Following opportunistic inventory drawdowns in the wake of the BPC breakup, we expect potash buyers will revert to more normal purchasing patterns in 2014. U.S. residential and commercial construction continues to improve, but weak federal support for infrastructure outlays dampens outlook for aggregates demand in 2014. As utilities approach more desired inventory levels, we believe U.S. PRB coal will begin to experience positive price momentum into 2014.
In aggregate, the basic materials sector looks slightly undervalued. Our coverage list sports a median price/fair value of 0.96. But this average masks significant valuation variation among basic materials industries. For example, we see good value in the beaten-up steel industry, with considerably less opportunity in chemicals and packaging.
Even within industries, there is significant dispersion. In mining, for instance, the dispersion cuts along the cost dimension. We continue to prefer low-cost producers that could withstand sustained price weakness in a rebalancing of China's economy to less metals-hungry growth. We see significant risk in long positions on high-cost producers for whom a rebalancing would constitute an existential threat.
Price uncertainty, caused by Uralkali's late-July decision to leave the cartel-like Belarusian Potash Company and pursue a volume-over-price strategy, has continued to roil potash markets. Producer profits have suffered from a lack of buyer interest in potash, as dealers and large purchasing countries hold out for lower expected prices. China and India have chosen to draw down inventories, rather than return to the market in a meaningful way. With pressure on both price and volumes, potash producer earnings have been weak.
Over the longer run, we think demand will normalize, likely as soon as next year. That said, there is still a fair amount of uncertainty regarding the path of future potash prices. In our view, strategy decisions by Uralkali, BHP Billiton (BHP), and Canpotex--the Canadian consortium of Potash Corporation of Saskatchewan (POT), Mosaic (MOS), and Agrium (AGU)--will be major determining factors for future supply, and thus prices. We expect Uralkali and Canpotex will stick with their current sales strategies, volume-over-price and price-over-volume, respectively. Further, we believe BHP will shelve its major greenfield potash project in Saskatchewan until the end of the decade.
Price pressure has also affected nitrogen and phosphate fertilizer markets. In nitrogen, high-urea imports from China have pressured prices, and in phosphate, major buyers have taken a step back from purchasing.
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 on a like-for-like basis. However, many of the European companies suffered from an appreciating euro, marring what was otherwise continued progress in cost cuts, price increases, and even some volume increases in the third quarter. Looking forward, 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, and barring any continued negative currency effects.
Looking at the U.S. market, we note that the current highway bill will expire in September 2014, and highway project planning typically becomes very uncertain around the time of bill expirations and extensions. This is likely to keep infrastructure's demand for aggregates muted and lumpy in 2014. While residential construction activity is growing strongly and a strong Architecture Billings Index level bodes well for nonresidential building, infrastructure remains the most important end market for aggregates. As such, highway bill news will define the industry's prospects in the near term. Given how weak actual support for infrastructure spending is at the federal level, as illustrated by the last and very recent round of bill expiration, extensions, and passage, we're taking a cautious view on Martin Marietta Materials (MLM) and Vulcan Materials (VMC) heading into 2014.
Major chemical conglomerates continue to reallocate their asset portfolios to specialty chemicals and away from commodity chemicals. Recently, Dow Chemical (DOW) gave more details on plans to carve out a portion of its commodity chemicals business, specifically, assets in the chlorine value chain. The assets represent roughly $5 billion of annual revenue and include about 40 manufacturing facilities. Additionally, DuPont (DD) has announced that it will separate its performance chemical segment from the rest of the company in a tax-free spin-off to shareholders.
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). Moatworthy commodity chemicals operations, such as DuPont's TiO2 business, are more the exception than the norm.
Trends in thermal coal prices differ across basins as the end of 2013 nears. PRB coal pricing continues to improve. Since the end of October, Western Rail PRB coal swaps have gained 14% to almost $12 per ton. This represents a 19% gain since the start of the year. In comparison, Central Appalachian coal futures have only gained 2% since the end of October to nearly $56 per ton. This represents a 4% decline since the start of the year. We believe PRB coal will carry this positive momentum into 2014, with pricing expected to continue to strengthen. Metallurgical coal pricing has slightly improved from lows seen in the third quarter, although pricing remains weak. We continue to expect that recovery levels will differ among 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 are finally showing signs of improvement. Through the third quarter, prices continued to see weakness even as natural gas prices rebounded from 2012 lows below $2 per mmBTU to almost $3.70 per mmBTU (at one point reaching over $4 per mmBTU). In response to the increase in natural gas prices, electric utilities shifted back to increased coal-burn. As of September, inventory levels have reached approximately 150 million tons, significantly below the approximately 180 million tons at the start of the year. 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.
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 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 with thermal coal) help Appalachian metallurgical coal producers absorb the region's high production costs, we do not expect prices to improve unless supply is rightsized. Production cutbacks in China and the U.S. and export declines in Mongolia, Colombia, and the U.S. are starting to reduce this seaborne oversupply. However, the problems caused by oversupply will be exacerbated if Chinese demand growth slows from a reduction in fixed-asset investment.
