Downside Scenario
The sobering news of manufacturing and steel plant closures outside of China invites comparisons to the slump in demand experienced during the GFC, and Goldman Sachs suspects there could be considerable downside to 2020 price assumptions.
Commodity prices are currently 25-30% above GFC levels but the drop in demand could be as severe as 2008, the broker points out. Assuming no cuts to expenditure and a -20% fall in commodity prices versus the base case, Goldman Sachs assesses free cash flow yield of BHP Group ((BHP)) is still attractive at 6% while Rio Tinto ((RIO)) is at 3%.
However, if prices were to drop and stay at these levels for the remainder of year then stocks that may be negative on cash flow and likely to need a reduction in expenditure, include OZ Minerals ((OZL)), Whitehaven Coal ((WHC)), South32 ((S32)), Iluka Resources ((ILU)), Sandfire Resources ((SFR)) and perhaps even Fortescue Metals ((FMG)).
The broker assesses the market is already pricing in commodity prices close to those at the time of the GFC, which implies iron ore down to US$60/t and copper at US$1.75/lb. Goldman Sachs considers BHP, Sandfire and OZ Minerals have the most resilient earnings in downside scenario.
Iron Ore
Macquarie points out Chinese steel inventory has declined in the past week as demand has risen and Australian iron ore miners delivered a strong rebound in shipments in the first three weeks of March.
The average is now close to forecast capacity for the three major miners. Macquarie’s estimates imply capacity of 810mtpa and assumes 360mtpa for Rio Tinto, 280mtpa for BHP Group and 170mtpa for Fortescue Metals.
The March quarter is usually a low period because of the potential for cyclones in the wet season. Shipments from smaller ports have been weaker, with Macquarie noting Roy Hill has been the main driver of the weakness in the past three months. The historical seasonality for Roy Hill is broadly similar to Rio Tinto.
Buoyant iron ore prices continue to underpin earnings upgrade momentum for these miners. Macquarie prefers Fortescue Metals, Rio Tinto and Mount Gibson ((MGX)). Forecasts for 2020 are in line with spot prices but the broker considers there is significant upside from 2021.
Elsewhere, Iron Ore Co Canada (part owned by Rio Tinto) has started 2020 strongly but this company ships from Quebec which is currently in lock-down, although operations appear unaffected for now.
The lock-down in Quebec has also meant Champion Iron ((CIA)) has curtailed production until at least April 13. Vale reported its second lowest level of shipping in the first week of March as it struggled with port availability and wet weather impacts. However, full year guidance has been maintained at 340-350mt which Macquarie suggests could be a stretch.
Manganese
Macquarie expects a short-term rally in manganese ore prices as South Africa’s shut-down of mining operations threatens supply. South Africa is the largest exporter of manganese ore.
That said, the broker notes there is no shortage of manganese ore globally. There is already around 4.6myof inventory at China’s ports. Even a complete halt to South African exports for a month would still mean there is a comfortable buffer compared to recent history.
The broker does not envisage panic buying of ore in the global market unless the lock-down is extended well beyond three weeks. Moreover, one offset to a supply shock is the collapse in demand. as Europe’s steel industry shuts down and production is scaled back in Asia.
While China’s steel demand is recovering, Macquarie notes the market needs to work through a huge pile of finished steel inventory. Market conditions have also been deteriorating for a while, Macquarie notes, as majors may have shown some production discipline but small marginal players in Brazil and Africa have continued to add tonnage.
Oil & Gas
Canaccord Genuity notes share prices for those oil & gas developers that are yet to draw revenue are down between -30-53% and it is difficult to assess any timeframe for a potential recovery. Further complicating the issue is the destructive price war between some of the largest producers.
The broker believes it is useful to consider relative merits of each developer and, after allowing for lower oil price assumptions of US$50/bbl for the long term, ratings are cut for Comet Ridge ((COI)) and FAR ((FAR)) to Hold, with targets of $0.24 and $0.03 respectively.
Comet Ridge is expected to defer Mahalo and Canaccord Genuity believes the company will need to cut discretionary expenditure The fact that FAR is yet to secure funding for Sangomar creates serious risk, the broker adds.
Carnarvon Petroleum ((CVN)), with a Buy rating and $0.36 target, is the broker’s preferred as it has the strongest balance sheet. The large Dorado liquids project will enter front end engineering design during the second quarter. Nevertheless, in light of current conditions, Canaccord Genuity pushes out the first oil to 2024.
Galilee Energy ((GLL)), with a Speculative Buy rating and $1.06 target, has high levels of cash and continues to make progress, albeit well behind schedule. The gas, based on the broker’s modelling, is economic even under a $6/gigajoule price scenario, which is around 20-25% below recent contract pricing.
