Making sense of the mining malaise

It's been an interesting week for the mining heavyweights; Rio Tinto kicked off the sector's reporting season with record numbers, China released better-than-expected second-quarter growth figures and Goldman Sachs became the latest big bank to warn that the end of the commodities super-cycle is nigh. But with many opposing views, what are investors to make of it all?

In its report Emerging Market Forex and the End of the Commodity Market Super-Cycle, Goldman Sachs warned that rising supply over the next five years would hit commodity prices. It expects copper to hit $6,600 per tonne (t) - down from over $7,000 now - and iron ore to fall from $98/t to $80. Calling the end of the commodity super-cycle, however, has become fashionable in recent years and need not herald an exit from mining stocks.

Since the turn of the millennia, China's industrial boom has driven year-on-year growth in commodity prices - urbanisation fuelling demand for metals and bulk commodities like iron ore and coal. Yet China's economy is no longer growing at double-digit pace, and if supply fails to slow amid a decline in demand, prices will inevitably head south.

"There had been a shortage of iron ore output in the first decade of the current millennia due to the Chinese expansion in manufacturing, but many commodities have caught up with that demand and as such the price has come off quite significantly," Paul Renken, senior geologist and mining analyst at VSA Capital told Interactive Investor.

And supply shows no sign of letting up either. In its production update released earlier this week, Rio Tinto announced that it had reached record production in the first half and is on track with its planned expansion, putting further pressure on iron ore prices. And BHP Billiton is expected to release similarly-themed results. While China grew slightly in the second-quarter to 7.5%, this cannot offset supply pressure and further damage to prices.

I am looking forward to some signs in the next few weeks that this is clearly the bottom of the market as far as the very small companies are concerned"Paul Renken

Iron ore, the main source of income for many of the companies reporting over the next few weeks, traded as high as $140/t only a year ago. It was just $90/t mid-June and currently trades down a quarter on the year, according to data from Investec Securities. However, Murilo Ferreira who runs Brazilian giant Vale, the world's largest iron-ore producer, predicted on Thursday that iron ore prices would rise to $110/t, pointing to ongoing Chinese demand and a lack of any additional supply planned from Australian miners during the second half of 2015.

Competition

The falling iron ore price has cut out a lot of competition from China, with even some western outfits shutting up shop. But that just hands market share to the majors.

"The big four iron ore producers have expanded their output in order to keep pace with the fall in price ... and they are producing at a higher cost, which means their revenues will remain level. This is the environment where institutional money is willing to stay, especially if those firms have signs that they are maintaining or increasing their dividends for income investors," says Renken.

He adds that the big caps' other sources of income have helped sustain their share price despite the bearish outlook for iron ore. Investec has called this the re-rating of non-iron ore earnings (NIOE), reckoning that the sector's NIOEs trade on a 2015 price/earnings (P/E) multiple of 15 against iron ore earnings P/E of 10.

"In my view, copper is going to stay at $3 a pound. So, as the companies like Anglo American, BHP and Rio are all big in the copper business and plan to be bigger as well, they will weather the storm quite nicely," says Renken. However, he does warn that P/E multiples may shrink as a result.

Previews

In the coming weeks, the diversified miners will release more updates, which should show solid underlying performance offsetting price falls. But it's not been the easiest of years. Iron ore producers have continued a three-year losing streak with share prices down an average 19% year-to-date, says Investec. NOIE plays were up 56% against relatively flat commodity prices, supporting the broker's re-rating argument.

After Rio's strong production result, Investec analyst Hunter Hillcoat increased his earnings per share target (EPS) from 483p to 496p with a 2015 P/E of 10.2, but warns: "The upgrade has been more than reflected in the market and we believe the company is currently fully valued". He adds that ramping up production is "absolutely necessary" for Rio to offset a weaker price.

Despite risks from possible strikes and concerns around earnings growth and dividends, Anglo American has been the best-performing stock so far this year. However, platinum production slumped by 40% and iron ore production rose by just 2%, and Anglo admitted that it is not expanding as fast as some rivals. Yet Investec says the company has met its challenges and delivered production in line with expectations. Analyst Albert Minassian says it is trading on a 2015 P/E of 13.5 and notes that its challenge will be ramping up platinum production to offset losses and exiting non-core operations.

