Resources stocks: boom or bust?

Anthony Fensom | 19 May 2017

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Regardless of what happens to commodity prices, investors should always choose carefully when investing in resource stocks, using Morningstar's moat ratings as a guide to the sector's superior businesses.

 

A strong start to 2017 had miners hoping for better times ahead in the Year of the Rooster. However, with commodity prices subsequently retreating, is it time to get onboard or is more pain in store for the sector?

Australia's biggest exports, iron ore and coal, enjoyed a solid start to the year that gave the mining sector a much-needed boost after its previous China-driven boom and bust.

In February, the benchmark iron ore price hit a two-and-a-half year high of US$94.50 per tonne on the back of stronger-than-expected Chinese steel demand, fuelled by renewed stimulus by Beijing.

Coking or metallurgical coal prices also surged in April, reaching more than US$300 per tonne, after Cyclone Debbie disrupted Queensland supply of the key steelmaking ingredient.

However, prices subsequently eased back to levels predicted by analysts. On 17 May, the benchmark iron ore price was trading at US$60.40 per tonne, while the coking coal price had fallen back below US$200.

False dawn

In a 6 April report entitled "False Dawn," Morningstar analysts Mathew Hodge and David Wang described the bulk commodity miners as "overvalued," stating that the rally would prove short-lived.

"Shares of iron ore and met coal miners have rallied to levels not seen since 2014, when Chinese steel demand peaked. In effect, the market appears to be extrapolating the 2016 Chinese demand growth trajectory far into the future," they wrote.

"Our conviction that a sell-off is coming has strengthened, as the underlying drivers of the 2016 rally are unsustainable."

The Morningstar analysts expect the benchmark iron ore price to average US$65 per tonne in 2017 but slip to US$51 next year, followed by a further retreat to US$37 for 2019 and 2020 due to a long-term structural decline in Chinese steel demand. The prices compare to the US$135 per tonne achieved in 2013.

The analysts are similarly bearish on metallurgical coal, tipping a drop from US$203 per tonne in 2017 to US$128 next year and just US$84 in 2019 as new, lower-cost supply helps drive down prices.

The analysts said they are "most bearish on the leveraged plays, those with a high proportion of earnings from iron ore and met coal, higher-cost miners with operating leverage, and those with debt," tipping a 50 per cent downside in major miners Anglo American, Fortescue Metals (ASX: FMG), Vale and Whitehaven Coal (ASX: WHC).

Even Australia's big two, BHP (ASX: BHP) and Rio Tinto (ASX: RIO), are considered "significantly overvalued," although the "Big Australian" should benefit from its greater exposure to oil.

Brighter signs

However, it is not all bad news for resource investors, with Morningstar pointing to brighter times ahead for commodities such as lithium and uranium.

"We think that the market underestimates the growth potential for electric vehicle adoption, and with lithium the primary beneficiary of its higher adoption rate, we think that higher-cost sources of lithium will need to come online in order to balance the market longer term, and this should drive pricing upwards," Wang said.

Meanwhile, uranium should benefit from the growing number of nuclear plants planned for China and the United States, Wang said.

"[Uranium] has been on a down market for many years as the effects of [the Fukushima disaster] still play out across the market. We've begun to see a slight uptick in uranium prices recently and we continue to forecast that uranium prices will need to increase over the longer term to incentivise sufficient production," he said.

Wang pointed to Canadian uranium producer Cameco, the world's second-largest uranium producer, and US lithium producer Albemarle, as two preferred stock picks as of April 2017.

For ASX-focused investors, Morningstar's "Best Stock Ideas" for May 2017 included oil and gas company Santos (ASX: STO). Analyst Mark Taylor said it had achieved a "material reduction in balance sheet risk," with its operations free-cash-flow positive at oil prices above US$36.50 per barrel.

China key

China's position as the world's largest single resource consumer has made it crucial to the future of commodities demand.

According to Nikko Asset Management's Chris Rands, portfolio manager fixed income, the recent rally in resource prices can be attributed to Beijing easing monetary policy, with the subsequent price retreat occurring as credit growth eased.

"The rally in iron ore prices coincided with an expansion of money in China's economy, which coincided with the devaluation of its currency and a period of fiscal expansion, which supported Australian commodity prices," he said.

"However, as this credit growth slowed, commodity prices also slowed. Looking forward, if they don't do more of that easy monetary policy and let it unwind further, then the commodity price boom could be finished before it even got seriously started."

Rands said US President Donald Trump's plans for a massive infrastructure boost could be the next stimulus to spur commodity prices, helping move the market from a China-led expansion to one driven by the world's biggest economy.

"Unfortunately, at the moment, we don't have enough evidence for what will happen. Trump could get something through Congress in the next six months or he could still be trying halfway through next year," he said.

According to ANZ Research, the latest Chinese industrial production data points to a moderation for the world's second-biggest economy in the second quarter, with a decline in producer price inflation suggesting "the end of the commodity-driven recovery".

Nevertheless, China is expected to maintain growth momentum ahead of the 19th Communist Party Congress in November, aiming to achieve its full-year GDP growth target of 6.5 per cent, while the central bank is seen maintaining a "prudent and neutral" stance.

Longer term, however, analysts point to India's rise as the world's fastest-growing major economy along with growing demand from ASEAN as supporting the outlook for commodities.

Consultancy AT Kearney has predicted the global middle class will expand to 3.2 billion people by 2020 from 1.8 billion in 2009, with nearly half of the growth occurring in Asia.

Jeremy Grantham, founder of asset manager GMO, has told Morningstar of his expectations that a dwindling supply of resources such as oil and fertilisers will drive commodity prices higher, particularly with the expected growth in the world population to an estimated 10 billion by 2050, up from the current 7.5 billion people.

Diatreme Resources (ASX: DRX) chief executive Neil McIntyre said: "The outlook for Australia's resource sector remains bright, due to our position as a secure supplier located next to the world's fastest-growing region, which continues to demand more resources as millions of people move into the global middle class."

In the meantime, though, investors are urged to choose carefully when investing in resource stocks, with Morningstar's economic moat ratings providing a guide to the sector's superior businesses.

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Anthony Fensom is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. The author does not have an interest in the securities disclosed in this report.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

This report appeared on www.morningstar.com.au 2017 Morningstar Australasia Pty Limited

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written content of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.