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For well over a year commodities both hard and soft have been hammered.  While metals and energy have stolen the limelight, commodities like cotton, sugar, and coffee have also suffered. 

In theory, futures contract pricing should simply reflect demand and supply of a given commodity.  Soft commodities suffer from weather conditions as well, but experts feel there is more going on with the recent plunge.  Take a look at the prices of corn and copper:

Copper is the economic bellweather since it’s essential for myriad construction and manufacturing activities, but in Australia it’s the price of iron ore that concerns us most. Australia has benefited from the commodity boom in iron ore, but trading futures in that commodity is in its infancy.  However, worrying for iron ore producers and shareholders in iron ore pure plays is the sharp decline in iron ore prices, from $180 to around $135. 

Originally intended as a protective hedge for a commodity producer and its end user, futures trading on commodity prices have become a barometer of macroeconomic health.  As such, macroeconomic concerns in times like these can radically distort the supply and demand fundamentals of individual commodities.

To complete the picture of the veritable collapse of the commodities complex we turn to the New York Board of Trade and the Continuous Commodities Index (CCI.)  This index includes 17 different equally weighted commodity futures from energies, metals, grains, livestocks, and softs.  The CCI is meant to provide a performance benchmark for investors and right now the picture is bleak.  Here is a 2012 chart for the CCI:

Speculating over the whys and wherefores often leads to more confusion than enlightenment.  One rational consideration is the rise of the US dollar, since commodities are priced in dollars. 

As you know, experts can be wrong and often are.  A recent case to make the point is Australia’s GDP.  With Europe in a shambles and both the United States and China showing signs of slowing, experts predicted quarterly GDP growth of an anemic 0.6%.  As you already know, the actual growth was an astonishing 1.3% for Q1, which was 4.3% higher than 2011 Q1.  This represents the fastest growth rate in more than four years. 

While there is no doubt times are tough, such times also present investing opportunities.  If macroeconomic concerns are driving down the prices of commodities and every other risk asset, does that equate with a slowing trend in commodities demand?  The growing middle class in emerging market countries should see that demand continue to grow, albeit at a slower pace. When searching for investment opportunities here are three sectors to consider:

Diversified Miners

Agricultural Products

Gas Explorers

The Miners

Without a doubt, the Australia’s miners have suffered more from the commodities sell-off than any other sector.  Gold miners continue to underperform and the picture for even our biggest diversified miners is far from rosy.  At greatest risk are the pure play iron ore miners, especially the juniors who face funding challenges going forward.  Here is a table of Australia’s two largest diversified miners and two junior miners:

Company

Code

Mkt Cap

Share Price

52 Wk Lo

52 Wk Hi

P/E

Div Yld

ROE

BHP Billiton

BHP

$102,517M

$31.92

$30.71

$45

9.13

3.2%

38.32

Rio Tinto

RIO

$23,792M

$54.60

$52.83

$84.53

7.26

2.8%

29.6%

Mt Gibson Iron

MGX

$917M

$0.84

$0.82

$2.00

4.15

5.3%

19.8%

Gindalbie Metals

GLB

$511M

$0.41

$0.41

$0.87

2.5%

 

Noticeably absent from the table is Fortescue Metals (FMG) for two reasons.  The first is that, unlike BHP and RIO, it does not provide safety in diversification.  The second is that it is a major target of short sellers.  

Here is a one year share price movement chart for Australia’s biggest dogs in the sector, BHP and RIO:

BHP is now trading at around $32 a share, only slightly above its 52 week low of $30.71.  Investors have not seen a price this low since the company’s share price began its post-GFC recovery in the second quarter of 2009.  BHP has a P/E of 9.13, a dividend yield of 3.2%, and an ROE of 39.2%, all solid indicators for value investors. 

At around $54 per share for RIO – again close to its 52 Week Low of $52.83 – is trading close to levels not seen since the third quarter of 2009.  With a P/E of 7.26, a dividend yield of 2.8%, and an ROE of 29.2%, RIO should also be appealing to value investors.  However, how much further can they drop?

For whatever it is worth, the analyst community remains positive on both, and especially RIO.  In early February, major brokerage firms BA-Merrill Lynch, UBS, Deutsche Bank, Macquarie, Citi, JP Morgan, RBS Australia, and Credit Suisse are all maintaining BUY, OUTPERFORM, or OVERWEIGHT ratings on RIO.  Opinions on BHP are similar, with both BA-Merrill Lynch and JP Morgan lowering price targets with NEUTRAL ratings.

By virtue of their sheer size and market share, BHP and RIO should weather any economic storm, as both have done in the past.  And if you can weather the extreme volatility that is likely to remain a hallmark of share market investing for some time, both are worth a look.

The same cannot be said of the two junior miners in the table, which are down some 50%.  Here is their share price chart:

Although Mt. Gibson Iron has an attractive dividend yield, a low P/E, a YOY positive increase in operating cash flow, and low debt, this stock continues to hit new 52 week lows.  Their most recent rating from BA-Merrill Lynch is UNDERPERFORM with High Risk, while a few weeks prior Deutsche Bank rated the shares a BUY.

While Mt Gibson may be attractive for punters happy to take on some risk, Gindalbie Metals is for speculators only.  The company has a debt to equity ratio (gearing) of 65.5% and long-term debt of $361.7M with negative operating cash flow.  Gindalbie has been surviving on financing and despite the anticipated difficulties of loans for small cap companies, analysts are still positive on GBG. From 27 January 2012 to 27 April 2012, Credit Suisse, UBS, BA-Merrill Lynch, JP Morgan, and RBS Australia are maintaining BUY, OUTPERFORM, or OVEREIGHT ratings on the stock, but with a High Risk warning.

