Resources Sector: Review – Strong 2006

As another strong year for global resource stocks draws to a close, Macquarie Research Equities (MRE) analysts provide an overview of the resource sector for the year, and offer some insights into the outlook for 2007, as well as their recommendations and preferences for the year ahead.

Global resource stocks have performed strongly for another successive year. Similar to 2005, the base metal stocks have continued to outperform, while aluminium stocks have lagged. This reflects the strong price performance of zinc, copper and nickel in 2006. Meanwhile, the major diversifieds have performed solidly, with the market primarily rewarding those who have been on the acquisition trail – Xstrata and CVRD. Along with historically high commodity prices, M&A activity in 2006 has also kept the resources sector in sharp focus. While consolidation at the top end of the sector was a key theme (Xstrata/Falconbridge; CVRD/Inco), activity also occurred at the smaller end (Peabody/Excel).

Base Metal prices
2006 has been a phenomenal year for base metal prices, with massive gains across the board. Severe shortages have developed in many metals including copper, nickel, lead and zinc, leading to enormous price rises. A combination of strong demand growth (especially in China and Europe) and ongoing supply disappointments, both operationally and from labour disruptions, has led to inventory levels falling to historic lows for most of the base metals.

Since 1 January 2006, nickel and zinc have been the best performers – up a massive 149% and 130% respectively. While copper has also had a phenomenal year, up 48%, copper prices have declined considerably from the peak of around US$4/lb in May. Meanwhile, aluminium has traded, relatively sideways in comparison, increasing 27% for the year. Of the global resource stocks under MRE’s coverage, the average share price appreciation (in US$) for 2006 was 43%.

Zinifex was again the top performer of global resource stocks under MRE’s coverage, with total share price appreciation of nearly 180%. Xstrata was a close second with its share price increasing nearly 140% for the year.

At the other end of the performance spectrum are the coal and aluminium stocks. Centennial was the worst performer of the year, down 23%, as it continues to be plagued by company specific issues. Meanwhile, Alumina (and its bigger cousin Alcoa) also posted a lacklustre finish to the year as the market downgraded expectations following a profit guidance announcement (in MRE’s view, primarily relating to the structure of AWAC’s sales book) and continuing cost pressures in the alumina business.

2007 – A time to be more selective
While MRE continue to be medium- and longer-term resource bulls, MRE believe it prudent to exercise caution in the short term given the near-term outlook for the US economy and MRE’s view that the risk to growth in 1H07 appears to be to the downside. In addition, the sharp increase in secondary metal consumption in China (in copper) and the evolving influence of substitution similarly suggest any rebound in demand within China may be more muted than previously envisaged.

As such, MRE increasingly believe the outlook for the various commodities is more clouded than it has been for some time, which is likely to drive increasing volatility and divergent performance across the metals complex. Simply, it appears that the complex is no longer a one way bet!

To that end, high cost marginal production and strong demand ensures MRE remain particularly attracted to the iron ore and thermal coal markets, while almost daily declines in zinc inventories suggests current strength in that market can be sustained, at least in the near term. In contrast, MRE continue to highlight the potential for weakness across the copper, nickel and aluminium markets through 1H07, although MRE note that prices are likely to remain at particularly attractive levels from an historical perspective.

In light of this cautionary stance and the increasing level of uncertainty and unpredictability in commodity markets, MRE believe it is prudent to move toward narrower, more conservative, high quality resources exposure. More specifically, MRE favour the size, quality and diversity of CVRD followed by Rio Tinto, BHP Billiton, Xstrata and Anglo American and suggest they should remain at the core of any metals and mining portfolio. In addition, MRE continue to favour those companies that offer either:
* Superior volume growth and/or a favourable commodity mix, or
* Those companies where deep value metrics and a leading industry position point to a favourable risk:reward equation.

In the Australian leveraged plays MRE recommend:
* Jubilee Mines (nickel).
* Macarthur Coal (PCI and thermal coal), upgrade to outperform.
* Alumina (aluminium/alumina).
* Iluka Resources (mineral sands).
* Lihir Gold, Kingsgate, Oceana Gold and Equigold (gold).

As base metal prices came under downward pressure, global resource stocks had a relatively strong week. The major diversifieds performed well, particularly Xstrata, up over 8% for the week. Meanwhile, Yanzhou was up nearly 11.7% for the week following positive sentiment from the China Coal IPO, while Macarthur Coal gained momentum following increased outlook in the thermal and PCI market.