Basic Materials: China's Investment-Led Growth Model Has Run Its Course

Jeffrey Stafford, CFA

Despite significant share price declines for metals and mining producers, we believe real value remains relatively scarce, with Vale a notable exception. Global oversupply continues to weigh on the steel market, and material improvement looks to be several years away. Since it looks increasingly likely that the Eastern European potash cartel will reform, we've raised our long-term potash price forecast and fair value estimates for potash producers in our coverage universe.

China continues to grab headlines in commodity markets. From both a consumption and production standpoint, the country has great influence on global basic materials, from its position as a large purchaser of industrial metals to its production decisions that affect global prices of steel and nitrogen fertilizers.

With China's economy rebalancing toward consumption and away from investment, we expect pressure on investment-oriented commodities will continue. As such, we don't see the recent share declines for metals and mining producers as a buying opportunity on average. With commodity prices shrinking, we think low-cost miners such as Vale provide the best value. The picture looks rosier for commodities where China still consumes a relatively small share of global demand, such as uranium and palladium.

Low natural gas prices in North America continue to affect basic materials companies, serving as a major positive for U.S.-based petrochemical and nitrogen fertilizer producers, but crimping demand for U.S. coal. Over the long run, we expect North American natural gas prices will increase materially, making coal-burn more attractive and putting pressure on margins for petrochemical and nitrogen producers in the region.

With basic materials companies in our coverage universe trading at an average price/fair value estimate of 0.99, we think the sector looks fairly valued on aggregate. That said, we still see some pockets of value on the industry and company level--highlighted by our top stock picks below.

Metals and Mining
Metal prices took a pounding in the first few months of 2014, along with the shares of those that dig the material out of the ground. Iron ore dropped from $135 per metric ton to begin the year down to $104.70 on March 10. Prices have recovered somewhat in the past couple of days to $111.50 as of March 13. Iron ore giant Vale is down 17% for the year. Smaller, higher cost Cliffs fell 31% over the same interval. We see iron ore prices remaining under pressure, and establishing a "new normal" below $100 in 2015. Cliffs will struggle to turn a profit at such levels and we see further downside risk to the shares.

Meanwhile, copper, still everybody's favorite metal, breached the wrong side of $3 per pound on March 11, marking the first time since July 2010, down from $3.36 to begin the year. Blue chip Freeport-McMoRan followed suit, losing 18% year-to-date. Copper prices are now in line with our full-year 2014 forecast of $3.00. But we see further downside to copper prices in 2015 ($2.67 per pound) and to shares of Freeport and peer Southern Copper.

Multiple proximate causes but have been identified to explain the sudden plunge in prices for these key metals. For iron ore, some cited rumors (later confirmed) of a default by a Chinese steel mill, privately owned Haixin Steel. For copper, traders blamed a Chinese government crackdown on copper financing deals, a major conduit for cheap, hot-money U.S. dollar-denominated loans to gain entry to China's supposedly closed capital account. China's weak February export data, while muddied by over-invoicing and Chinese New Year anomalies, didn't help matters for either metal, nor did the default of Chaori Solar.

Each of these explanations probably has some merit. But underlying them all is one common denominator: the growing realization that China's investment-driven growth model has run its course and that the transition to a more sustainable model will be harder and generate lower growth than most expect.

Since at least 2007, China's top leadership has recognized the danger of the existing growth model and the need to steer the country onto a more sustainable path. But to date, resolve has been lacking. On multiple occasions Beijing has squeezed off the flow of credit. Each time, this triggered a significant softening of the real economy and market prices suffered. Each time, nervous leadership turned back from the brink, injecting credit as well as a healthy dose of optimism to markets. Metals prices, predictably, have rebounded strongly each time.

Will this time be different? It's extremely difficult to time macroeconomic inflection points and harder still to do so when outcomes rest less on market dynamics than political considerations. The latter is the case here. Beijing possesses manifold tools to inject life into the market. Short positions in metals or miners could risk suffering accordingly. But in the end, this would be a shot of whiskey to cure a hangover.

A shift away from a growth model predicated on ever more infrastructure, residential high-rises, and manufacturing capacity implies a significant downshift in the commodity-intensity of China's economy. That will mean the end of an era for nearly all industrial commodities, save a precious few such as palladium and uranium.

Despite significant share price declines, five-star stocks aren’t terribly abundant. Low-cost iron ore miner Vale is one of the more undervalued mining names we cover. Here, it's worth emphasizing that our valuations represent fair value estimates, not price targets. With extremely low costs and an enviable growth profile, we certainly think Vale is undervalued.

