Digging deep to find improved optimism

Nov 25 2009 by Andrew Miller, The Journal

AFTER a torrid period at the end of 2008 and the beginning of 2009, the tone in commodities markets has improved noticeably of late.

Indeed, import numbers for most commodities continue to significantly exceed the most optimistic expectations, while currency effects – notably the weak US dollar – have added to upward price trends for many commodities.

Looking ahead, and given a much more favourable macroeconomic backdrop than that at the start of 2009, we remain positive on the mining sector’s fundamentals for three key reasons.

First, we believe the demand recovery in Europe is likely to continue, as restocking over the second half of 2009 should be followed by real demand pick up and investment spending next year.

In particular, we believe demand for iron ore should rise; steel capacity utilisation collapsed in 2008 but it has been drifting higher in recent months. This should be supportive of demand for iron ore.

Second, China’s imports of commodities are continuing (anticipated stronger demand and/or future supply shortages, and no signs of contraction in steel production are all important factors here). We believe Chinese demand should remain strong, and as the “swing” supplier in commodities markets, we believe that China will want to see continued evidence of higher commodities prices in order to justify putting its own currently idle capacity back online.

Third, with the Chinese authorities facing increasing international pressure to revalue the renminbi again, a stronger Chinese currency could imply higher long-term prices for those commodities where China is already the marginal producer (specifically iron ore, thermal coal, aluminium, zinc, and steel).

At the mining company level, cost containment and asset disposals have been important drivers of stronger cash flow generation and lower debt levels at many companies. The recent interim results period has shown that, although they have seen signs of recovery, management teams at many mining firms are keeping a cautious tone in their outlooks and are still reluctant to increase capital expenditure just yet. However, merger/acquisition and partnership talks - whether official or only rumoured - are also back on the agenda.

Given these supports, we are raising our estimates for most mining companies by around 15% from 2010, based on their latest results, as well as higher prices for iron ore.

In terms of share price performance, the UK-listed mining stocks have continued to outperform the UK equity market over the last three months and consequently many mining shares have upwardly re-rated, thus leaving them somewhat less attractive from an investment viewpoint.

As mining stocks are very well covered by brokers and the bullish commodities theme is not completely new news, we believe many mining company valuations are now well up with events and because of this it is important to be selective when investing in the sector, despite the clearly attractive fundamentals of the industry as a whole.

Indeed, reflecting the fact that some shares have already re-rated, we recently downgraded Vedanta and BHP Billiton to Neutral on valuation grounds.

However, elsewhere in the sector, we still see significant upside for Xstrata and Rio Tinto and continue to view both stocks as offering good exposure to the still positive fundamentals of the global mining industry.

Andrew Miller is regional office head of Barclays Wealth in Newcastle