expected to support relatively flat price outperformance or at the least a further tightening in front-end spreads.

The duration of this tightening may be limited, according to Barclays, as sustained price rises in China would stimulate smelters to sell more product and ramp up output. This would lift exports, so easing demand pressure on producers in the rest of the world.

For Barclays, lead is a base metal standout as it is the least sensitive to global growth cycles, meaning demand should prove to be more resilient if there is any sharp deterioration in the global economic growth outlook.

Turning to coal, Barclays notes in China there have been moves to raise on-grid power tariffs and to introduce a cap on domestic coal prices. Both policies are aimed at increasing utilisation rates at coal plants by minimising the losses incurred by generators faced with high coal prices and regulated end-use power tariffs.

These policy changes could potentially increase demand but Barclays sees any significant increase as unlikely as coal plant utilisation rates at thermal coal plants are already at above-average levels and coal prices have risen strongly in recent years.

The policies are more likely to give the big state-owned generators a stronger negotiating position against miners, something Barclays suggests could close the current coal arbitrage opportunity between China and exporting countries.

This would reinforce a key theme in the coal market this year, one of greater international trade of low-quality coal. Barclays expects any attempt to regulate Chinese domestic coal below international prices will simply cause traders to look for cheaper coal.

Still on coal, and Macquarie notes while Chinese metallurgical coal output has risen in 2011 to record highs, data suggests this has been at the expense of increased cost in terms of falling incremental quality. Such a trend could impact on future market balances, according to Macquarie.

Year-to-date figures suggest Chinese apparent production of metallurgical coal has risen 17.2% in year-on-year terms, largely as a response to a lack of Australian supply given the floods early in the year. But Macquarie notes the data also suggests more coke is being used per tonne of iron than was previously the case, which implies weaker strength coal is being mined in China.

Using its base case assumptions, Macquarie suggests Chinese supply of metallurgical coal will meet the majority of demand growth, but will see grades fall even further. This has the potential to impact on productivity in the steel market, while also creating the requirement for a technological cycle to deal with the lower grades being produced.

In the oil market, Citi has seen fit to lift its price forecasts to reflect better than expected demand and weaker supply than had been anticipated. Citi is now forecasting Brent crude prices of $US110 a barrel in 2012 and $US120 a barrel in 2013, 28% and 41% respectively higher than previous forecasts.

Expectations for West Texas Intermediate (WTI) have also been increased, Citi lifting its numbers here by 40% and 32% respectively to $US101 a barrel in 2012 and to $US113 a barrel in 2013.

Factoring in these new oil price assumptions has seen Citi lift earnings estimates across the Australian oil and gas sector. Increases to estimates have been material in 2012, with Citi's numbers increasing by 70% for Oil Search (OSH) and by 53% for Santos (STO) as examples. Price targets have been adjusted accordingly.

With Citi's long-term oil price forecast of $US80 a barrel for Brent crude unchanged, the valuation impact of the changes to price estimates has been less pronounced, to the extent there are no changes in recommendations across the sector.

This means Citi continues to rate Oil Search, Santos, Woodside (WPL) and Australian Worldwide Exploration (AWE) as buys; while Beach Energy (BPT) remains a hold and Aurora Oil and Gas (AUT) continues to be rated as a Sell.

This article was originally published by FN Arena on December 20.