Steel
The global steel community continues to navigate oversupply conditions that have prevented price appreciation across nearly all major product categories. Given the lack of discipline exhibited by the world's largest steelmakers, particularly in China, a rebalancing of supply and demand appears highly unlikely over the near term. In our view, oversupply conditions will remain as steel consumption growth is unlikely to match steel production growth until 2016 at the earliest. Chinese steel production, which accounts for slightly less than 50% of global production, is likely to grow at a decelerating rate as the government aims to rationalize production and reduce pollution. Even so, however, this will have little impact on oversupply conditions within the country, as Chinese consumption growth is also likely to decelerate rapidly. Currently, excess steel capacity in China amounts to 300 million metric tons, or a whopping 19% of actual global production in 2013.

While excess supply will have a negative impact on pricing, we anticipate that lower steelmaking raw material prices will play an even larger role in driving down steel prices on a global basis. Since the end of 2013, steel prices in most regions have decreased, as iron ore and scrap prices have declined materially. Through the end of 2015, we expect lower iron ore prices to further flatten the industry cost curve, thereby applying downward pressure to prevailing steel prices.

Within the United States, capacity utilization has improved very modestly to 76.5% year-to-date, although high volumes of imports remain a concern for domestic producers. Steel imports in January grew just over 20% relative to the same period last year and imported steel now comprises roughly 30% of total supply within the U.S. As such, domestic steel producers have brought forth a series of anti-dumping petitions in hopes of minimizing the impact of low-cost imports. The Department of Commerce has ruled in favor of the petitioners in some of these cases but, even so, the flow of imported steel has declined only marginally. Within the U.S., benchmark hot-rolled coil prices, which had crept upward in the second half of 2013, have fallen about 3% through the first two months of this year. Given that steel prices and iron ore prices tend to move in tandem, we expect steel prices will follow iron ore prices lower through the rest of the year.

From a broader perspective, the global steel industry continues to languish in an extended cyclical trough as oversupply weighs on the trajectory of its recovery. In our view, material earnings growth for the major players within the industry will not be realized until healthier steel demand from developed markets improves the outlook for global economic growth.

Agriculture
The global potash market looks like it could be close to turning a corner with a more normalized demand environment expected in 2014, the increasing likelihood that the cartel-like marketing organization between Uralkali and Belaruskali will reform, and what looks to be a near-term bottom in potash prices.

We've raised our long-term potash price forecast to $350 per metric ton from $300. This higher price represents our view that it now looks more likely than not that Uralkali and Belaruskali will repair their broken marketing relationship. We believe this relationship gives support to potash prices, as the cartel-like organization has in the past held back supply during periods of weak demand. This runs counter to Uralkali's new strategy--announced last July--that it would run at full capacity without regard to demand or pricing.

Phosphate prices are also on the mend with a big increase in spot prices that started at the beginning of 2014. Price appreciation will boost the fortunes of Mosaic (MOS), the largest phosphate producer in our coverage universe. Mosaic is also set to add to its phosphate operations with the pending purchase of CF Industries' (CF) rock mines. Nitrogen fertilizer prices have also increased since the beginning of the year, after prices were pressured in 2013 by sizable imports from Chinese producers. We expect nitrogen margins of North American producers will tighten in the coming years as natural gas prices rise to our long-term forecast.

Forest Products
European forest products companies like UPM-Kymmene Oyj (UPM1V) and Stora Enso (STERV) continue to face cyclical and secular headwinds in publication papers where volume declines have largely offset the benefits from the industry shutting European paper capacity in recent years. Without meaningful industry consolidation--that is, a merger between UPM and Stora Enso's paper business--we think the European paper industry will struggle to generate meaningful profits in the coming years. We do not believe European regulators would allow the world's two largest graphic paper suppliers (UPM and Stora Enso) to combine resources during a still-challenging European economic backdrop where consumers benefit from lower paper prices.

In 2013, both firms saw positive contributions from their building materials and pulp divisions. The former was due to stronger European construction and remodeling demand--a trend we expect to continue in 2014. Pulp growth was driven primarily by robust paper demand in emerging markets, as well as steady global demand for tissue and paper-based packaging products. We expect these pulp demand trends to continue in 2014, but forecast slightly weaker pulp prices for the remainder of 2014 as more low-cost pulp capacity is added in South America and Southeast Asia.

Speaking of South American pulp production, we recently reduced Brazilian eucalyptus pulp producer Fibria Celulose's (FBR) economic moat rating to none from narrow. We expect low-cost eucalyptus pulp capacity will continue to be added into the market in the coming years, resulting in further flattening of the global pulp cost curve. Though Fibria continues to produce pulp in the first quartile of the global cost curve, the difference in production costs between mills in the first and fourth quartiles has shrunk considerably in recent years and we no longer believe Fibria has a durable competitive advantage against other pulp producers.

