Aussie miners, through the eyes of 3 brokers and a fund manager

A mainstay of the Australian economy, the commodities sector soared in the first half of 2022. But the ASX 200 Materials index has since pulled back, currently down around 15% since the middle of the year. In this feature, I consider how local broking firms JPMorgan, UBS and Macquarie are looking at the sector. I also get a fund manager's perspective from David Franklyn of Argonaut.

For the gold bugs

JPMorgan’s lead mining analyst, Al Harvey, remains cautious on near-term gold price dynamics, the broker’s key takeaways on the sector including:

• Gold is still affected by rising interest rates and the associated strength of the US dollar, although this currency strength benefits the revenues of several Australian dollar-denominated gold stocks under JPMorgan’s coverage.
• The modest upside to the net present value - the difference between the present value of cash inflows and the present value of cash outflows - is emerging among gold mining stocks. But he’s cautious of both macro and operational headwinds over the next six months.

Expanding on the first point, Harvey notes the Australian dollar gold price is up 6% in 2022 so far, versus a decline of 9% during this period in US dollar terms.

And in the context of the US macro environment, he notes that further falls in the gold price there seem likely.

“While recession calls grow louder, we await the bounce as potential rate cuts come into focus,” Harvey writes in a recent note.

“But with the market not pricing in easing until mid-2023, risks to gold pricing look skewed to the downside.”

While the lower rate environment weighs on US dollar gold, this is offset slightly by the lower Australian dollar and the effects on JPMorgan’s coverage in the space.

The UBS view

Commenting on the broader commodities basket, UBS’s George Tharenou says commodity prices are mixed versus his team’s estimates. Based on current prices, prices of iron ore, metallurgical coal, copper, and lithium are above UBS’s forward estimates for 2022 and 2023. But prices of zinc, aluminium, alumina, and gold are trading below its expectations.

In his view, most commodity prices remain too high and mining stocks aren’t yet fully pricing the risk of a recession.

The two commodities sectors UBS is most bullish on are:

• Thermal coal and natural gas
• Lithium.

“We see further downside in copper, iron ore, and platinum group metal prices; aluminium downside should be limited by high energy costs and production cuts,” says Tharenou.

Key commodities YTD: iron ore -17%, met coal -21%, copper -22%, aluminium -20%, gold -8% while thermal coal and lithium prices have more than doubled.

Based on stock valuations as of 12 October, UBS estimates they’re pricing in:

• Iron ore price of between US$79 and US$83 a tonne
• A copper price of US$3.10 to US$3.80 a pound
• Gold price of US$1,300 to US$1540 an ounce
• Spodumene prices of US$900 to US$2,250 a tonne, and
• Lithium hydroxide price of US$13,000 to US$20,300 a tonne.

What would change UBS’s view on commodities?

1. A change in China's COVID policy,
2. A pick-up in the China property market, or
3. Peak pricing of US and other central banks’ rate hikes and a reversal of US dollar strength.

“We see the relaxation in the zero-COVID policy as key, as this will release pent-up demand and support a pick-up in construction activity; however, in our opinion, this is unlikely before the June quarter next year,” writes Tharenou.

The risk-reward trade-off is improving

On the supply side, Tharenou criticises copper, iron ore and zinc miners for continuing to underperform and miss guidance. “Supply should recover but the miners have been saying this for some time,” he says.

“Our preferred commodities see support from the energy crisis (thermal coal, zinc, aluminium) or are likely to be more resilient due to strong demand growth medium-term (lithium, nickel, cobalt).

“We believe the risk versus reward for the miners is improving and long-term value is emerging, particularly for commodities with robust demand outlooks, such as energy transition metals.”

Where Macquarie sees value in the miners

Among iron ore miners, Macquarie favours the following:

• BHP Group (ASX: BHP)
• Mineral Resources (ASX: MIN)
• Deterra Royalties (ASX: DRR)

“BHP is our preferred large-cap exposure as the company boasts stronger organic growth options,” writes Macquarie in a recent note.

“Our positive view on MIN is unchanged despite the weaker outlook for iron ore as the impact is outweighed by our strong outlook for lithium.”

DRR, a portfolio of royalty assets derived from BHP’s production at Mining Area C, appeals because of its low volatility exposure to iron ore.

Key risks to earnings and valuation

Across these three companies, movements in the prices of iron ore, copper, coal, aluminium and spodumene have the biggest influence on earnings forecasts and valuations.

Macquarie analysts also highlight “accelerating ESG momentum” and the threat of a carbon tax as further risks. These have already resulted in higher borrowing costs for BHP and RIO.

Other companies the broker covers within the sector include:

• Champion Iron (ASX: CIA) and
• Mount Gibson Iron (ASX: MGX).

Across each of these, movements in iron-ore prices present the key risk to Macquarie’s earnings estimates and valuations.

“Variances in assumptions (production, capex, opex, and shipping rates of both core asset) versus our base case present risks (upside and downside) to earnings forecasts and valuation,” writes Macquarie.

