A breakdown of the Eastern European potash cartel has repercussions in the global agriculture industry. Still-low natural gas prices in the U.S. are helping domestic chemicals companies, hurting coal producers. Concerns about emerging market economic growth rates have put pressure on commodity prices.
2013 has been an eventful year for the basic materials sector, but not all the news has been positive. Year-to-date through Sept. 13, the sector (as measured by the Materials Select Sector SPDR (XLB)) is up 13.6%, but has also underperformed the S&P 500 by about 650 basis points. Lower commodity prices from gold to aluminum to corn have contributed to the underperformance as investors have dialed back expectations for emerging market growth--particularly in China, which is shifting its economic focus from investment to consumption. In addition, a shake-up in the Eastern European potash cartel in August put pressure on the share prices of both major and minor potash producers alike.
Although the basic materials companies that we cover trade with an average price/fair value estimate near 96%, we believe that there are indeed pockets of opportunity to purchase some wide- and narrow-moat companies (highlighted below) at attractive prices.
The announcement of a new volume-before-price strategy by large player Uralkali roiled the potash markets during the quarter. We believe Uralkali's decision to leave the Eastern European potash cartel, Belarus Potash Company or BPC, will put pressure on potash prices both over the near and long term. As such, we have lowered our long-term potash price forecast closer to marginal costs of production. Uralkali's new strategy has also caused us to update our potash supply forecast. With potash prices lower in the near term, we have excluded a number of greenfield projects from our forecast. Lower potash prices make it more difficult for greenfield projects to generate acceptable rates of return.
The potash situation is now more dynamic than ever, and we plan to be flexible with our long-term price forecast. In a twist worthy of a bestselling thriller, the Belarusian government detained the CEO of Uralkali following potash meetings in Belarus, charging him with abusing his power in the market to the detriment of Belarus. We think this action substantially decreases the likelihood of a quick reconciliation between the two sides and a reformation of the cartel-like marketing organization, which would be positive for potash prices, in our opinion.
European and North American-based building materials continue to muddle through a multiyear period marked by weak European construction activity and uneven improvement in North American demand. Perhaps surprisingly, the companies’ cost cuts and price improvements have more than offset any weakness in demand, and many building materials companies have posted modest profit growth so far this year. The fruits of these cost cuts and price increases should really start to show up in substantial profit growth once demand improvement takes greater hold.
This past quarter we implemented a material valuation assumption change for the two North American aggregates producers we cover, Vulcan Materials (VMC) and Martin Marietta Materials (MLM). We increased our cost of equity assumptions for Martin Marietta and Vulcan Materials to 12% from 10% and our fair value uncertainty ratings to high from medium following a review of our basic materials COE assumptions and uncertainty ratings. We had assigned medium uncertainty ratings and 10% COEs to these aggregates producers because we thought their high revenue cyclicality and financial leverage were mitigated by very modest operating leverage. However, considering these two companies within the context of our broad coverage universe, we don't think their modest operating leverage is enough to offset that high revenue cyclicality and financial leverage, and therefore high uncertainty ratings and 12% COE assumptions are more appropriate. We are maintaining both companies' wide moat and stable trend ratings, as the characteristics of aggregates markets and production methods still lend themselves to more favorable pricing and operating flexibility for producers than is the case with most other commodities. Further, we still think both companies' profits are set to grow materially in the coming years as construction activity improves and their pricing power manifests itself.
While chemical producers continue to experience relatively soft end-market demand, petrochemical producers in the U.S. are benefiting from low natural gas liquids costs at the U.S. Gulf Coast. The shale gas revolution in the U.S. has shifted the global ethylene cost curve to the advantage of North American producers. For example, Dow Chemical's (DOW) performance plastics business--petrochemicals are the primary precursor for many plastics – posted very strong margins in the second quarter, and segment EBITDA grew 33% year over year. Based on our assumptions for marginal costs of production, supply, and demand, we're expecting U.S. natural gas prices will meaningfully increase over the long run, dampening future margin opportunities for North American petrochemical producers.
While construction markets in the developing world continue their slow recovery, we expect diversified chemical companies will continue to lean on specialty projects to replace earnings from more cyclical end markets. Agricultural products have been the "go to" solution in this regard for many of the chemical giants.
Year-to-date domestic coal prices remain weak, with spot prices for Powder River Basin (PRB) and Central Appalachian (CAPP) thermal coal only up 2% to 3% since the beginning of the year and benchmark seaborne metallurgical prices falling another 15%. In response, coal miners have remained conservative with production, as they wait for prices to recover to better levels. However, much of the recovery will likely not happen until next year, as most production has been contracted and priced for the year. We continue to expect that recovery levels will differ amongst the various U.S. basins, with western U.S. thermal basins (primarily Powder River Basin) outperforming both eastern U.S. metallurgical and thermal operations.