Chemicals
With the shale gas revolution in the U.S. causing a marked shift in the cost curve for global petrochemicals, North American chemical producers continue to hold an input cost advantage over their European counterparts. As such, European-based producer BASF has turned to the U.S. for expansion, last year announcing plans to evaluate a joint investment with Yara for a world-scale ammonia plant on the U.S. Gulf Coast. Despite a relative feedstock cost disadvantage, BASF's Verbund process has created enough cost savings company-wide to generate returns on invested capital that consistently outpace the company's cost of capital. We see the new ammonia plant as an opportunity to improve BASF's cost position. However, we caution that strong chemical and fertilizer demand for natural gas in North America in the coming years should have a positive effect on natural gas prices in the region.

Major chemical conglomerates continue to reallocate their asset portfolios to specialty chemicals and away from commodity chemicals. Both Dow Chemical (DOW) and du Pont (DD) have plans on the docket to separate commoditized offerings. The shift to businesses with less cyclicality and more consistent profitability will lead to more stable earnings for Dow and DuPont. That said, not all the businesses these companies are jettisoning are disadvantaged. In particular, we think DuPont's titanium dioxide business benefits from a unique production process that creates a cost advantage. We expect large chemical companies will keep trimming commodity products from their portfolios. In general, we think this is a sound strategy (assuming the company receives a fair price). Moat-worthy commodity chemicals operations, such as DuPont's TiO2 business, are more the exception than the norm.

Building Materials
The Highway Bill story will help determine demand for building materials companies in the U.S. This affects not only U.S. aggregates producers such as Vulcan Materials and Martin Marietta Materials, but also the major global cement players with significant operations in the U.S. such as Lafarge, Holcim, HeidelbergCement, and CEMEX. The Highway Bill, which sets federal spending levels for infrastructure, expires in September 2014, and at the rate lawmakers are making progress, there’s little chance the next bill will ready in time, making continuing resolutions likely. If it feels like we’ve heard this story before, it’s because we have, and very recently. The current bill, MAP-21, only lasted for a couple of years, in contrast to the five or six years that previous highway bills had run.

The familiar highway bill saga of expiration, lawmaker gridlock, continuing resolutions, and 11th hour solutions is really just noise that distracts from a much more fundamental--and troubling--issue. Federal spending on highways is paid for through gasoline and diesel taxes. These per-gallon taxes have been frozen since 1993 and thus the fund's purchasing power has deteriorated with inflation as well as increased fuel efficiency. Therefore, shortfalls in these user fees have been plugged from the general fund. The U.S. has the lowest fuel taxes outside of OPEC members. The quickest and most economically sound solution for funding highway spending would be to raise gas and diesel taxes. A vehicle-miles-traveled fee is another possibility that would help take care of the fuel efficiency “problem,” but this solution would take longer to implement because of the necessary devices and infrastructure. Although both of these options make perfect sense in that they ask the users of highways to pay for highway construction and maintenance at a rate commensurate with their usage, both Republican and Democrat politicians are loath to raise the federal gas tax despite cries from the U.S. Chamber of Commerce and other business groups to do just that.

As a result of this morass, funding levels for highway construction and maintenance will continue to be uncertain, and demand for building materials will suffer. Fortunately for building materials companies, residential, commercial, and industrial demand for building materials has been on the rise. Combined with price increases and cost cutting measures, we expect profit growth for building materials companies (and segments) in the U.S.

Coal
U.S. price trends for thermal coal have been positive through the beginning of 2014. Since the end of 2013, Western Rail Powder River Basin coal swaps have gained 4% to over $12 per ton. Central Appalachian coal futures have also gained 4% since the end of 2013 to over $57 per ton. However, in comparison to the start of 2013, PRB coal has seen a 21% increase while CAPP coal has only seen a 3% increase. We believe PRB coal will carry this positive momentum into the year, with pricing expected to continue to strengthen. Seaborne thermal coal and metallurgical coal prices continue to suffer from global overcapacity, with both coals reaching levels lower than the previous lows seen in 2013. Looking forward, we expect U.S. thermal coal recovery to strengthen amid higher natural gas prices and increased coal burn, with the Powder River Basin the best positioned given stronger coal burn amongst its users. In comparison, we expect seaborne thermal and metallurgical coal to remain challenged amid continued oversupply.

Year-to-date U.S. thermal coal prices continued showing signs of improvement. Through January of this year, U.S. natural gas prices have continued to climb to $4.71 per mmBTU, compared to 2012 lows below $2 per mmBTU and representing an 11% increase from December of last year alone. High U.S. natural gas prices have led to continued strong coal burn by electric utilities. As of September, inventory levels have remained at roughly 155 million tons, significantly below the roughly 185 million tons at the start of 2013. On the whole, utilities seem to be nearing more desired inventory levels.

