Resource bears will be buoyed by recent falls in spot ferrous prices. Scrap is highly leveraged to emerging-market steel consumption and sometimes a harbinger of broader metal-market conditions given the high liquidity of physical spot scrap prices.
Benchmark Turkish import prices of ferrous scrap fell more than 15% last week, including the largest recorded fall in a day. Markets are speculating on weakening steel demand from India, Turkey and other emerging markets.
The scrap price is highly correlated to the rising iron-ore price because scrap is a competing feedstock to iron-ore in steel production. Scrap’s fall makes iron ore look relatively dearer.
Scrap price weakness follows declines in manganese and metallurgical coal this year. The latter is a key ingredient in Chinese steel-making.
These trends suggest growing pressures in emerging economies, outside of China. Emerging markets, an important source of commodities demand, are vulnerable to a rising United States dollar and aggressive protectionist trade moves under President Trump.
Higher US interest rates in 2017 could spark a capital exodus from emerging markets to the US and make it tougher for developing countries with high US dollar-denominated debt. Trade restrictions would hurt emerging markets that depend on the US for their exports.
It is too early to tell if the sell-off in scrap and some other bulk metals is an early warning sign of a deepening malaise in emerging markets – possibly even the seeds of another Asian Financial Crisis. For context, some of these metals prices rallied so hard in 2016 that a decent sell-off seemed inevitable.
That was one reason why I nominated Sims Metal Management as one of five stocks to sell, for this report in November 2016. Sims has fallen almost 10% since then.
I also suggested taking profits on South32, Whitehaven Coal and Fortescue Metals Group, principally because of reservations about the speed of the commodity-price recovery in 2016. South 32 and Whitehaven are trading in line with late November prices. Fortescue has rallied from $6.12 to $6.81 since that column and looks fully valued.
Commodity prices can remain at elevated levels this year and the growth in mining company earnings will underpin a rising Australian sharemarket in 2017. A stabilising Chinese economy and expectations of gains in the US economy should offset emerging-market weakness and an expected supply-side response to higher metals prices.
But current resource-sector valuations, to my thinking, are already factoring in commodity prices remaining elevated. One could argue analysts are, collectively, still using commodity price forecasts that are well below spot metal prices in their company-valuation models. As they lift those forecasts, resource-sector earnings and valuations will rise. It all depends on one’s view of commodity prices.
I wrote last year for this report that the resource-sector rally could extend into 2017, such was the crowded nature of this trade as fund managers rebuilt portfolio weightings in mining and energy shares. But that the rally would lose steam as reality set in about higher global economic uncertainty under a Trump Presidency and problems in emerging markets.
That does not mean commodity prices, particularly that of iron ore, are about to roll over or that the big mining stocks will underperform. But it does highlight the dangers of extrapolating commodity price gains too far into the future and buying overvalued miners.
The easy share-price gains from rising commodity prices – which weren’t that easy to spot in advance – are over, for now. Investors will need to be a lot more company-specific and focus on businesses that still can rally with or without commodity price gains from here.
Here are three resource stocks to watch at current prices:
1. Santos (STO)
The energy major barely moved during the resource rally, starting 2016 at $3.83 and finishing the year closer to $4. Some Santos shareholders were probably grateful that the stock at least stabilised last year after savage price falls in 2015.
Santos’ refreshed management team is doing a good job of cutting costs, focusing on core long-life, low-cost natural gas assets, and improving the company’s cash generation. Santos’ recently released fourth-quarter production fell (quarter on quarter) but higher Liquid Natural Gas prices and record sales boosted revenue.
The Santos balance sheet, an investor turn-off, is improving. Net debt fell to US$3.5 billion at the end of 2016, from US$4.7 billion in 2015. Strong operating cash flow is helping Santos pay down debt, but the reintroduction of dividends is probably still a year away.
A median share-price target of $3.44, based on a consensus of 16 brokers, suggests Santos is overvalued at the current $3.83. The market is too bearish. Morningstar’s $5.30 valuation looks more reasonable and some good broking judges have 12-month price targets above $6.
Santos looks undervalued and could be a target for an offshore predator – a reason for its inclusion in the Switzer Super Report takeover portfolio.
Source: Yahoo Finance
2. Mount Gibson Iron (MGX)
The iron-ore producer tumbled from $1.18 in November 2014 to 20 cents in early 2016 as commodity prices tanked. Mount Gibson has rallied to 38 cents and looks in better shape.
The company recently delivered a promising second-quarter production result that beat market expectations.
Mount Gibson is well placed to grow earnings through rising production. Final approvals for the company’s Iron Hill extension, expected in early 2017, will incrementally extend production and capitalise on higher iron-ore prices. The market might be underestimating the impact of early approval for Iron Hill on Mount Gibson’s earnings.
Mount Gibson does not suit risk-averse investors; the company is a relatively higher-cost producer and has single-commodity risk. But the balance sheet is strong and it has plenty of cash for a company its size. Macquarie Group estimates Mount Gibson has net cash backing of 43 cents a share, which compares to the 38-cent share price.
Macquarie’s 12-month share-price target of 53 cents for Mount Gibson looks achievable.
Source: Yahoo Finance
3. Evolution Mining (EVN)
Gold was a casualty of Trump’s surprise win in the US election in November as investors rotated from defensive to growth assets. Gold bullion fell from US$1,300 an ounce in early November to US$1,150 in early January, before stabilising to US$1,210.
I would not give up on gold just yet. The potential for financial shocks this year, principally in emerging markets, and other global volatility will reinforce gold’s safe-haven qualities. Also, a lower Australian dollar against the Greenback should help local gold producers.
Evolution Mining, my preferred gold-sector idea, was nominated for this report at $1.52 in April 2016. Evolution soared to $3.04 and has since retreated to $2.17.
That is an opportunity to re-enter the stock. Evolution, among the sector’s best-run companies, delivered an excellent December-quarter production report. Record production of 217,812 ounces, and the first contribution from the Earnest Henry Mine, pleased investors.
Evolution has plenty of growth options and continues to deliver promising exploration results. The balance sheet is strengthening as debt is repaid.
Eleven of 12 brokers that cover Evolution rate it a buy and one rates it a sell. A median share-price target of $2.42 suggests the stock is undervalued. I’m always concerned when almost every broking recommendation is positive on a stock – Evolution has plenty of fans.
But the stock looks a lot more interesting after a 28% fall from its 52-week high, for no apparent reason other than the Trump-inspired gold-price sell-off.
Source: Yahoo Finance
Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at February 2, 2017.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