Year-to-date thermal coal prices have continued to see weakness even as natural gas prices rebounded from 2012 lows below $2 per mmBTU to over $3.50 per mmBTU (at one point reaching over $4 per mmBTU). In response to the increase in natural gas prices, electric utilities have shifted back to increased coal-burn. However, recovery in coal demand has lagged, as utilities burn through five-year high inventories built up from the switch to gas. By April of this year, inventory levels reached approximately 170 million tons, below the five-year average of approximately 180 million tons. However, this does not necessarily mean that utilities have finished reducing inventories to desired levels. At current gas prices, western U.S. thermal coal is an attractive alternative, which should lead to pricing improvement. For example, PRB is attractive at natural gas prices of $2.50 to $2.75 per mmBTU and Illinois Basin is attractive when gas is at $3.25 to $3.50 per mmBTU. In comparison, Appalachian thermal coal only becomes attractive at natural gas prices of $4.50 to $5.00 per mmBTU. As a result, we expect to see better thermal coal recovery in the western U.S. basins. As seen in the precipitous fall of metallurgical coal prices from 2011 highs, despite consistent growth in steel demand, the metallurgical coal markets are operating with excessive supply. As high cost producers suffer worst during periods of weak pricing, we believe Appalachian thermal coal is undergoing a secular decline where the ill effects can only be mitigated by further production rationalization. Although higher selling prices (compared to thermal coal) help Appalachian metallurgical coal producers absorb the region’s high production costs, we do not expect prices to improve unless supply is right-sized. Furthermore, the problems caused by oversupply will be exacerbated if Chinese demand growth slows from a reduction in fixed-asset investment.
Although we are optimistic for a recovery in domestic thermal coal, we believe that the industry will have to struggle through continued near-term weakness until electric utilities reach desired inventory levels and demand returns. Furthermore, lower-cost regions such as Powder River Basin and Illinois Basin are likely to see a recovery much sooner and much better than the high-cost Appalachian region. We are not so hopeful for domestic metallurgical coal, as U.S. supply sits on the higher end of the cost curve and the industry currently suffers from oversupply. Therefore, we are more enthusiastic about Cloud Peak Energy (CLD) and Peabody Energy (BTU), who have leading positions in the Powder River Basin and no exposure to Appalachia. Given exposure to Appalachia (in spite of Arch Coal's (ACI) second-largest position in the Powder River Basin), we are less excited for Arch Coal and Consol Energy (CNX).
European forest products companies Stora Enso (STERV) and UPM-Kymmene (UPM1V) continue to battle both secular and cyclical headwinds in European publishing paper demand. Though UPM's legacy paper operations continue to struggle, its second-quarter results revealed a few reasons for longer-term optimism. UPM announced an additional cost-cutting measure of EUR 140 million, which should help offset some margin weakness in paper. Management also mentioned its desire to "simplify" the business and "uncover the value of UPM assets," which we believe could mean strategic asset sales--a move we would welcome. After a number of delays, Stora finally received the Chinese government approvals to build a plantation-based board and pulp mill in Guangxi. The problem is that in the time it took to secure the permits, Stora's interest in the project may have cooled somewhat. The company's original plan to build the EUR 1.6 billion integrated mill at once has now been split into two phases--the consumer board machine will be operational in early 2016 and the chemical pulp mill will come later. As a result, any cost advantage that Stora might have had being vertically integrated won't be realized for at least another few years. Stora also has a number of sizable debt maturities coming up between 2014 and 2016, which we think also influenced the decision to split the project into two phases.
In recent quarters, Fibria Celulose (FBR) has done an admirable job keeping a tight grip on cash costs amid significant inflation in Brazil, but was unable to repeat the performance in the second quarter, with cash costs (excluding downtime) up 7% on a year-over-year basis compared to Brazilian inflation of about 6.7% (measured by the benchmark IPCA-15 index). Over the medium term, we think Fibria will achieve its goal of keeping cash costs below inflation. On the bleached eucalyptus kraft pulp (BEK) capacity front, Suzano's new large mill in Northern Brazil is nearing completion and should begin production by the end of 2013. Another large BEK plant, Montes del Plata--a joint venture between Stora Enso and Arauco--is set to begin production at the end of the third quarter. Though we believe that some higher-cost BEK capacity will concurrently come offline to offset some of the negative effects of new capacity, we expect the regional capacity additions to be a headwind for BEK prices in the medium term.
Metals and Mining
Signs of an accelerating Chinese economy have put a spring in the step of mining shares heading into the fourth quarter. The most important monthly macroeconomic readings for metals demand, including industrial production and fixed-asset investment, suggest economic growth on the mainland turned a corner in July and gained traction in August. Shares of the largest miners we cover have enjoyed 20% QTD through mid-September on the hopes that the 7.5% GDP growth reported for the second quarter marked a bottom for China.
