Commodity prices have surged in recent months, and resource stocks have followed. Has the last pocket of value in the market been discovered, or is this rally overdone? Livewire reached out to three specialists for their view on key commodities, and the mega-cap miners that produce them.
The commodities sector is more interesting now than it has been for a long time – regardless of whether you’re a bull or a bear. Chinese government stimulus and a weakening US dollar just add further complexity to a situation with shifting supply dynamics. In responses from Stephane Andre, Alphinity Investment Management; Craig Evans, Tribeca Investment Partners; and Jim Copland, IFM Investors, we hear that the market is overly cautious on Rio and that BHP is poised to return $10 billion to shareholders.
Expectations are lagging reality
Stephane Andre, Alphinity Investment Management
While it appears that the recent commodities rally is a response to a combination of factors ranging from a weaker US Dollar and improving global demand growth, I believe China remains the dominant driver of higher commodity prices. Demand from China has surged since the end of 2015 on the back of stimulus injection via its infrastructure and property engines. In parallel, its aggressive pursuit of capacity and environmental reform is strongly affecting the supply dynamics of commodities such as iron ore, coal, steel, aluminium and copper. Speculators have jumped on that thematic and are pushing prices, in some cases to levels above what fundamentals would suggest.
While the rally is not sustainable longer term, the upcoming government transition in China and winter closures are likely to provide ongoing support over the next 6 months. Eventually, prices will correct on any sign of demand weakness and/or policy relaxation. It is inevitable given China cannot keep growing its infrastructure and property sectors at the current pace.
We believe however that market expectations for commodity prices remain too far below the level of current spot prices. As expectations adjust, there will be momentum for future commodity price upgrades, further supporting earnings and share prices.
Market is overly cautious on Rio
Rio Tinto (ASX:RIO) offers for us the best upside from both an earnings and valuation perspective. The business is primarily exposed to iron ore, copper and aluminium via their tier 1, long life, low-cost assets. Should current spot prices hold, earnings will be almost double what the market is expecting in CY18. While we are expecting a commodity price normalisation, we still believe the market appears overly cautious. For example, Copper price expectations are $2.50/lb for CY18 vs a spot price above 3.0$/lb. The lagged demand impact from China infrastructure, property fit out and grid tendering combined with a likely ban on China scrap imports will keep the market tight.
The dynamics for Aluminium, with policies putting a cap on supply growth combined with cost increases, are also compelling, implying a higher floor than the one expected by the market. In addition to RIO's broad portfolio exposure, we also like management’s approach to active divestment of non-core assets, its large brownfield investments and its well-capitalised balance sheet. This provides the business optionality to pursue capital management initiatives and attractive opportunities as they arise. Flexibility combined with discipline is a potent combination.
‘Buy the dip’ remains the theme
Craig Evans, Tribeca Investment Partners
Commodities have benefitted from several key drivers. The combination of a trending weak USD that started in mid-June, a more robust than forecast Chinese economy, a series of Government supply side constraints which has caused a scramble for onshore product and a steel-led price boom as mills rush to take advantage of positive steel refining margins and to stockpile ahead of the Winter curtailment period.
Upside momentum in metals and bulk commodities has started to slow with long biased open interest in key commodity contracts becoming elevated. If we assume no huge recovery in the USD and no China data surprises, we would expect any corrective price action in the metals and bulks to remain bought on dips in the near term.
BHP poised to return $10 billion to shareholders
We feel that of the major diversified miners, BHP continues to be well placed, given both internal initiatives to arrest underperformance and asset quality. Valuation realisation from the shale divestment and likely returns to shareholders should see the stock outperform despite any volatility in commodity prices. There is a clear path for around AU$10bn to be returned in a tax effective manner over the coming 18 months while the company continues to invest in its core pillars of iron ore, coal, conventional petroleum and copper.
In addition to BHP, we continue to hold a positive view on the growth in battery technology (including electric vehicles), we like Glencore which has significant exposure to copper, zinc, nickel and cobalt. With the balance sheet issues largely resolved, we can see Glencore taking advantage of mispriced assets as they have recently done with their buy into the Yancoal JV.
When fundamentals and politics clash
Jim Copland, IFM Investors
Fundamentals are driving the rally, and it’s sustainable (for now!). Chinese IP and economic data are strong, and for the first time since 2010, Europe, US and emerging economies are growing at the same time as China. Speculators are, of course, exacerbating moves, but they’re looking at the same drivers we are. From here, growth moderates but remains positive. Because the supply side of most commodities has rationalised over the last few years, or been rationalised by the Chinese, commodity prices do not retrace to recent nadirs and remain sufficiently buoyant to give quality operators a sustainable business. The main caveat is the current escalated level of geopolitical risk surrounding North Korea. We’re living in risk on and risk off at the same time!
We favour pure-play exposure
If I had to choose among the large-cap miners, it would be Freeport-McMoRan. I like copper’s fundamentals over the medium to longer term particularly on the challenges to the supply side, and in a constructive environment, pure plays can outperform the diversified miners. Freeport is also a deleveraging story, after a near death experience from a problematic acquisition. Finally, a resolution to the ownership impasse with the Indonesian government at Grasberg may be a catalyst for unlocking further value at this world class district. It is not without risk, but the ingredients for long term outperformance are there.