Fair value upgrades on the table: Morningstar resources update
Supply disruptions following Russia's invasion of Ukraine are forcing analysts to consider the possibility elevated prices persist.
Lewis Jackson: Commodity markets are booming from nickel to copper. Prices are at or near record highs. I'm joined today by Morningstar's Director of Equity Research, Mathew Hodge, to talk through what's happening in commodity markets and how investors can respond.
Mat, thanks for joining me.
Mathew Hodge: Thank you, Lewis.
Jackson: Mat, what is going on? Coal prices are more than double the 2020-2021 average and that's after falling a quarter in the last week?
Hodge: Well, it's a good question. Actually, I think if you take thermal coal, I was looking earlier today, in August 2020, it was below 50 bucks. That was kind of the nadir of the whole thing, and up until not that long ago was over 400, which is just unprecedented, right? Even for coking coal, that would be a humongous price. Coking coal is at 600. So, I think, there's just – this Ukraine-Russia war has caused a lot of gyrations in the market. I think we're going through a period of extreme volatility, and we saw that with nickel as well. Trading on the LME suspended for a week basically. So, the market is just trying to digest what's happening here. And the reality is, we don't really know. There's definite risk on the supply side for some of these commodities that Russia and Ukraine, in some cases, produces. But we don't know, like, how long is this war going to go for, how will Russia be in the cold for. That's the thing, right? But as far as some of these minors go, you highlighted thermal coal, I think that's the obvious one. The thermal coal miners and those who are exposed to coking coal probably secondarily for how long this lasts, there's windfall profits and they're meaningful.
Jackson: And at today's prices – you've talked a lot about Russia and Ukraine. But is it just what's happening in the Ukraine, or are there longer sort of histories here behind some of these price movements?
Hodge: Well, it depends which commodity you're talking about. The commodity market, it's a big topic. We could be here all afternoon. But if we just…
Jackson: Iron ore, for example.
Hodge: Well, iron ore is somewhat impacted because the Ukraine produces pellets which go to Europe. We're talking about, I think if I'm remembering, a smaller impact to the market that when Vale had the tailings dam failure. And with Vale's tailings dam failure that took – it still hasn't recovered. That's 2019. So, it's taken years to recover. This might be more of a political solution. So, I think iron ore is probably less impacted. I think with thermal coal, for example, like thermal coal was in the toilet in 2020, right, and people were talking about is this commodity going away. And I don't think the world can transition that quickly away from thermal coal, but I don't think there's a lot in the cupboard in terms of new supply. And we've seen demand really take off as economies have stimulated their way out of the COVID downturn. That's kind of all happening at once. Tight supply because prices were so terrible. Not much coming on. So, there's that cyclical reason. But then, on top of that, I think Russia is about 15% of global traded thermal coal. So, that's a big concern as well. And you've got what's happening in energy in Europe. And Europeans looking to move away from Russian gas and trying to cut that substantially just in this year means that everything in terms of energy supply needs to be on the table.
Jackson: And with what we're seeing today, we're seeing forecasters increase their price targets for different commodities – copper, coal, especially. What's Morningstar's position on this? Are you considering any changes to fair value, or do you see this is something that's just going to fade away quickly in a few months?
Hodge: I mean, that point is really difficult. So, how long is this going to last for? We don't know. It's a political problem as opposed to like a – like supply has been blown up and needs to be rebuilt, because if that was the case, you would say, okay, if there's been damage to that infrastructure and production, it's going to take a while to come back on like what happened with Vale. I don't think we're in that situation yet. It depends on the commodity, right? Russia is a very small producer of copper. So, it's not really a big deal there. It can still cause some impact around the edges. But if we're talking about fair value impact, that's why we put the note out, I think, last week to try and give people an indication of where the leverage really lies and where the leverage does lie in particular is among the coal miners and nickel. We've seen nickel as being quite crazy, but there's not a lot that we cover has got massive exposure to nickel. Platinum Group Metals, we cover Anglo, and they have some exposure there. Yeah, so thermal coal and coking coal are probably the main ones. We'll update our commodity prices when the quarter finishes, we'll put through the historical and what we think is likely for the next, kind of, short to medium term to take into account of this. And that's how we'll deal with it.
Jackson: So, are you saying that if prices were to stay sort of at these levels or even somewhere near these levels, that would lead us, in the case of coal then, to material changes, sort of the profitability and therefore the fair value of these companies?
Hodge: Yeah, we laid that out in the note, but definitely thermal coal is a big one. I think at the time the thermal coal price was above 400. And if we ran 400 through our models for Whitehaven and New Hope, you basically have them earning their share price and their valuation in just over a year, right? So, if it lasts for a year, who knows? Because it's so far away from the cost curve that it's floating on a cloud. There's nothing fundamental underpinning it, and if you have some small changes, that could all come back down to Earth. But if it were to last for a year, you're almost looking at a doubling the valuation for those two stocks.
And then, on the coking coal side, BHP has got some pretty decent leverage. Anglo American has got a bit; South32. There are some other stocks that have got leverage to that as well. And we're seeing a bit of action in the gold market as well, probably not as much as what one might expect given the uncertainty, but I think also the fact that I think the idea of buying gold for from Russian point of view to keep their economy running and then use that to get hard currency, I think that one being closed off.
Jackson: And do you have a sense with the uncertainty, including uncertainty around Morningstar's fair values, as someone looking at the commodity sector now, it's been really volatile. There's been 2, 3, 4 spikes, even just year-to-date. What are some names or some companies that are at this point fairly valued, or you think are a good pick?
Hodge: Yes, I think Newcrest is probably the one where they've got reasonable exposure to copper, which I think the market probably overlooks a little bit. They've got long mine life. Low costs and high quality and all of that sort of stuff. So, I think that's one where we see some reasonable value around Newcrest. And I think it's just in that phase where they're spending a lot of money on developing new mines. Those mines aren't in production yet and aren't contributing to profitability. So, from a free cash flow point of view, it's a bit depressed because of the CapEx. And then, from an earnings point of view, they haven't got the benefit of that yet, but I'm pretty sure that's just a timing thing that and it will be overcome. Otherwise, I think the two thermal coal miners – I mean, they asked that it drift up a little bit now. But depending on how long this lasts, I mean, those prices could well be cheap in hindsight. Those are probably the main picks, I think, yeah.
Jackson: How high and for how long would prices have to go to state to make some of the bigger diversified miners like a PHP, for example, start to look fairly valued?
Hodge: Yeah, iron ore is the big driver there. I think petroleum is like 10% or less of our EBITDA forecast. So, not a big driver. So, they've got a little bit of energy, but not a not a big driver there. Really, kind of, gets dwarfed by iron ore. So, it's like, iron ore at 150 is still very good for all of those iron ore facing miners. But it's a long way from the cost curve, too. And iron ore is much more about China given China's 75%, roughly of the traded market, So, what happens there is really important.
Jackson: And on China, do you have a sense of how the recent COVID shutdowns and some of the concern in markets around that, how that could impact iron ore and BHP and Rio or Fortescue?
Hodge: Well, it's interesting because steel production in the back half of last year and into this year was – it basically stopped growing. So, we have seen a buildup in iron ore stocks at the port. I think the market is confident that demand will recover in China and that will start growing again, and that those stocks will be worked through. But I think there's room for disappointment on that front.
Jackson: Okay. Fantastic. Mat, thank you for your time.
Hodge: Thank you.