What commodity price uptick means for miners, investors

With few exceptions, mined commodity and miner share prices are overvalued, propped up unsustainably by Chinese stimulus, according to Morningstar analysts.

Iron ore’s relative buoyancy since early 2016 is “emblematic of most industrial commodities”, says Morningstar equity analyst Seth Goldstein, CFA.

“Recent conditions have been highly favourable for miners, particularly the bulk miners, as exemplified by our forecast 2017 adjusted earnings for Rio Tinto (ASX: RIO), which are in line with 2012 levels.

“We do not expect this to last. With China’s credit growth slowing, we continue to expect mined commodity prices in general, and particularly for iron ore, to fall materially and for share prices to follow,” he says.

To explain Morningstar’s view that miners are generally substantially overvalued, he points to “structural change in demand growth from China, as its economy matures and transitions toward less commodity-intensive and more consumption-driven growth”.

“High-cost miners and those with outsize exposure to iron ore and coking coal tend to look the most overvalued."

BHP (ASX: BHP) holds several of the world’s largest mines, with iron ore, coking coal and copper the predominant commodities it extracts. Despite a recent fair value estimate (FVE) upgrade in response to “very strong commodity prices in the past few months,” Morningstar senior equity analyst Mat Hodge views BHP’s current trading price of $30.78 at a substantial premium to his $22 FVE. It continues to hold a “reduce” rating.

“As with Rio Tinto (ASX: RIO) we expect at least some of the benefit of higher near-term commodity prices to flow into dividends,” Hodge says, though he believes this situation won’t last. “While near-term multiples appear attractive, we think fiscal 2018 earnings reflect market conditions close to a peak and are unlikely to be sustained.”

In other commodities, aluminium has fared better than iron ore in recent months, with spot prices revisiting 2012 highs. “Prices have moved higher because of better-than-expected aluminium demand, as well as the perceived benefits of capacity reductions in China,” Goldstein says, but tempers this by suggesting “investors have become overly enthusiastic on both counts”.

“We forecast a significant deceleration in aluminium demand growth and anticipate that the impact of capacity cuts will prove far overstated. Accordingly, we forecast a long-term aluminium price of only US$1,475 per metric ton (in real terms), roughly 25 per cent below current levels,” he says.

Goldstein believes a price decline of this magnitude would have a substantial impact on share prices for several companies, including Alumina (ASX: AWC), “which is trading well above our fair value estimate”.

“On the demand side, the key factors underpinning our bearish outlook are our below-consensus forecast for Chinese fixed-asset investment and fading benefits from Chinese stimulus. Additionally, we contend that India is still a number of years away from picking up the slack as the next major driver of global aluminium consumption.”

He expects Chinese structural overcapacity to remain in place, “as large swathes of new, low-cost capacity more than offset the country’s progress in closing high-cost facilities”.

A bright spot

In Morningstar’s view, gold is among the few mined commodities that isn’t directly tied to the fortunes of Chinese fixed asset investment.

Referring to the situation in the US, “gold investment in exchange-traded fund holdings remains as high as it did when [Federal Reserve] rates were meaningfully lower”.
“As real yields on U.S. Treasuries and other safe-haven asset prices rise, the opportunity cost of holding gold will rise.”

Though he forecasts gold prices will fall further from the US$1300 peak they hit in 3Q2017—having fallen below US$1250 per ounce in the last quarter—to US$1150, “we still believe gold has a promising future, and we forecast a nominal gold price of US$1,300 per ounce by 2020”.

“We expect that in the long term, Chinese and Indian jewellery demand will fill the gap left by waning investor demand,” Goldstein says. “However, the rise of consumer demand will take time, which points to downside risk in the near term.”

Glenn Freeman is a senior editor at Morningstar.
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