Our Outlook for Basic Materials Stocks
Basic materials companies are in a period of very mixed near-term outlook in terms of end-market demand.
Basic materials companies are in a period of very mixed near-term outlook in terms of end-market demand. On the positive side, we have a stronger outlook for U.S. construction activity than has been the case for several years thanks to positive indicators from all three major end markets (housing, non-residential, and infrastructure). To some extent, chemicals producers and steel companies should also benefit from improving construction activity, although to a lesser extent than building materials firms as chemical and steel companies have broader end-market exposure. This positive demand trend is being enhanced by construction materials producers' significant cost-cutting and price increase efforts. The picture is also bright for agricultural input providers for North American growers, as farmers will look to take advantage of currently high crop prices by planting a robust number of acres using healthy levels of fertilizer, premium seeds, and crop protection chemicals. This should have the biggest positive impact on nitrogen fertilizer producers, who are also benefiting from historically low natural gas costs. The impact on potash producers is somewhat muted, however, as these producers are facing lower selling prices this year relative to 2012.
European end-market demand seems to be a universal source of weakness for basic materials companies in 2013. Government austerity measures and weak economic activity there are hurting the outlook there for building materials companies, chemicals manufacturers, paper companies, and steel producers. Firms are looking to permanently shut capacity to better match demand and supply, but in some cases there can be significant political roadblocks to closing down a plant which employs a lot of people.
Chinese demand for raw materials—especially steelmaking ingredients metallurgical coal and iron ore—looks set to be especially volatile. In a big picture sense, we think the country is slowing down from a decade-long period of heady fixed-asset investment and the attendant robust demand for steel and cement. In general, this means that Chinese consumption of steel and its raw ingredients should slow over the next several years. However, the road is likely to be very bumpy given periods of inventory destocking and restocking; we've seen rapid oscillations over the past year, and we expect these to continue in 2013.
The near-term outlook for U.S. thermal coal demand is brighter, but only compared to a devastating 2012. Weather-driven demand for electricity (and therefore thermal coal) was weak in 2012, and extremely low natural gas prices led to more electricity being generated from natural gas power plants. Assuming normal weather in 2013, demand for thermal coal from power generators should improve thanks to the recent increase in natural gas prices.
We expect a strong season for crop inputs in North America, as farmers strive to rebuild depleted stocks. Drought took its toll on yields last growing season, and farmers again look poised to plant fence row to fence row, in an effort to take advantage of high crop prices. Farm income remained solid in 2012, as yield declines were offset by higher selling prices. As such, many farmers should have enough cash in their pockets from last growing season to apply crop inputs at recommended levels. That's good news for producers of seeds, crop chemicals and fertilizers.
The potash market became clearer in late 2012 and early 2013, with the signing of new contracts by China and India. Both countries had taken extended breaks from the market, putting pressure on producer sales volumes. The new contracts bring a more certain demand picture for 2013, but the major potash marketing organizations--Canpotex and BPC--did give some on price to entice China and India back to the table. That said, prices remain well above marginal costs of production, and we think the lower prices will help spur global demand. In our opinion, other buyers were waiting for a new China and India price before committing to purchases.
Upon the backdrop of high corn prices and low natural gas costs, nitrogen producers in North America continued to print money in the fourth quarter. Based on current prices and large North American corn planting, we expect another strong year for producers in 2013, but we think nitrogen margins will shrink in the long run as corn prices eventually ease and gas costs inch upward. Further, the current conditions have led to a multitude of proposed nitrogen expansion projects, as producers look for ways to spend cash piles. We are wary of projects announced during what we see as a peak in the cycle.
The near-term outlook for U.S. construction activity is stronger than it's been for several years. This outlook is supported by positive momentum in federal highway obligations (which bodes well for highway construction activity), strong recent readings for the Architecture Billings Index (a leading indicator of nonresidential construction activity), and a positive trend in housing starts. The near-term outlook for European construction activity is much more negative. There, it's likely that austerity measures and slow economic growth will hurt construction activity. Continued strong demand growth is expected in emerging markets, with the exception of China, where an expected slowdown in fixed asset investment will likely have an impact on the demand for cement.
We expect building materials producers' earnings to improve in 2013, thank not only to relatively stronger demand in the U.S. and emerging markets, but also the cost cutting and price increase efforts that the companies have been undertaking. In 2012, many producers' margins expanded despite the lack of sales volume growth thanks to the beginnings of price and cost initiatives. As these initiatives taken even greater hold in 2013, we expect margin expansion to follow.