While the third-quarter GDP print seems likely to confirm the acceleration embodied in the monthly figures, we're wary of the longer-term sustainability of the apparent turnaround. Much of it stems from a massive (and worrisome) expansion in credit earlier in the year that only in recent months made its way into the "real" economy. Furthermore, the turnaround has been most palpable in infrastructure and real estate--areas of the economy where excess capacity and swelling debt were already major concerns.
Accelerating infrastructure and real estate activity is a near-term boon for many major mined commodities, from aluminum to zinc. But the impact has been most plainly evident in the iron ore market, where China dominates the demand side of the equation, consuming two-thirds of seaborne iron ore. With Chinese steel output up 12.8% in August (YTD +7.8%), iron ore demand and prices in the seaborne market have been more resilient than many had expected. As of September 16, benchmark 62% fines were indicated at $134/t, putting year-to-date average at $136/t versus our full-year forecast of $133/t.
Just as we view China's credit-dependent infrastructure and real estate-led turnaround as unsustainable, so too do we doubt China's iron ore demand can maintain its current growth trajectory. We continue to expect slowing demand growth along with a bumper crop of new supply to pressure iron ore prices in the quarters to come, eventually push prices down to $90 per metric ton (real dollars).
We see a similar story playing out in other "investment-oriented" commodities, such as copper. We continue to favor low cost producers, such as Rio Tinto and Vale, that could sustain a lengthy slump in prices.
Global oversupply in the steel market has continued to take its toll on steel prices. While broad-based steel demand in the U.S. improved marginally over the most recent quarter, the recovery lacks true momentum, as a steady stream of imported steel products has suppressed price appreciation in the domestic market. Domestic capacity utilization has improved to 78% versus 73% a year ago. While imported steel has historically comprised about 25% of total supply the U.S., imports increased to a 30% share in the most recent quarter.
Imported steel products have been particularly noteworthy in recent months, as two anti-dumping petitions filed by U.S. steel producers are currently being investigated by the Department of Commerce. The first petition, filed in early July by a group of domestic producers of oil country tubular goods (OCTG), argues for the imposition of anti-dumping duties on OCTG imports from nine countries. Indeed, at the time of the filing, OCTG imported shipment volume had jumped nearly 40% relative to the previous year. The second petition, filed in early September by a separate group of domestic producers, alleges that the U.S. steel industry has been injured by the illegal dumping of rebar by Turkey and Mexico. Rebar imports from these two countries alone accounted for a 17% share of the U.S. rebar market over the first half of 2013, up from a 7% share as recently as 2010. If the Department of Commerce rules in favor of the petitioners in either of these trade cases, the implications could be significant as the imposition of countervailing duties on these imports would likely allow domestic OCTG and rebar prices to appreciate materially.
On a global basis, capacity utilization remains just below 80%, down slightly year over year. Even though global steel production has increased less than 1% over the first half of 2013, significant overcapacity remains as demand growth has been sluggish. Steel consumption in Europe, for example, remains nearly 30% below pre-crisis levels. As such, the Organization for Economic Cooperation and Development (OECD) has urged the governments of steelmaking countries to reduce subsidies, which would encourage steel producers to cut production, thereby ultimately allowing for a rebalancing of supply and demand. Given the lack of discipline exhibited by the world’s largest steelmakers, however, a healthier balance of supply and demand appears highly unlikely in the near term. Even so, tracking market dynamics through the final months of 2013 should provide us with additional visibility as to how soon we should expect an inflection with regard to the growth rates of steel supply and demand.
PotashCorp of Saskatchewan (POT)
Morningstar Rating: 3 Stars Fair Value Estimate: $38.00Economic Moat: WideFair Value Uncertainty: HighConsider Buying: $22.80 PotashCorp looks undervalued, but an investment in the company comes with a fair amount of uncertainty. While we have reaffirmed our wide moat rating for PotashCorp, we have lowered our fair value estimate to $38 per share from $49 to account for lower near- and long-term expectations for potash price realizations.
We think PotashCorp has a wide economic moat thanks to its low-cost potash assets and high barriers to entry created by staggering greenfield capital costs. PotashCorp is on the low end of the potash cost curve, allowing the company to pump out profits even if potash prices should approach marginal costs of production. Lower costs stem from the geology of the company's Canadian deposits and the scale of its mines. Further, barriers to entry in the potash market are high, in our opinion. Economically viable deposits are found in only a handful of locations around the globe, with Canada, Russia, and Belarus as the main producing regions. PotashCorp's brownfield expansions come at lower capital costs per ton than proposed greenfield projects, most notably BHP Billiton's (BHP) Jansen project. Additionally, greenfield projects can take more than seven years to complete and fully ramp, creating a barrier to entry for new participants.