At current gas prices, western U.S. thermal coal continues to be an attractive alternative, as demonstrated by the increased coal burn. In general, Powder River Basin is attractive at natural gas prices of $2.50-$2.75 per mmBTU and Illinois Basin is attractive when gas is at $3.25-$3.50 per mmBTU. In comparison, Appalachian thermal coal only becomes attractive at natural gas prices of $4.50-$5.00 per mmBTU. Unsurprisingly, thermal coal has seen better recovery in the western U.S. basins. Regions closer to the PRB have returned to about 60% coal burn whereas regions farther away have continued to rely heavily on gas, as transportation costs have negated PRB coal's price discount to natural gas. While factors appear to support higher Powder River Basin prices, prices have yet to see major improvement. Powder River Basin miners anticipate needing a major delivery amid tight supply in the near-term to finally drive prices upward.

Top Basic Materials Sector Picks
Data as of 03-17-14.

Alumina (AWC)
Star Rating: 5 Stars
Fair Value Estimate: AUD 2.60
Economic Moat: None
Fair Value Uncertainty: High
Consider Buying: AUD 1.56
Alumina Limited is deeply undervalued and is an outstanding "straw hats in winter" opportunity. AWC's only asset is 40% of Alcoa World Alumina and Chemicals, the world's largest producer of alumina with circa 15% market share. The replacement cost of AWAC's plant is AUD 30 billion and it has no debt. Through Alumina, investors can buy the plant at AUD 25 cents in the dollar. If AWAC can achieve only a 5% ROIC on plant replacement cost, the equity share of profits for Alumina investors will represent a return approaching 20% per annum on the current share price.

Cloud Peak Energy(CLD)
Star Rating: 4 Stars
Fair Value Estimate: $26.00
Economic Moat: Narrow
Fair Value Uncertainty: High
Consider Buying: $15.60
Cloud Peak is a pure play on PRB coal prices, which we believe will head higher over the next couple of years. While investors wait for PRB coal prices to rise, Cloud Peak should provide a relatively safe haven to ride out current weak domestic thermal coal prices, thanks to its sturdy balance sheet and low production costs. Our investment pitch on Cloud Peak is largely driven by our bullish price forecast for PRB coal, which is now trading around $12-$13 per ton in the spot market, above the marginal production cost in the basin of more than $11 per ton on a cash basis. With natural gas prices now hovering under $5 per MMBtu, we estimate that PRB coal is cost-competitive versus gas in large regions of the country even if PRB coal prices rise to $15 per ton.

The huge disconnect between PRB coal's recent prices and what it should fetch relative to stronger natural gas prices was caused primarily by huge coal stockpiles among the domestic utilities, and PRB coal prices have begun to improve slightly as this inventory overhang is nearly removed. While factors appear to support higher PRB prices, prices have yet to see major improvement. PRB miners anticipate needing a major delivery amid tight supply in the near term to finally drive prices upward. With still-high natural gas prices driving continued strong coal burn, utilities have started issuing requests for proposals for 2014 deliveries. We think it is only a matter of time for stronger PRB coal prices, which should correspondingly benefit Cloud Peak.

Newcrest Mining (NCM)
Star Rating: 5 Stars
Fair Value Estimate: AUD 22.00
Economic Moat: None
Fair Value Uncertainty: High
Consider Buying: AUD 13.20
The gold price declined the most in 30 years in 2013, driven by ETF liquidation equivalent to about one third of annual mine supply. Margin compression sees industry returns at unsustainably low-single-digit levels. Applying an industry standard finding cost of $30 per ounce of reserves, almost one fourth of Newcrest's enterprise value is accounted for just by the cost to replace its gold reserves. After the troubled takeover of Lihir Gold and two large simultaneous expansions at Lihir and the Cadia Valley, management has refocused on operations and cash costs in the first half of fiscal 2014 fell about 10%. Improving operations and margins from a very low base, coupled with the industry-leading reserve and resource life, are the key attractions. The risk is that gold is subject to herd behavior from investors, as was the case in 2013. Gold can fall further, but we argue that would bring about a supply response as it would not make sense to continue to invest in exploration or the development of new mines and existing mines would be at risk of closure.

Vale(VALE)
Star Rating: 4 Stars
Fair Value Estimate: $19.00
Economic Moat: Narrow
Fair Value Uncertainty: High
Consider Buying: $11.40
We've long expected prices for iron ore, Vale's top commodity, to come under pressure as China's credit-fueled infrastructure and real estate boom loses steam. While the market has increasingly priced in such an outcome, we think it underappreciates the extent to which Vale's low (and falling) production costs will keep margins at reasonably attractive levels.

Jeffrey Stafford, CFA does not own shares in any of the securities mentioned above.