Chemical producers wrapped up 2012 dealing with many of the same issues that plagued operators earlier in the year, namely demand softness with particular weakness in Europe. Dow Chemical's (DOW) meager fourth-quarter results reflected the difficult demand environment for producers. Chemical companies continue to restructure operations, specifically in Europe, to better match supply with demand. On a positive note, North American producers using cheap natural gas have been able to offset some of the demand weakness with lower feedstock costs.
While the demand picture doesn't look set for an exceptionally quick turnaround, there are some signs of light in housing that could translate into better growth for chemical companies weighted toward construction markets. In the meantime, large diversified players will continue to lean on specialty products to bridge the gap. In particular, companies have been steadied by results from crop chemicals and genetically-modified seeds. We think chemical players will continue shifting portfolios to specialty products in an effort to improve margins and reduce cyclicality. In addition, recent restructuring could help speed this transition.
Although coal miners endured a painful 2012 due to depressed coal prices, we believe domestic coal prices are due for a modest rebound in 2013. However, recovery will not arrive evenly across the coal sector in our view, with thermal coal producers faring better than metallurgical coal miners, and coal miners producing from the western U.S. (particularly from the Powder River Basin) outperforming peers focused on the eastern regions of the country.
2012 saw extreme looseness within the domestic coal supply and demand dynamic, which was at its loosest during the second quarter of 2012. Supply and demand for domestic coal began to gradually tighten during the back half of 2012, however, boding well for coal prices heading into 2013. The improving fundamentals of the U.S. coal market are due to a number of factors, including natural gas prices rebounding from their nadir, a hot summer that helped whittle down overflowing coal inventories, and significant curtailment in domestic coal production, particularly from the eastern U.S. coal miners. The EIA projects 2013 domestic coal burn for power generation to rebound by 40 to 50 million tons from the dismal 2012 figure of 827 million tons, assuming that normal weather patterns return, and natural gas prices remain at current levels. With natural gas prices now above $3.50 per Mcfe, lower-cost coal from the western parts of the U.S. can effectively compete against natural gas on a price-to-energy basis. Low-cost coal from the Powder River Basin (PRB), in particular, looks underpriced versus natural gas at its current spot price of just over $10 per ton. Coal miners with large exposure to the PRB include Peabody Energy (BTU), Cloud Peak Energy (CLD), and Arch Coal (ACI), with Cloud Peak representing the purest play on PRB coal prices.
Despite our optimistic outlook, coal inventories at the utilities still remain well above the historical average, which we think will hinder domestic coal prices from rising to higher normalized levels. Nevertheless, we are looking for domestic coal prices to slowly rebound in 2013 as this inventory overhang continues to be worked down, continuing the trend that started the back half of 2012. We believe rising domestic coal prices will not lift all coal miners equally, however. Higher-cost Appalachian coal still cannot compete versus natural gas at current prices, and many of the production curtailments and mine closures announced by the Appalachian coal miners this year may very well become permanent. Coal miners with heavy exposure to Appalachian coal basins include Arch Coal, Alpha Natural Resources (ANR), and Consol Energy (CNX). We are also not as sanguine on the prospects for metallurgical coal, which is affected more by global economic activity than by domestic power generation dynamics. We project slower global steel-making activity combined with significant supply expansions in response to recent high metallurgical coal prices to cap gains in met coal prices over the long term. Coal miners we cover with significant exposure to metallurgical coal include Arch, Alpha, and Consol. For Arch and Alpha, our tepid price outlook for metallurgical coal is exacerbated by the fact that these two firms leveraged their balance sheets to gain additional exposure to metallurgical coal via major acquisitions in 2011.
European forest products companies UPM-Kymmene Oyj (UPM1V) and Stora Enso Oyj (STERV) continue to struggle with declining domestic demand for graphic papers. What's been particularly troublesome is that the pace of the secular decline in European graphic paper--which is due largely to the rise of digital substitutes for reading papers--has been accelerating in recent months rather than leveling off. The industry is in the process of slashing extra capacity, but we do not think they will be able to reduce capacity quickly enough to meaningfully improve profit margins. Aggressive consolidation--including a potential merger of UPM and Stora--would likely better match supply with demand in the medium term and benefit the industry, but neither company appears eager to invest in the structurally weak European paper industry, instead preferring to diversify their revenue streams by investing in non-paper businesses or in growing emerging markets. While those growth investments may benefit the companies in the longer term, we think the companies are missing a near-term opportunity to pick up the paper assets of smaller producers on the cheap and improve industry fundamentals.
