Industry-Level Insights: Chemicals
Most chemical players had a banner year in 2010, with revenue increases largely wiping out depressing 2009 figures. We attribute most of the growth to industrywide restocking, combined with a strong rebound in automobile production. However, we think 2011 will be less rosy than 2010. The OECD countries are experiencing fragile economic recoveries, and housing and construction markets will continue to be weak, in our view. We do not see a clear catalyst for both markets to rebound strongly in 2012, and we feel the story will continue to be managing cost structures in mature economies and taking advantage of emerging markets in 2011.
Additionally, the crude oil price has run up to almost $90 per barrel in the past quarter, and petrochemical players, particularly those relying on naphtha chains, will face disproportionately larger feedstock increases in the near term. We think that will put significant pressures on margins, unless companies are confident enough to push through price increases. We are also looking at ethylene capacity increases coming online in the Middle East in 2011-12, which may create an ethylene and propylene oversupply situation worldwide. We fear this low-cost production will encroach heavily on US petrochemical producers' margins.
Industry-Level Insights: Coal
Coal stocks fared very well recently, with most stocks in our coverage universe rallying 20% to 50% in the last three months. This is perhaps somewhat surprising considering that the growth in developed economies remains anaemic, and natural gas prices are barely above $4 heading into the peak heating season. However, as we have said previously, the coal market is not primarily driven by domestic factors any longer. International developments have become much more influential.
In that department, coal has found something to cheer for. China's economy continues to steam along merrily, and the government recently refused to raise key interest rates despite inflationary concerns, fearing a hard landing for the economy. The Pacific coal markets responded, with the Australian Newcastle benchmark rallying to $115 per metric ton, up from $90 in August. Prices inside China reached as high as $130 per metric ton. To put these numbers in context, Central Appalachian coals trade for just $70 per short ton and Powder River Basin coals are worth only $13 per short ton.
Of course, the big risk in this story is Asian economic growth. The coal market is finely balanced right now, and even a small disruption to the demand dynamic could send prices tottering. We see precious few signs of this at the present, but that doesn't mean danger isn't lurking around the corner.
Industry-Level Insights: Engineering & Construction
The performance of E&C companies is increasingly diverging depending on their geographic exposure to the US and the UK versus the Middle East, Asia, and other fast-growing regions, in addition to their areas of expertise. In 2011, we expect companies operating in diverse geographic regions will fare generally better than companies that concentrate on the US and Western European countries. In particular, we are seeing a resurgence of nuclear power plant design and construction in the Middle East and Asian countries, mostly to the benefit of a selected few E&C companies. We also expect companies to start deploying their cash judiciously, either through M&A activity or share repurchases, to improve their earnings growth profiles.
Industry-Level Insights: Metals & Mining: Aluminium
The fourth quarter looks relatively bright for aluminium producers, particularly those outside China, but the supply/demand picture also requires a close watch. The average price of aluminium on the London Metals Exchange has increased considerably compared to the third quarter.
While there is a short lag in the price impact on financial results, higher average prices should give a decent boost to the top line for global aluminium producers. Part of this pricing support came from government-mandated production cuts for an estimated 20% of Chinese smelters due to energy efficiency goals. As China represents over 40% of global aluminium production, this took a sizable share of supply out of the market having a positive effect on pricing. With relatively stable order rates and production costs for the fourth quarter, this could be the best quarter of the year for companies unaffected by these output restrictions.
Whether aluminium prices hold strong into 2011 depends heavily on the supply/demand balance, particularly in China. While aluminium consumption is slowly rising globally, there exists massive overcapacity with high-cost smelters sitting idle and plenty of excess inventories. In the absence of permanent capacity reductions, aluminium prices have only a little room to climb in the next year.
Industry-Level Insights: Metals & Mining: Mining
Industrial metals prices and mining stocks fared well in the fourth quarter, despite uneven macroeconomic readings in the OECD countries and recurring worries that the Chinese government would take meaningful action to tamp down the country's arguably overheated growth rates.
Iron ore rose 19% to $170/ton in the spot market as of Dec. 14 from $142/ton as of Sept. 30. Among base metals, no commodity had a better quarter than copper, which rose 15% to $4.20/lb from $3.65/lb breaching all time highs set in the first half of 2008. (Meanwhile, more ballyhooed gold was up a mere 7%.)
Multiple supply-side developments fuelled copper's relative outperformance. For starters, the industry continues to be plagued by labour unrest, highlighted in the fourth quarter by a lengthy strike at Collahuasi in Chile (the world's third-largest copper mine, accounting for 3% of annual global output). Worries about the potentially deleterious supply-draining effects of physical copper ETFs also contributed to the story. Finally, in contrast with fellow base metal nickel--for which nickel pig iron acts as a swing supplier when prices get high--copper has no such release valve (nickel gained 6% in the quarter).
At the end of the day, mining companies would love to goose output, but there's simply no slack left in the system, as evidenced by the 6% decline in LME stocks through Dec. 14. Barring a setback in emerging-markets growth, we're unlikely to see a significant drop in industrial metal prices in the first quarter of 2011.
A few years down the road, however, it's another matter entirely. After several quarters of cautious capital budgeting and cash conservation, mining companies look ready to open their wallets in a major way. Growth, not survival, is now the name of the game.
As we discussed in our last quarterly outlook, we continue to believe capital expenditures will be the primary means of growth. Notably, this would stand in sharp contrast to the massive M&A deals we saw in the years leading up to the financial crisis. Five of the largest miners we cover-- Vale (VALE), Xstrata (XTA), Anglo American (AAL), Freeport-McMoRan (FCX), and Teck Resources (TCK)--spent a staggering $79 billion on acquisitions from 2006 through 2008, more than double the sum they spent on expansionary capex. Yet judging by the most recent budget plans we've seen, the ratio is likely to reverse in the coming years.
Take the three largest for instance: Vale, Xstrata, and Anglo. Vale, already a massive firm ($182 billion market capitalisation as of Dec. 14), plans to double its size by 2015, budgeting $24 billion in capital expenditures for 2011 alone (more than twice its previous high-water mark). Xstrata sees 50% growth by 2014 and the potential for 80% growth by 2016. Anglo projects 33% by 2013 and 90% further down the road.
Granted, some of the projects contemplated by these miners may never come to fruition. But conditions are arguably much riper for growth than they have been in recent memory: Commodity prices are very strong, balance sheets are healthy, and borrowing costs are low. Consequently, we'd argue that as long as these conditions persist, we're likely to see more marginal projects getting the green light and fewer projects ending up on the cutting room floor.
Go back to our overall outlook for basic materials equities.
