Goldman Sachs JB Were Bows To Higher Metal Prices March 02 2006 - Australasian Investment Review – (AIR)
Over the last two years, we have seen a battle rage between those analysts who subscribe to the "super-cycle" paradigm, otherwise known as the "stronger for longer" paradigm, and those who warn that history is littered with analysts who ignored the "fact" that markets always revert to their long term mean.
As time passed, numbers in the mean reversion school dwindled as more and more analysts bowed to reality and threw their models out the window. Metals prices, it seemed, were not going down.
Twelve months ago, GSJB Were analysts were among those arguing strongly on a stronger for longer theme, and duly shifted their metal price forecasts as a result. Nevertheless, Weres maintained an ultimate belief that within about two years prices would indeed revert towards the mean.
In January, the analysts were forced to upgrade shorter date prices to more closely reflect spot prices. Weres did not wish to be seen undervaluing Australian resource stocks, but maintained that prices a full two standard deviations above the mean were looking unsustainable. The analysts announced they would put prices under monthly review.
Suffice to say, the review is over. Weres’ forecasts now "embrace the notion of step-change". Having studied the situation extensively, the analysts cannot perceive of a supply surge that will suddenly take the market into surplus. Nor do they consider that current high prices will serve to undermine demand and rebalance the markets. They are now "increasingly confident" that higher commodity prices are with us for some time to come.
The analysts have used recently available data to reassess their demand/supply modelling, and rolled out longer dated forecasts to 2010. New price forecasts appear in the accompanying table, and Weres now suggests an order of preference for metals investment should be zinc number one, followed by nickel, then copper, aluminium and lead.
China’s predicted ongoing demand has been well documented. On the supply side, Weres can identify a number of issues that have limited the response of the mining industry to higher prices: a paucity of quality projects ready for development; infrastructure limitations; rising capital and operating costs; skills shortages; and long lead-times for equipment orders.
Weres still believes in a natural order, meaning that one day these bottlenecks will be overcome, and supply will arrive. However, the analysts’ "tenure of forecast" is only to 2010, and they can’t see it happening before then. China, and increasingly India, will ensure commodities prices remain demand-led.
Is there a risk to Weres’ newfound faith? Well, there’s always a risk. At this stage of the game, a risk would have to be a demand disruption of global consequence, as has occurred before in the form of two oil shocks, the fall of the Soviet Union, and the Asian crisis.
Such crises are never easy to predict, but Weres suggests a collapse of Middle East stability and a bird flu pandemic are two that spring to mind. On the supply side, well the industry is already working at 100% capacity just to meet demand. Any "shock" would likely only be on the downside.
As Weres’ analysts to date have been mean reversion disciples, they have not often changed their long term price forecasts. Indeed, when moved to raise them 12 months ago, it was the first time in ten years. At that point they also assumed ongoing "flat" prices in discounted terms, meaning longer dates fell on the appropriate discount.
Now they suggest prices will stay flat in nominal terms, out to 2011, applying a 2% inflation rate.
The accompanying chart suggests that in the past 36 years, commodities prices (as measured by the Goldman Sachs Commodities Index) have step-changed only once – during the first oil shock of the 1970s. The question now is: at what new level will the index settle at as a point of mean reversion?
On a metal-by-metal basis, Weres believes zinc still has the strongest fundamentals of all. Zinc concentrates are in acute deficit, treatment charges are at record lows, and some smelters are struggling to source feedstock. The analysts are finding it hard to identify sufficient mine projects that could be developed quickly enough to bring the market back to balance before 2008 at the earliest.
Nickel has jumped over aluminium and copper to be number two on the podium. Although continuing to forecast a modest surplus in nickel for 2006, Weres suggests beyond that the market is relying on supply projects that could take three years to reach design capacity. Hence nickel will likely return to deficit in 2008-10.
Copper should also remain in modest surplus for the time being, but again Weres has concerns about the development of sufficient new mine capacity that could prevent a return to deficit after 2008.
Aluminium is the odd one out, as although it is in deficit in 2006, increasing Chinese smelting capacity could well see the market balance by 2007, and move into surplus beyond. Will Chinese government attempts to curb aluminium exports work?
A significant policy change in the analysts’ long term metals forecasting unsurprisingly has significant repercussions for Australian resource stock valuations. Let’s start with everyone’s favourite twins – BHP Billiton (BHP) and Rio Tinto (RIO).
On the basis of general price increases (and assuming iron ore at a forecast 10% increase), Weres has now switched preference to the "cheaper" stock with the greatest metal leverage – BHP.
BHP’s greatest exposure is to copper and nickel, and Rio to copper, both of which Weres predicts will hit a trough before 2007 but then rise substantially thereafter. The accompanying table indicates the analysts’ updates to normalised profit after tax (NPAT) and earnings per share (EPS).
Most notable are the changes to dividends per share (DPS) for Rio as opposed to BHP. This reflects Weres’ assumption that BHP will undertake buybacks rather than lift dividends, but that Rio will undertake buybacks but continue to pay special dividends.
Looking now at other significant metals companies, Weres is forecasting earnings increases for Zinifex (ZFX) of 4%, 40%, and 62% in 2006-08, and a present valuation increase of 39%. Weres rates Zinifex as Outperform.
The unexciting changes include Alumina (AWC): 0%, 9%, 1%, 11% (downgrade to Marketperform) and Iluka (ILU): 0%, 0%, 0%, 1% (Underperform).
Stop press: Merrill Lynch metals analysts have just released a report in which they, too, have made significant upgrades to metals prices. Merrills suggests, however, that while supply/demand fundamentals continue to look strong, there is at least some evidence of inventory-build in copper, nickel, lead and aluminium over the past months. Only zinc inventories have significantly declined.
But despite inventory changes, Merrills believes the market is principally being driven by extensive investment fund buying.
The analysts have made metal price increases across the board, with copper up 21% in 2006 and 21% in 2007. Similar changes have been made to zinc (54%, 72%), and nickel (7%, 15%). Aluminium has been lifted 5% in 2006, and Merrills’ thermal coal prices have been raised from US$43/t to US$48/t in the 2006 Japanese financial year, and from US$40/t to US$48/t in the 2007.
Once again, the flow through of metal price increases is significant for those Australian companies leveraged to such prices. Thus Merrill’s earnings forecasts for BHP have increased by 7% in FY06, 9% in FY07 and 13% in FY08.
Similar increases have been applied to Rio Tinto (8%, 8%, 5%), Zinifex (50%, 222%, 268%), Oxiana (55%, 72%, 73%), and Minara (19%, 20%, 15%). Alumina remains the odd one out again with 2%, -1% and 0%.
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