We're beginning to see material improvements in Fibria Celulose's (FBR) financial health. Since it was formed in 2009, Fibria's high leverage has been the primary risk to the low-cost producer's business. Indeed, Fibria has twice renegotiated debt covenants in the last two years, dramatically reduced the size of its capital investment program, and sold equity and assets in an effort to get ahead of its debt burden. It appears that the company is making progress toward that end, however, and we currently do not consider the company to be in danger of breaching its debt covenants. Fibria also announced a $20/ton price hike on eucalyptus kraft (BEK), which should support group profit margins going into the second quarter.
Metals & Mining
No major mined commodity had a stronger first quarter than iron ore, which touched a multiyear high of $159 per metric ton in January, not long after spending a few weeks on the wrong side of $100 in August and September. We viewed the $159 level as no more sustainable than the sub-$90 we saw last year. So far, that view is playing out, albeit somewhat slower than we had expected. Prices have come off to $134.60 in the spot market as of March 15, according to TSI.
Quarter-to-date, prices have averaged $150 versus $121, setting up markedly stronger earnings from the iron ore miners than we saw in fourth quarter, which was particularly brutal for higher cost players like Cliffs Natural Resources.
We expect the mostly favorable price momentum to turn negative for the remainder of the year. Specifically, we continue to forecast an average price of $133 for 2013, implying a sub-$130 average through year-end, as Chinese inventory levels normalize and new Australian iron supplies begin to hit the market.
From there, we see prices falling further toward $90 by 2015 (real dollars) as supply growth gathers steam and Chinese steel demand expands at a fraction of the rate posted over the past decade. Moat-worthy names like Vale will endure margin contraction in such a scenario, but an enviable cost position will keep profits at healthy levels. For higher cost Cliffs, which in 2012 had unit cash costs roughly twice Vale's, the picture looks decidedly darker.
A rebound in iron ore prices combined with tepid scrap prices has sent mixed signals to U.S. steel prices, which have abandoned their typical seasonal strength in the first couple months of the year. Domestic capacity utilization has crept back into the upper 70% range from the low 70% levels of last fall, but just because there is more production, doesn't mean the market needs it. Demand is improving but lacks momentum, and has been fully offset by stronger steel imports. The U.S. experienced a 17% increase in imported steel in 2012, while demand only grew by 8%, causing domestic producers to lose market share.
The only sign of optimism for 2013 in the U.S. appears to be in non-residential construction, with producers almost unanimously pointing to a revival beginning in the latter half of the year. We think there still remains a lot of uncertainty around the timing and the extent of an acceleration in construction activity, if any, and we expect 2013 demand overall to look much like 2012, though with a weaker start in the first quarter. Reduced raw material costs compared to 2012 should provide some margin expansion if the mills are able to maintain or increase steel prices from current levels.
If overcapacity problems plague the U.S., they pale in comparison to the challenges in Europe and China. Industry association Eurofer is calling for a 25% decrease in European steel capacity in the next 3 years in order for Europe to remain competitive. This would mean elimination of most of the currently idled production capacity. However permanent closure runs into opposition from politicians who see steel as an important industry for preserving jobs.
China has completed its high-growth stage in steel consumption, and the government has publicly stated that it wants to accelerate consolidation of its steel industry. But this will be no easy task when 50% of all steel mills in China are privately-held, most with newer and more profitable facilities. They are likely to resist merging with state-backed producers who post weaker profitability. The slowdown in Chinese steel demand has created some cost relief for steel companies everywhere by giving raw material production a chance to catch up. But without a halt in new capacity or shuttering idled production in Europe and China, demand will not be able to restore supply/demand balance and return industry profits to normalized levels. This will take years to play out, but we think some telling signs, good or bad, will become visible in 2013.