Top Basic Materials Sector Picks Data as of 09-20-2013.
Morningstar Rating: 4 Stars Fair Value Estimate: $14.00Economic Moat: NoneFair Value Uncertainty: HighConsider Buying: $8.40 Alcoa is involved in every stage of the aluminum production process, including bauxite mining, alumina refining, aluminum smelting, and the manufacture of specialized aluminum products. Our investment thesis for Alcoa is largely driven by our long-term forecast for aluminum prices. Currently trading around $1,800 per metric ton on the London Metals Exchange, we believe that the price of aluminum will ultimately appreciate to $2,400 per metric ton (in real terms), which we believe to be consistent with the long-run marginal cash cost of production. We believe that higher aluminum prices will be a function of continued strength in global aluminum demand and more discipline on the supply side, as we anticipate that high-cost Chinese smelters will be more active in curtailing production capacity. This would allow for the growth rate of global demand to exceed the growth rate of global supply for the first time in years.
Alcoa is well-positioned to benefit from higher aluminum prices, as it operates on the low end of the industry cost curve. Additionally, Alcoa should be able to make further progress down the industry cost curve in the coming years as management closes legacy high-cost production facilities and optimizes energy costs, which can account for approximately 30% of the total cash cost of production. Additionally, Alcoa will benefit from strong demand via the automotive and aerospace end markets in the coming years. Management anticipates that aluminum body sheet content in North America vehicles will quadruple by 2015 while Boeing and Airbus have an eight-year backlog for orders that will require a steady stream of aluminum deliveries. While the high-margin, downstream fabrication business provides Alcoa with access to important growth markets, it also helps cushion Alcoa’s earnings during periods when aluminum prices are low. As primary aluminum is effectively an input cost for the downstream business, low aluminum prices actually boost margins for Alcoa’s aluminum fabrication segment and, as such, Alcoa has remained consistently profitable while many of its peers have operated in the red in recent years.
Cloud Peak Energy (CLD)
Morningstar Rating: 5 Stars Fair Value Estimate: $27.00Economic Moat: NarrowFair Value Uncertainty: HighConsider Buying: $16.20 Cloud Peak is a pure play on PRB coal prices, which we believe will head much higher over the next couple of years. While investors wait for PRB coal prices to rise, Cloud Peak should provide a relative safe haven to ride out current low 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 trading for just over $10 per ton in the spot market. This price is below the marginal production cost in the basin of more than $11 per ton on a cash basis, in our estimation, and we regard this situation as being unsustainable. Also, with natural gas prices now hovering near $4 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 current price and what it should fetch relative to stronger natural gas prices was primarily caused by huge coal stockpiles among the domestic utilities, and PRB coal prices should improve once this inventory overhang is removed. Domestic coal burn has increased year-to-date in 2013 relative to 2012, thanks to higher natural gas prices, and we expect this trend to continue through the back half of the year. This increase in domestic coal burn, coupled with stagnant domestic coal production growth, has helped coal inventories fall below the five-year average. Inventories should reach utilities’ desired levels over the next few quarters, clearing the way for PRB coal prices to move higher, which should correspondingly benefit Cloud Peak.
Morningstar Rating: 3 Stars Fair Value Estimate: $46.00Economic Moat: NoneFair Value Uncertainty: HighConsider Buying: $27.60 Though International Paper is currently trading near our $46 per share fair value estimate, we think dividend-minded investors should keep an eye on the name in the event of a pullback. After cutting its dividend in 2009, the company is on much better financial footing and the board is confident about the company's prospects, as evidenced by the recently announced share repurchase program along with a 17% increase to the quarterly dividend. Indeed, IP's quarterly dividend is now 40% above its pre-financial crisis level, which we believe is a testament to management's skillful acquisition and integration of Temple-Inland and its impressive domestic containerboard operations.
Morningstar Rating: 4 Stars Fair Value Estimate: $20.00Economic Moat: NarrowFair Value Uncertainty: HighConsider Buying: $12.00 As the world's largest iron ore producer and the most iron ore-reliant of the major diversified miners, Vale's fortunes are inseparably linked to the sustainability of China's investment-led growth model, which has pushed China's share of global iron ore demand to two thirds. We expect significantly lower Chinese fixed-asset investment growth in the years to come as the country rebalances toward consumption, hitting iron ore prices hard as new supply comes on line, thereby pressuring profits at Vale. But by virtue of an enviable cost position--the basis of our narrow-moat rating--such a development is far from the existential threat it might be for higher cost producers.
Todd Wenning does not own shares in any of the securities mentioned above.
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- Vulcan Materials