Agricultural Products

Considering the drop in soft commodities one would expert Australian agricultural shares to have suffered across the board, but this is not the case.  There is one standout.  Here is a table of four of Australia’s top agricultural products companies:

Company

Code

Mkt Cap

Share Price

52 Wk Lo

52 Wk Hi

P/E

Div Yld

ROE

Incitec Pivot

IPL

$4,398M

$2.70

$2.62

$4.13

9.43

4.2%

14.3%

Graincorp

GNC

$1,870M

$9.43

$6.74

$9.65

9.87

4.8%

12.1%

Nufarm

NUF

$1,256M

$4.79

$3.08

$5.74

11.18

6.5%

Australian Agriculture Company

AAC

$340M

$1.08

$1.02

$1.48

26.99

1.8%

 

On occasion, an agricultural company’s share price will move in seemingly perfect synchronisation with the price of the commodity it produces. AAC gives us such a picture.  As Australia’s largest cattle producer, the company’s beef is exported internationally.  Between 2011 and 2012 the company is expected to more than double its NPAT – from $11.8M to $27.8M – and its earnings per share – from $0.04 to $0.089.  Here is their one year share price chart:

Now let’s look at the price of cattle futures contracts:

It now appears AAC’s share price is decelerating faster than cattle prices.  Analyst coverage is sparse but RBS Australia has a HOLD rating on the company, but that was based on higher cattle prices back in February 2012.  The company has negative cash flow and in 2011 relied on share issuance to fund operations.  Although the demand for beef products is expected to grow in emerging markets, there are better plays.  One of them is GNC (Graincorp.)

GNC does not produce grain, although it does buy and sell wheat through a subsidiary.  Its principal business is grain storage and handling.  We can see a correlation between GNC’s share price and the price of its principal grain – wheat.  Here is their one year price chart, followed by the one year chart for wheat futures:

Although the analyst community is lukewarm on GNC with only two recent BUYS along with an UNDERPERFORM and two HOLDS, this stock bears watching.  It is up about 15% year over year while the ASX 200 XJO index is down about 12% and it tripled its net operating cash flow from F 2010 to F 2011 – from approximately $100M to $300M.

The remaining agricultural companies provide products that help produce healthy crops – fertilizer (Incitec Pivot) and pesticides, herbicides, and disease preventatives (Nufarm).

In addition to its agricultural fertiliser offerings, Incitec Pivot (IPL) is a major international player in industrial explosives and that part of their business has suffered a slowdown.  However, analysts like them as a long-term play based on the growing need for fertilizers globally.  Despite their poor share price performance, five major brokers maintained BUY and OUTPERFORM ratings as of 15 May 2012.

Nufarm (NUF) is also international in scope, selling products in over 100 countries.  The share price was trending upward when first half earnings results disappointed the analyst community resulting in three downgrades; one at Citi from NEUTRAL to SELL, one from BA-Merrill Lynch from BUY to NEUTRAL high risk, and one from Macquaire from OUTPERFORM to NEUTRAL.  Most cited European concerns in their analysis.

No discussion about investing opportunities in commodity related stocks would be complete without including natural gas.  Until the recent commercialisation of LNG natural gas has not been transportable and therefore is priced locally.  While the price of natural gas in the US has reached historic lows, this is due to the explosion of supply from the technological capability of extracting natural gas from shale formations. 

LNG may revolutionise the world’s energy mix because it makes it possible for countries with high demand and limited supply like Japan to import gas to use as the replacement fuel for its nuclear energy generating facilities.  Right now Australia is already the fifth largest exporter of natural gas in a liquefied state (LNG) and this is only the beginning of a resources boom that could make the iron ore boom pale in comparison.

Here is a chart of Australian natural gas production and LNG exports over the last 45 years:

LNG processing and transport facilities are beginning to come online in Australia and there is some concern about our ability to provide sufficient supply of natural gas to these facilities.  However, we now know Australia may be blessed with more unconventional sources of natural gas – coal seam gas and shale gas – than previously imagined.  In short, companies in the unconventional natural gas exploration sector have explosive share price potential, although at high risk.  If you are a regular follower of the markets, you know one of 2011’s star performers was Beach Energy (BPT), one of the first Australian companies to begin drilling for unconventional gas.

Every serious investor should be exploring possibilities in companies engaged in coal seam gas or shale gas exploration.  While our major LNG players like Woodside and Santos are struggling with LNG project delays and cost overruns, they should pull together over the long term.  With junior natural gas explorers, every positive geology report or drilling result has the potential for upward price movements.  You may have heard of some of the other players here like Buru Energy and Norwest Energy, but here are two for your watch list that may be unfamiliar, Icon Energy (ICN) and Strike Energy (STX).  Here is a one year share price chart for these two companies:

Both have suffered from the European dramas of late, but here are two teaser facts to pique your interest.  You remember the shale gas drilling that sent Beach Petroleum shares skyward in late 2011?  Icon Energy owns 40% of that project.  The project is located in the Cooper Basin located in South Australia and extending into Queensland.  Of the four Australian basins with shale gas potential, Cooper appears to be the most promising.  Strike Energy has over 4 million acres of exploration permits and applications in the richest part of the Cooper Basin.  And they have begun drilling.

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