We are optimistic for a recovery in domestic thermal coal, and believe that despite continued near-term weakness, there are positive signs of improvement with electric utilities nearing desired inventory levels and prices improving. We continue to believe 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 and Peabody Energy, who have leading positions in the Powder River Basin and no exposure to Appalachia. Given exposure to Appalachia (in spite of Arch’s second-largest position in the Powder River Basin), we are less excited for Arch Coal. With Consol Energy’s sale of five West Virginia longwall coal mines, the company has effectively transformed itself into a natural gas company.
European forest products companies Stora Enso (STERV) and UPM-Kymmene (UPM1V) continue to battle both secular and cyclical headwinds in European publishing paper demand. In August, UPM announced a new simplified business structure that it hopes will produce EUR 200 million in near-term cost savings. We think the strategic reorganization is the right long-term move for the company as the current structure was not conducive to managing multiple business lines across multiple geographies. The biggest positive is that UPM is splitting the paper business into Paper Asia and Paper ENA (Europe & North America), which should allow the leaders of each segment to better manage the Asia and ENA paper markets, which have very different growth trajectories.
We expect slight improvement in Stora Enso's printing and writing segment margins in the medium term as the industry reduces regional capacity, but unless the often-rumored merger between UPM and Stora occurs, we do not think the European paper industry will be able to sustain a good balance between supply and demand. A merger of UPM and Stora--or at least a combination of the companies' paper-making operations--would be an ideal scenario for Stora and the European paper industry, but we think the European Commission would be skeptical of such a deal on antitrust grounds.
In recent quarters, Fibria Celulose (FBR) has done an admirable job keeping a tight grip on cash costs amid significant inflation in Brazil, with third-quarter cash costs (excluding downtime) up 5% on a year-over-year basis compared with Brazilian inflation of about 5.9% (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, or BEK, capacity front, Suzano's new large mill in Northern Brazil is scheduled to launch this month. Another large BEK plant, Montes del Plata--a joint venture between Stora Enso and Arauco--is set to begin production at the start of 2014. Although we believe that some higher-cost BEK capacity will concurrently come off line 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
Supported by solid Chinese demand growth, prices for iron ore, the mining industry's biggest moneymaker, traded in the $130s for much of the fourth quarter. Through November, Chinese steel production was up 7.8% from last year, underpinned by renewed strong growth in infrastructure and real estate. As we write, benchmark-grade iron ore has averaged $135 per metric ton year to date, slightly higher than our original forecast of $133. This promises a strong set of results to wrap up the calendar year for the industry's Big Three--Vale, BHP Billiton, and Rio Tinto (RIO), where cost savings are also starting to take hold. Looking ahead to the first quarter, the potential for cold-weather constraints at Chinese mines and seasonally wet conditions in Brazil and Australia are reasons for tightness. However, with inventories of iron ore at Chinese ports up significantly from this time last year, material increases in prices seem unlikely. After the almost-always eventful first quarter, which includes steel mill shutdowns for Chinese New Year, we see iron ore prices on a downward trajectory as new supply hits the market and Chinese demand growth slows. We see prices averaging $115 for 2014 before hitting our long-term price expectation of $96 in 2015. For the Big Three, profits would remain robust. At prevailing share prices, each looks undervalued. These moat-worthy firms remain our preferred exposure in an industry we expect will endure more headwinds than tailwinds.
Prices for metallurgical coal, iron ore's partner in steelmaking, continued to struggle. At prevailing spot prices of $138 per metric ton for premium-grade coking coal and a quarterly contract price of $152, many producers are making cash-on-cash losses. That's quite a reversal from the $209 averaged in 2012. Take-or-pay contracts with railways and ports are largely to blame. This condition isn't permanent, but will take some time to resolve. We see only a little respite in the first quarter of 2014, but see higher prices prevailing over the long haul (about $160 in real terms), reflecting our assessment of marginal cost plus a healthy $20 "kicker" to account for the periodic price spikes wrought by flooding in Queensland (for example, prices surged to $289 in 2011), the dominant supplier of metallurgical coal to the seaborne market.
Copper prices fared better than we expected in the fourth quarter, enjoying the same infrastructure and real estate-driven demand growth from China that iron ore did. We adjusted our price forecast accordingly, but continue to see copper prices on a downward trajectory--falling from $3.33 per pound this year to $3.00 next year, and a long-term price of $2.67 in 2015. Our bearish outlook is a function of mine supply additions and weaker Chinese demand growth. We don't think prevailing growth rates in Chinese copper demand (which accounts for 40% of global demand) are sustainable largely because the debt assumed to fund copper-hungry fixed asset investment continues to rise much faster than the economy. We expect debt will define the limit of China's investment-led growth model, just as it has in past cases of the model.
