Summary: Resources are back on the table for Australian investors, but the sector is still struggling with oversupply and low prices - and only when higher commodity prices join with the effects of cost cutting will a more stable recovery take place.
Key take-out: Future earnings upgrades will be one indicator that cost cutting has paid off and a more sustained recovery is on its way.
Key beneficiaries: General investors. Category: Commodities.
Resources are back on investor radar screens, but if you missed the re-start in late-January don’t panic, because there are plenty of signs pointing to the recovery being a long one.
As Alan Kohler put it in his weekend email last Saturday (March 19: read it here): “ My main message as we begin 2016 is that it’s time to look at resources stocks. This sector has led the rally since late January (up 25 per cent versus 5 per cent for the banks, 9 per cent for industrials and 6.7 per cent for the ASX200). The rally may have only just begun."
But before we get too excited, the next few months are more likely to see a pullback than a continuation of the hectic demand which has seen resource stocks rocket ahead while the rest of the market has risen by around 6 per cent.
Much of this first stage of an inevitable resources revival, which will come after five “down” years, can be attributed to two companies: BHP Billiton and Rio Tinto.
Other mining and oil stocks have also performed strongly over the past two months, led by BHP Billiton spin-off South32, mineral sands miner Iluka and copper producer OZ Minerals.
There has also been significant activity among smaller miners, while gold stocks have been on fire. Gold-market darling Northern Star is up 33 per cent since the start of the year. Fellow gold producer St Barbara is up 83 per cent. Explorers with interesting prospects have done even better. Breaker Resources has more than doubled from 12.5c to 27c since early January.
It’s the mid-tier and small miners which have got too far ahead of their underlying commodity market, whereas the big two, BHP Billiton and Rio Tinto, have been driven by a different force – dividends.
BHP Billiton and Rio Tinto were driven down to 12-month lows in the first few weeks of the year as reality dawned on investors that overly generous dividend policies were doomed. In the lead up to the formal cutting of dividends, yield-hunters bailed out in droves.
BHP Billiton hit its low of $14.06 on January 21, two days before its unsustainable progressive dividend policy was cancelled. Rio Tinto dropped to its 12-month low of $36.53 on February 3, eight days before it revealed its new dividend policy.
Replacing dividend hunters with investors prepared to buy and wait for growth to return is what’s been driving Australia’s top two resource stocks, which have actually done virtually nothing this year with share prices which have returned to where they started 2016.
BHP Billiton was actually down 5c at the close last night, slipping from first sales in January at $17.85 to $17.80. Rio Tinto was down 89c from $44.75 to $43.86.
Now that the dividend drama is over investors in the resources sector can focus on what really matters; commodity prices and what drives them – the forces of supply, demand and global industrial production.
It’s when you get down to the basics that a more sobering picture emerges of an industry that continues to re-balance after passing the peak in China’s surge in demand for materials required to modernise its economy.
Re-balancing will take time, which is why the resources sector should continue to be treated cautiously because there is unlikely to be a sector wide trend evident over the rest of the year with some commodities performing strongly, and others not.
What investors should really be looking for in Australian resource equities is the start of earnings upgrades which will signal that the combination of cost cutting and improving prices, however modest, are starting to flow into profits.
Morgan Stanley, an investment bank, sees a six-month lead time between an upward move in resource sector share prices and corporate cash flow. Its thesis is that earnings upgrades are coming and the equities market is positioning itself for better profit news.
The question for today is whether optimism has run too far ahead of reality, because while commodity prices are starting to trend up, headwinds remain, not the least being the strengthening Australian dollar which is eroding potential future profits.
Perhaps the best way to treat the resources revival is on a sector-by-sector basis, and company-by-company, partly because there is not likely to be another China-driven boom lifting everything for some time (if ever) and also because the re-balancing of supply and demand will be uneven.
This is how I see the sectors and their leading participants playing out for the rest of 2016:
It has been making a strong return after a deep dive late last year, but whether the latest price of around $US58 a tonne can be maintained in the face of persistent supply increases and little evident of a corresponding increase in demand for steel is a critical issue.
Fortescue Metals has been the big winner from the iron ore bounce, rising by 43 per cent since the start of the year to around $2.69, with the peak being trades as high as $3.29 on March 8, a 12 month high.
The consensus view of seven investment banks is that at its current price level Fortescue is overpriced by 9 per cent and expected to fall back to $2.44, though some banks are much gloomier. Citi reckons Fortescue will retreat by 48 per cent to $1.41. Morgan Stanley has $2.10 as the target price.