Our Top Basic Materials Picks
|Top Basic Materials Sector Picks|
|Star Rating|| Fair Value |
| Economic |
| Fair Value |
|Cloud Peak ||$28.00||Narrow||High||Standard|
|Compass Minerals ||$93.00||Wide||Medium||Exemplary|
|Potash Corp ||$51.00||Wide||High||Exemplary|
|Steel Dynamics ||$22.00||Narrow||High||Standard|
|Data as of 03-19-2013.|
Cameco (CCJ) (
)While we don't regard shares of uranium miner Cameco as materially undervalued on an absolute basis, we think they represent among the better relative values in the mining space. Our comparably favorable view of Cameco stems from a bearish outlook for Chinese gross capital formation (infrastructure, real estate, factories), which has underpinned the decade-long run-up of prices for everything from iron ore to metallurgical coal to copper. In the decade to come, we expect lower Chinese GCF growth rates will take some of the steam out of prices for these commodities. Uranium is still a China story, but it's different in two crucial respects. First, while China is already the world's largest consumer of every industrial metal out there (40% of copper consumption for example), it's a comparative lightweight in terms of uranium, with a reactor fleet not much larger than Canada's. That's set to change in the decade to come as China builds out its nuclear power industry in a big way. Second, in contrast to iron ore or copper, Chinese demand for uranium isn't predicated on the sustainability of China's investment boom, but the government's commitment to a policy choice. We think the several weeks Beijing spent shrouded in dangerous smog will strengthen the resolve of that commitment.
Cloud Peak Energy (CLD)
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 the firm's sturdy balance sheet and low production costs.
Our investment pitch on Cloud Peak is largely driven by our bullish forecast for PRB coal prices, which are currently trading for just over $10 per ton in the spot market. This price is significantly 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 above $3.50 per Mcfe, we estimate that PRB coal is cost-competitive versus gas in large regions of the country even if PRB coal prices were to 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 is likely being caused by bulging coal stockpiles among the domestic utilities, and PRB coal prices should spike higher once this inventory overhang is removed. The U.S. Energy Information Administration expects domestic coal burn to increase 40 million-50 million tons in 2013 from 2012 given the unusually warm winter and low natural gas prices that prevailed in early 2012. This forecast increase in domestic coal burn coupled with stagnant domestic coal production growth in 2013 should help coal inventories to fall to more normalized levels over the next several quarters, clearing the way for PRB coal prices to move higher, which should correspondingly benefit Cloud Peak. Our $28 fair value estimate implies that Cloud Peak's shares are significantly undervalued.
Compass Minerals (CMP)
This company has very strong and sustainable competitive advantages for the production of highway deicing salt and sulfate of potash specialty fertilizer. The company's rock salt mine in Goderich, Ontario is the world's largest and has access to a deep-water port, which allows Compass to deliver salt cost effectively to customers throughout the Great Lakes region. Further, the company's Great Salt Lake solar evaporation facility allows the company to produce sulfate of potash specialty fertilizer at a much lower cost than most other producers that use ore mining or a chemical process. Compass' earnings should grow long-term as the company expands its sulfate of potash fertilizer production and grows into its expanded rock salt capacity.
Potash Corporation of Saskatchewan (POT)
PotashCorp is the world's largest producer of the fertilizer potash. The potash industry functions as an oligopoly with the top six producers controlling about 80% of capacity. This leads to a cartel-like situation where production decisions are typically rational. In periods of slow demand, producers shut in production to better match supply with demand and support prices. As a result, potash prices have tracked well above marginal costs of production. Not only is PotashCorp the world's largest potash producer, the company also controls some of the lowest cost potash assets in the business, and its position on the low end of the cost curve allows for attractive returns. Recently, results have been dented by slow buying from China and India, but volumes are set to expand in 2013 with those buyers coming back to the market.
Steel Dynamics (STLD)
Steel Dynamics tends to trade at a discount to its closest peer Nucor (NUE) due to its smaller size and higher financial leverage, but we think that gap has room to close. Progress in new products such as rail has mitigated the effects of the downturn and its innovative Mesabi Nugget project should remove a major earnings drag when it starts using internally sourced iron ore concentrate in 2013. A more attractive long-term growth story given its smaller size and status as a relative newcomer to the U.S. steel sector also bodes well for the company. Steel Dynamics is the only U.S.-based steelmaker under our coverage to be profitable every quarter since the start of 2010, despite the continued depressing state of the construction markets, which in normal times make up roughly 40% of its business.
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Elizabeth Collins has a position in the following securities mentioned above: FBR, CCJ. Find out about Morningstar’s editorial policies.