Oversupply continues to weigh on the global steel industry as 2013 production has outpaced consumption on an annualized basis. Even so, due largely to a seemingly nonstop build-out of production capacity in China, global steel capacity utilization has actually fallen slightly on a year-over-year basis and currently sits at 78%. For the full year, capacity utilization has mainly hovered between 77% and 80% as a gradual improvement in global steel demand has been offset by an increase in global production capacity. Given the lack of discipline exhibited by the world's largest steelmakers, a rebalancing of supply and demand appears highly unlikely in the near term. In our view, oversupply conditions will remain as growth in steel consumption is unlikely to match growth in steel production until the beginning of 2015 at the earliest.
While excess supply will have a negative impact on pricing, we anticipate that a decline in steelmaking raw materials will play an even larger role in driving down steel prices on a global basis. In the most recent quarter, steel prices in most regions were mostly unchanged, as iron ore, coking coal, and scrap prices edged up very slightly. Through the end of 2015, however, we anticipate that materially lower iron ore prices will flatten the industry cost curve, thereby applying downward pressure to prevailing steel prices.
Within the United States, capacity utilization has improved to 76%, which amounts to a significant increase from 70% at this time last year. High volumes of imports remain a concern for domestic producers, as imported steel currently comprises approximately 30% of total supply within the United States. 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 only declined marginally. Within the United States, benchmark hot-rolled coil prices have crept upward since the end of last quarter, and North America represents the only major steel market in which prices have appreciated in recent months.
From a broader perspective, the global steel industry continues to gradually emerge from a cyclical trough. Material earnings growth for the major players within the industry, however, will not be realized until a recovery in developed markets improves the outlook for global economic growth.
Top Basic Materials Sector Picks Data as of 12-16-13.
Potash Corporation of Saskatchewan (POT)
Star Rating: 4 Stars Fair Value Estimate: $38.00 Economic Moat: Wide Fair Value Uncertainty: High Consider Buying: $22.80 PotashCorp looks undervalued, but an investment in the company comes with a fair amount of uncertainty. Our fair value estimate is $38 per share. Russian potash producer Uralkali has sent shockwaves through the market, choosing to adopt a new volume-over-price strategy. This will probably put continued pressure on potash prices, but PotashCorp, as a low-cost producer, will still generate an attractive margin on potash. The company's volumes are set to increase from brownfield expansion projects that will be completed at much lower capital costs per ton than greenfield projects by potential new entrants. We believe the market will better appreciate PotashCorp's competitive position following a quieting of the noise created by Uralkali's new strategy.
Rexam PLC (REXMY)
Star Rating: 4 Stars Fair Value Estimate: $43.00 Economic Moat: Narrow Fair Value Uncertainty: Medium Consider Buying: $30.10 We think Rexam is an attractive name in the basic materials sector given the relatively stable demand of its end product, its healthy balance sheet, and its above-average dividend yield currently near 3%. The three largest beverage can manufacturers--Rexam, Ball Corporation (BLL) and Crown Holdings (CCK)--account for 60% of global supply, and in large beverage can markets like North America, Europe, and South America, the three account for closer to 90% of supply. We believe the significant capital investment to build can plants, the incumbents’ long-term supply contracts with input cost pass-through provisions, and the need to run plants with high utilization rates discourage new entrants from competing in these markets. After Rexam completes the sale of its healthcare packaging business, it will be the only publicly-traded company that's solely focused on the growing global metal beverage can market. In contrast, Ball and Crown Holdings have considerable exposure to metal food cans where secular headwinds exist from a slow-and-steady shift toward flexible packaging alternatives. We expect the beverage can-focused Rexam to improve operational efficiency at plants and generate high returns on investment in its major markets while investing for growth in frontier markets like Africa, the Middle East, and India where beverage cans remain a small part of the beverage packaging mix.
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 Powder River Basin 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 relatively 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 now trading for below $12 per ton in the spot market. Prices are finally beginning to surpass the marginal production cost in the basin of more than $11 per ton on a cash basis. 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 recent prices 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 have begun to improve as this inventory overhang is nearly removed. Domestic coal burn has increased year to date in 2013 relative to 2012, thanks to higher natural gas prices, and we expect strong coal burn to continue into next year. This increase in domestic coal burn coupled with stagnant domestic coal production growth has helped coal inventories near utilities' desired levels. PRB coal prices are starting to show signs of recovery, which should correspondingly benefit Cloud Peak.
Star Rating: 4 Stars Fair Value Estimate: $19.00 Economic Moat: Narrow Fair Value Uncertainty: High Consider Buying: $11.40 Despite our still-bearish outlook for Chinese fixed-asset investment and iron ore prices, we regard iron ore giant Vale among the best relative values in mining. Down roughly 30% year to date, shares now reflect our negative view on iron ore. However, we don't think the market appreciates the threefold benefits of Vale's reinvestment in its moat-worthy iron ore business. The next few years will see surging volumes, lower costs, and higher price premia--all of which will offset the bottom-line effect of lower benchmark prices. The market doesn't seem to credit Vale for an impending turnaround in the long-disappointing base metals and coal businesses. Here, the ramp-up of key assets over the next few years will turn red ink to black.
Daniel Rohr, CFA has a position in the following securities mentioned above: VMC