BHP Billiton is in the process of rerating and its year-to-date stock performance has been about its diversification, ensuring that it can pay a special dividend despite the fall in iron ore prices, says Minassian. Other analysts expect the firm to report good operating performance, especially from its US shale gas business, and Barclays sees no reason why it can't close the gap on Rio in regards to iron ore operation expenditure.

Unlike the other three firms, Barclays expects Vale's second quarter results to be "tricky". "We estimate a $2.1/t mark-to-market negative adjustment to realised iron ore prices to give a realised price of $78/t for the second quarter. This will be partially offset by a strong nickel price and iron ore shipments. Nonetheless we forecast earnings to decline 41% year-on-year and 3% quarter-on-quarter," its analysts say.

Renken agrees. Vale is his least favourite big-cap at the moment and the most vulnerable on pricing of iron ore and profit margins/tonne to Asia, largely due to distance. It's less commodity diversified than its peers, too.

Glencore is Renken's top pick of the big-cap diversified miners, and Barclays analysts expect a strong first-half trading.

While calling these a "relatively safe" investment, although not an outperforming one, Renken reckons Investec's 13 times earnings multiples are too high. "I would probably put them a bit lower unless they are able to get some of these other commodities which aren't in the pressure of iron ore into higher levels of output, I would suspect around 11 or 12 on a P/E basis."

Smaller companies

Save Vale, these companies have coped well with falling commodity prices, but what about the smaller caps?

"From the junior mining space, the valuations and market caps have continued to fall through the floor since the beginning of 2012 and the liquidity has dried up for the kind of risk taking that is involved," says Renken. "But the signs indicate we are probably at the bottom... so I am looking forward to some signs in the next few weeks that this is clearly the bottom of the market as far as the very small companies are concerned."

Renken advises retail investors to cherry-pick small cap holdings "while we are bouncing at the bottom", highlighting shares in North River, Mwana Africa, Pan African, Rambler Metals and Mining, Central Asia Metals and Goldplat.

Other commodities

Big-caps need to be able to diversify in order to sustain their performance, but there are other routes to ensure commodity exposure in your portfolio.

Thanks to Indonesia's export ban, the nickel price is up by nearly 40% on a year ago and many expect China's ore stockpiles to be completely drawn down sometime in the second half of 2014. There is no other alternative to Indonesia.

However, Chinese nickel pig iron producers are looking at getting around the ban by buying lower-grade material and labelling it as iron ore.

As long as volumes continue to rise, mine output continues to be bought and doesn't have to be curtailed as far as mine closures are concerned, I don't think the super-cycle is done in that respect"Paul Renken

Investec reckons if the strategy is successful it will put a cap on nickel prices, although it doubts it will be as cost-effective for nickel pig iron producers as higher grade lower iron content ore.

Renken stands by VSA Capital's bullish outlook on diamonds, with "very nice increased prices" being seen for diamonds in auction, with this being translated in diamond share prices, he says, highlighting Petra Diamonds.

"As far as precious metals are concerned, the credit crisis developed in 2008 and the banking crisis in Europe put constraints on how well economies will survive and how strong the currencies that are backing those economies are. They put a lot of institutional money into physical precious metals, including gold and silver." And although institutional demand for precious metals has come off in the last year, retail investors are still interested, he adds.

Renken also highlights continuing demand for lead-zinc concentrate due to a shortage of seaborne zinc as big mines reach the end of their production life. "The metal traders have been trying to lock into some consistent supply around the world and we see the zinc price responding upward and the mental inventory in LME (London Metal Exchange) warehouses of both lead and zinc have come off quite a lot since the beginning of the year, which is all supportive of that particular view."

He points to Glencore in particular as a firm that is positioned to be a "powerful force" in the zinc space going forward, yet this has not been reflected in its numbers so far.

End of the super-cycle?

Barclays is "positive" about the European mining industry and although Renken flags price volatility as a challenge facing all miners, he does not think the super-cycle is at an end, and puts the falling price down to "one of those really strong corrections".

"As long as volumes continue to rise, mine output continues to be bought and doesn't have to be curtailed as far as mine closures are concerned, I don't think the super-cycle is done in that respect," he says.

Albert Minassian concludes: "While on the demand side China has slowed and investors are looking for stimulus, the sector rerating is a more important event in the near term, in our view. But key uncertainties include how much further for the re-rating of NIOE and when a rerating of IOE will start."