Macquarie Bank said in a cautious assessment of the resources sector that it was “wary about iron ore into 2017”, a way of saying the recovery is coming, but not just yet.
Long regarded as the bellwether metal because of its extensive use in several industries, including construction, transport and electricity generation, copper is a commodity close to a supply/demand balance, which points to a steady price for several years.
Goldman Sachs is forecasting a copper price of $US2.89 a pound for this year, falling to $US2.62/lb next year. Macquarie, normally a bank more bullish than Goldman Sachs when it comes to commodities, is using a copper price for its investment recommendation of $US2.29/lb for this year, and $US2.39/lb next year.
If those price tips are correct it is reasonably good news for BHP Billiton and Rio Tinto because both are big, low-cost copper producers, though their copper earnings tend to be masked by other commodities.
For pure-play copper stocks (which generally have gold as a by-product) there is evidence of share prices having moved ahead of the commodity market. OZ Minerals and Sandfire Resources have performed well since the start of the year. OZ is up a sparkling 35 per cent to $5.36. Sandfire is up a less impressive 4 per cent to $5.86, and has further to go according to our Chris Both (read more here: Sandfire makes the grade, March 21).
The copper price, which underpins both stocks, is up 15 per cent since the start of 2016 but down 21 per cent on this time last year, and down 50 per cent on this time five years ago.
Copper really is the bellwether showing that a recovery appears to have started but it has a long way to go, which is one reason why there is no need for investors to rush back into the resources sector.
Gold has been a stand out performer over the past 12 months for two reasons: The US dollar gold price has not retreated below $US1000 an ounce as tipped by some investment analysts, rising instead as global financial market uncertainty rumbled on, and secondly thanks to a lower Australian dollar.
The US dollar gold price remains attractive and trended higher overnight after the terrorist attack in Brussels which has thrown a fresh spotlight on Europe’s fragile economy, but the rising Australian dollar has dragged the local gold price down from its all-time high reached last month.
Stars of the gold sector are starting to feel the pull of the Aussie dollar with local leaders slipping from recent highs. Newcrest has slipped from its 12-month high of $18.63 reached on March 1 to $17.23. Saracen is down from $1.09 reached on March 8 to 98.5c, and Northern Star is down from $4.07 reached on February 26 to $3.71.
Smaller metals, such as zinc, manganese, lead and tin are potentially better recovery stories than the bigger commodities like iron ore, coal and copper, because production cuts are working faster.
The problem for investors is finding pure play exposure to smaller metals other than through higher-risk exploration stocks.
As for the commodity that once vied with iron ore for Australian resource leadership, coal, there are signs of a price-bottom forming but it will be years before an excess of supply is absorbed by a market burdened by political and environmental factors.
Oil is in a different category to minerals but a key commodity nevertheless and one suffering from the same problems of over-supply and sluggish demand growth.
If, and that’s a very big if, oil producers agree on supply restraint such as a freeze on output being proposed by Saudi Arabia and due to be debated at a conference in Qatar next month, then oil could stage a strong rally – until US production rises to fill any gap left by other countries.
The key to what’s happening in commodities today is that the sector is overdue for a revival, but for that to happen in a significant way there are stockpiles of excess material weighing down most metals and fuel, including oil and coal.
The bounce, which started in mid-January, was encouraging but probably premature with a lasting resurgence more likely once it becomes clear that slightly higher commodity prices are joining with lower costs to deliver stronger profits.
Credit Suisse, in a report written after a visit by its analysts to China, said that the Australian mining sector recovery was too far, too fast.
“The recent price moves in the miners (outperformance against the ASX 200 by 9 per cent in the last three months) suggests the next move for the mining sector might be a round of earnings upgrades, the first of any materiality since early 2014, but we remain cautious,” Credit Suisse said.
Morgan Stanley echoes that view, telling clients to keep an eye on “the road signs” pointing to a resources recovery.
“We generally find acceptance for the thesis that there will be an earnings upgrade cycle, but debate as to when it might start,” Morgan Stanley said.
Goldman Sachs, traditionally the biggest bear in the room, did not disappoint on Monday when it warned that “what commodities give, currency takes away”.
A round of earnings upgrades in the next few months are expected by Goldman Sachs, especially for iron ore, but in the longer view is that there are “hard times ahead” thanks to the lingering effects of over-supply rather than lack of demand.
For now, enjoy the start of the resource resurgence but be prepared to play the long game.