Macquarie: Are We Being Too Conservative?
13/04/2006
In light of the recent strong performance in the resource sector, Macquarie Research Equities (MRE) have conducted a review of their resource sector forecasts and have incorporated significant changes to a number of base metal, bulk commodity and currency estimates. Most notably, MRE have made significant upgrades to zinc and copper over the short and medium term. MRE's key picks remain BHP Billiton (BHP), Alumina Ltd (AWC), Oxiana (OXR), Jubilee Mines (JBM) and Kagara Zinc (KZL).
Upgrading the base metals.
Although MRE only recently completed a thorough review of their base metal price forecasts and considered themselves to be in the bullish camp, MRE have again been proven too conservative as the improving macroeconomic backdrop has shored up the demand outlook while ongoing supply disruptions continue to dampen the supply-side response. Consequently, MRE now expect metal markets to remain (in many cases) exceptionally tight and in deficit for an extended period. MRE therefore find it difficult to see the catalyst for a sustained correction in base metal markets in the short term.
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The most significant change (given its importance to both the base metals complex and equities) is the ~50% increase to MRE's copper price forecasts for 2007 and 2008, which now exceeds US$2.00/lb until end 2008. In MRE's view, the consistent failure of producers to meet (lofty) expectations will necessitate broad upgrades across the market and drive strong earnings momentum for the sector.
Zinc and copper the big movers
Copper supply disruption maintaining the tightness- MRE continue to see a large number of supply disruptions due to strikes, mine production problems, equipment delays and lower ore grades. Those issues have had a substantial impact on MRE's production forecasts, have raised the forecast concentrates deficit, and have now swung their refined market balance forecast from surplus to deficit in 2006. With stocks already extremely low, this deficit is enough to make MRE question whether there is any justification to forecast a significant pull-back in prices this year, and MRE's conclusion is that there is not. As a result, MRE have revised up their forecast average copper price for 2006 from $2.20/lb ($4850/t) to $2.54/lb ($5590/t).
The zinc rundown continues – In zinc, MRE have not changed their supply/demand balance significantly. MRE still see the refined zinc market in deficit by around 400,000t in 2006 – enough to run inventories down to record low levels. What has changed is the price reaction to these developments.
Prices have reacted earlier than MRE had forecast, and have been above the levels suggested by the historical price/inventory relationship for the past six months. However, it would appear that the market is simply looking ahead to the tightness which is looming later in the year.
MRE continue to expect virtually all of the LME zinc stocks to be run down by the end of the year, and the zinc market to be displaying all the signs of a shortage market – including prices moving to record highs. Copper is an interesting case study for those looking at possible price outcomes for zinc – in copper, prices have gone higher than we would ever have imagined – simply because there has just not been enough to go around. In zinc it is difficult to say just how high prices could go in a real shortage situation. MRE do not believe there will be significant price-related substitution out of zinc in the galvanised steel market.
The earnings upgrade trend will continue.
Earnings estimates for a number of MRE's favoured equity picks now comfortably exceed consensus forecasts. For example, MRE's BHP Billiton, Alumina Ltd and Zinifex forecasts are 16%, 29% and 44% ahead of the consensus in 2007 while forward earnings multiples remain at a significant discount to the market and the historical norm and are expected to ensure strong interest in the sector is retained.
MRE's Favoured picks.
Although MRE have upgraded their recommendation for Rio Tinto to outperform given the revised earnings outlook, MRE retain a preference for BHP Billiton given strong leverage to terminal metal markets and superior earnings growth in the medium term. Strong fundamentals for the aluminum market are expected to remain supportive of Alumina Ltd performance while Oxiana, Jubilee Mines and Kagara Zinc cannot be ignored given impressive leverage to base metal markets.
In summary, MRE's key picks within the sector remain BHP Billiton (BHP), Alumina Ltd (AWC), Oxiana (OXR), Jubilee Mines (JBM) and Kagara Zinc (KZL).
MRE continue to recommend an overweight position in the resources sector. In MRE's view, investors should remain acutely aware of, and not underestimate, the challenges facing the supply-side in this robust demand environment and therefore, the potential for ongoing positive (commodity) price surprise.
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