Mining for value in 2016

The good news for investors in mining stocks is that analysts at Deutsche Bank believe that commodity prices have fallen into “ridiculous territory”, a comment that hints at Australia's mining sector being oversold with value soon to emerge.

The bad news is that the late Lord Keynes, one of the world's great economists and a skillful private investor, famously once said: “Markets can remain irrational longer than you can remain solvent”.

Over the next 12 months both of those views will be tested, with some stocks likely to rebound as metal and oil prices stabilise, while others are forced to continue with cost cutting or led into mergers to ensure the survival of their core business.

Picking winners in mining in 2016 will be difficult because but there are two themes likely to emerge:

• Low-cost producers exposed to traditional raw materials such as iron ore, copper, zinc, nickel, aluminium and oil will recover as increasing volumes of high-cost material is forced out of the market, and

• Smaller companies exposed to the increasingly interesting range of “technology metals” such as lithium and graphite will benefit from the worldwide push into low-carbon sources of energy in the wake of the recent Paris climate change agreement.

In the first category there are the usual suspects, led by Rio Tinto, BHP Billiton, South32 and Iluka, but with a distinct leaning towards Rio Tinto as it has suffered less damage in the commodity-price crash and is not exposed to the weakest of all commodities...oil.

However, in terms of portfolio management the top two of the resources sector, Rio Tinto and BHP Billiton, remain the go-to stocks because of the companies' diversified nature of assets and the ability to shift capital out of the weakest sectors into areas which offer a growth prospect.

* Rio Tinto's decision to proceed with its Weipa Cape York $2.6 billion Amrun bauxite project (formerly called South of Embley) is an example of how its strong balance sheet is providing the firepower to continue growing in tough times.

Similar expansion moves to take advantage of low prices and possible distressed asset sales by rivals can also be expected in the company's copper and possibly its aluminium divisions. Its flagship iron ore business is likely to continue expanding thanks to status of being one of the world's lowest cost producers of the steel-making material.

* BHP Billiton faces a trickier future having been too optimistic in the past and having made promises, especially about its progressive dividend, which will be hard to keep. But once the dividend is reset, the company will be well placed to benefit from a modest rebound in commodity prices, when it comes.

After the big two and their dominance of traditional minerals the quality of listed mining stocks falls away steeply thanks to the difficult process of adjusting from a prolonged period of high commodity prices to what could be a prolonged period of lower ones.

Deutsche Bank's view is that the “extreme stress” being experienced in the mining and oil sector will lead to more cuts in capital spending, project deferrals, asset sales, capital raising and mergers and acquisition activity during 2016.

Macquarie Bank sees the year ahead as period dominated by “destocking, divestment and desperation” – but not demand.

“We are currently projecting 2016 demand for all major metals and bulk commodities remaining well below their 10-year norms,” Macquarie said.

Most of the 38 resource stocks researched by Macquarie were downgraded earlier this month, with two gold producers, Northern Star and Doray Minerals, the only upgrades.

Three key trends underpin Macquarie's view of the resources sector in 2016: demand contraction driving commodity price cuts, progressive dividends needing to be re-set, and pressure on balance sheets.

“Stocks with elevated levels of gearing such as Fortescue, Whitehaven and Newcrest are likely to see increased focus on cash-flow break-even points,” Macquarie said.

“Higher cost mid-cap producers are also under pressure and we note that Panoramic Resources, Mincor and Alumina are all expected to run short of cash if loss making operations are not put on hold quickly enough.”

Just how tough the outlook has become for all resource producers is underlined by the near-universal negative view of companies producing traditional minerals and metals.

Credit Suisse, another investment bank, sees commodity prices “nearing a crisis point”, but also sees a handful of high-quality miners becoming attractive buying opportunities because they have been sold down too far.

BHP Billiton is top of the Credit Suisse buy list despite the likelihood of it having to cut annual dividend payments in half. “The 30 per cent share price retracement in the past three months sees valuation multiples now at a discount to its peer Rio Tinto.”

Stocks in the Credit Suisse buy list (described as outperform) include BHP Billiton, South32, Whitehaven, Independence Group and Western Areas.

The challenge for investors in traditional mining stocks is that the commodity-price crash of the past 12 months has been so severe and so sudden that shock waves will be felt into 2016 as profits evaporate and losses grow.

If producers of conventional minerals face an uncertain start to 2016, the outlook for companies exposed to the next generation of materials is more interesting, albeit with the risks associated with the new technologies to which they are exposed.

Top of the “new” metals is lithium, a material described by Goldman Sachs as the new gasoline thanks to its use in long-life batteries of the sort used in electric cars as well as for industrial and household use.

• One of the leaders in the race to produce commercial quantities of lithium is Orocobre, an ASX-listed stock with most of its assets in Argentina where it is developing the Olaroz project on the bed of a dried salt lake where lithium has been concentrated.

Over the past six months as the rest of the mining sector has crumbled Orocobre has held its ground, successfully raised $32 million to develop Olaroz and it has benefited from the Paris push to replace fossil fuels with renewable energy technology.

With a stock market value of $307m Orocobre is currently worth more than the combined value of three one-time favorites in the iron ore sector, BC Iron, Mt Gibson and Atlas Iron.

The shift away from traditional metals to new or technology-focussed metals is a fresh playground for investors but it will come with the risks associated with anything new, including questions of the size of the potential market and the level of competition.

Graphite is a second emerging favorite thanks to its use in battery storage systems and its application in a wide variety of industrial uses when produced as graphene, a super-thin, super-strong material.

• Syrah Resources is the graphite leader on the ASX thanks to its advanced Balama project in Mozambique, which attracted $211m in fresh funds in August.

Potentially, Syrah could grow into a world-class supplier of graphite, and while there other emerging graphite miners such as Talga and Kibaran, it is Syrah with its market value of $807m which is being most closely followed.

Another emerging technology which will require a supply of metal is 3D printing, with titanium showing the greatest promise for the production of advanced products such as jet engine parts using powdered titanium dioxide to “grow” components.

• Iluka is the mining company most exposed to 3D printing with its titanium dioxide and zircon mines, as well as a strategic stake in a British company Metalysis, which is developing new ways of producing titanium metal.

It is companies such as Metalysis and the electric car maker, Tesla, which will drive demand for technology metals such as lithium, graphite and titanium – but for most investors exposure to “new” metals should be treated with care.

Lithium, for example is a hot commodity for Orocobre today but it is also a metal with a worldwide market measuring a miniscule 50,000 tonnes.

If demand for lithium takes off and the price rises sharply, it will be easy for big miners to snatch a slice of the action. Rio Tinto is one of the majors sitting on sidelines with a big lithium deposit in Serbia being worked up to a development decision.

Overall, 2016 will be a year when the mining industry resets the meter with excess material likely to hang over prices for at least the first half of the year, and for more mine closures to come before prices can stage a meaningful recovery.

But, as the year progresses, value will emerge and oversold stocks with quality assets will recover.