JPMorgan’s gold pick

JPMorgan’s preferred gold stock is Northern Star Resource (ASX: NST), which owns three production centres in Australia and North America. The company is also regarded as holding the lowest operational risk heading into quarterly results, alongside more favourable yield comparisons.

“Balance sheet exposure has been core for investors, with Newcrest (ASX: NCM), NST and Evolution Mining (ASX: EVN) approaching peak gearing in FY23 in currently announced

UBS’s Buy, Sell ratings

UBS currently awards Buy ratings to the following:

- Allkem (ASX: AKE)

- Evolution Mining (ASX: EVN)

- Gold Road Resources (ASX: GOR)

- IGO Limited (ASX: IGO)

- Mineral Resources (ASX: MIN)

- Northern Star Resources (ASX: NST)

- South32 (ASX: S32)

- Sandfire Resources (ASX: SFR)

- SSR Mining (ASX: SSR).

Both Fortescue Metals (ASX: FMG) and Pilbara Minerals (ASX: PLS) are rated as Sell.

UBS prefers BHP over Rio Tinto, and South32 is its pick of diversified miners.

NST (large cap) and Gold Road Resources (mid-cap) are its top gold picks.

How to weigh up commodities

A high-conviction investor in Australian resources companies, David Franklyn – who heads up the Argonaut Natural Resources Fund, believes commodity prices, in general, will remain flat in the medium term.

He points to the high level of uncertainty, including the Ukraine war’s impact on supply chains, and slowing global growth in the post-COVID environment.

“With a lot of moving parts, in these kinds of markets, the view we take is that it’s a better time to be more reactionary than to take high conviction positions,” Franklyn says.

As part of this approach over the shorter term, he starts from the top down in identifying what he regards as some of the most resilient themes. He then assesses which commodities should respond best to those themes, before working out which companies provide the best exposure.

Key themes

• COVID – “We’ve gone from the virus, to the vaccine, the stimulus and the tightening. And different stages have different impacts,” says Franklyn.
• The energy transition – The push toward net-zero by 2050 means “a whole new wave of demand for a relatively small group of commodities including copper, nickel, lithium, rare earths and graphite.”
• Increased geopolitical risk, with associated supply chain challenges – as we’re seeing currently between the US-China and Australia-China, and most dramatically between Russia and Ukraine.

“We’re not sure what’s going to happen with commodity prices, but if you want to back resources on a five to 10-year view, the energy transition is one of the spots you want to be in,” Franklyn.

“And if you look across each of those, there’s an emerging shortfall of supply and escalating demand.”

On top of this, much of the supply currently relies on regions that are problematic. For example, South America and Africa are big suppliers of copper and other commodities.

“Gold is well-placed”

He notes gold has performed well given the rapid rise we’ve seen in interest rates this year, and also regards it as having been out of favour for a while.

“The time to buy commodities is when they’re out of favour…it’s hard to be specific about timing, but if you can buy good quality gold producers now, it will pay off at some point in the future,” Franklyn says.

“The gold price in US dollars is pretty flat over the last 12 months, down around 2%, while Australian dollar gold equities are down about 25%. There is a mismatch there where we see opportunity.”

Key signals to watch

Looking at copper as an example, he notes that the energy transition industry’s consumption amounts to only a tiny proportion of the 25 million tonnes per annum industry.

“For industrial uses, demand for copper will ease a bit. The question is, can the energy transition demand wave offset that?” he asks.
“In the short term, no – and that’s why copper prices have come off – but in the medium term you’ll have a rebound in global economies and probably a doubling in copper demand between now and 2050.”

Looking at lithium, Franklyn regards the scenario as very different, with almost all of this material used in the production of batteries and other outputs to support the energy transition.

“The energy transition and the move to EVs is continuing to escalate and supply is still relatively small. While most commodities have fallen over the last six months, lithium has gone through the roof, as a smaller market where demand still outstrips supply,” Franklyn says.

Three top commodity stocks

• Mineral Resources (ASX:MIN)
• Oz Minerals (ASX: OZL) 
• Evolution Mining (ASX: EVN) 

On the first of these, Franklyn regards MIN as a top five global lithium producer and also highlights its iron ore business which he believes could double production in the next few years. In addition, the company has a mining services business that currently generates more than $500 million EBITDA annually. “This will probably grow to $1 billion EBITDA in the next five years.”

“It’s uniquely placed, with a strong balance sheet, good management, and is a favourite for those reasons,” Franklyn says.

He describes OZL as “arguably the best-managed resources company in Australia.” Focused on copper, with long mine life and low operating costs, and good growth projects.

And with BHP having already made unsuccessful approaches to the company, he believes it’s only a matter of time until the mining major lobs a higher bid and completes an acquisition.

On the gold side, Franklyn expects both Newcrest and Northern Star will do well when gold demand picks up.

“But the one I’d mention is Evolution, which has gone through a major de-rating over the last 12 months, down around 50%,” Franklyn says.

“With good production growth and a developing project in Canada, we think it’s a standout.”

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