Melting Pot

Although commodity-based companies have fallen in line with the overall market in the past one month, earnings growth prospects for them in FY11 appear limited as the global commodity prices stay under pressure. Investors should ask for solid justification before investing in commodity stocks, say Pallavi Mulay and Ramkrishna Kashelkar

WHEN clouds start gathering in the sky, it always pays to run for shelter. Be it the monsoon clouds in India or the clouds that are gathering over the prospects of the world’s socalled advanced countries. Just like Indian consumers are making a beeline to umbrella shops, the investor community is going towards safer assets. It is no wonder, therefore, that we saw gold as well as US dollar appreciating strongly in the past one month.
Global commodity prices, which had run up substantially, thanks to the sustained growth in liquidity, cooled off suddenly last month. As speculators rush away, commodity prices are unlikely to revive in the near future, which has put the FY11 earnings forecast of commodity companies under pressure. Investors are advised to be extra cautious while investing in such companies going forward.
After attaining the lifetime high levels around mid-2008, commodity prices — that of steel, base metals, crude oil, cement, etc — crashed substantially amidst the global meltdown. The fall in prices was in the range of 55-75% from the peak and the prices bottomed out in December 2008. The bear-run in commodities was, however, short-lived. On account of easy liquidity, signs of economic recovery globally and return of risk appetite amongst investors, commodity prices once again rallied from March 2009 onwards fuelling a run-up in the stock price of steel makers, aluminium makers, iron producers and sugar manufacturers.
Base metals such as copper, aluminium were up almost 72% and 150%, respectively, while crude oil was up 123% from the bottom, which they had attained earlier. Prices of regionallytraded commodities such as cement and steel have also shown a smart recovery in the past one-and-a-half years. In short, the year gone by proved to be a boon period for commodities. A strong rally in commodities took the prices within striking distance of their earlier historical high levels by April 2010. (See chart)
However, the party got disrupted as the world abruptly woke up to the European debt crisis. The cautious efforts by the Chinese government to cool down their own economy further added to the worries. Commodity prices fell around 10% in May 2010 and continued to fall further.
Last month, we saw crude oil prices falling from $85 level to $70 per barrel. Other internationally traded commodities, such as base metals, have also started softening. The S&P Industrial Metal Index lost 12.5% in the past one month. Prices of commodities, such as cement and steel, which are regionally traded and hence don’t have much speculative demand, are also on a downward journey. The prices were beaten so badly that it is now time to review what is in store for commodities going ahead.
As the European economic problems unfold and the Chinese economic juggernaut slows down, the genuine as well as speculative demand for commodities is expected to remain depressed throughout FY11. In fact, a further 10% correction in commodity prices could put them in a phase of consolidation in the first half of FY11.
Provided the economic problems are contained, the high level of global liquidity may enable commodity prices to gain momentum in the second half of FY11. However, considering the high base of last year, commodity prices may not rule higher on a y-o-y basis. As a result, companies selling these commodities could see their realisations almost stagnant throughout the year. Any profit growth, therefore, can come only from volumes growth. But given the high fixed cost of commodity producers, volume-led profit growth will not be juicy enough to excite markets.
Although a number of brokerage houses are reiterating their buy recommendations on metal or cement companies, their EPS growth projections for FY11 are stagnant. In fact, they are cleverly pitching their investment ideas based on earnings estimates for FY12.
METALS
The steel industry has witnessed prices easing while the iron ore prices are strengthening, of late. Although the domestic demand remains strong, global uncertainties are affecting the pricing environment. While a further fall in prices may not take place due to high costs, the margins are expected to remain under pressure throughout the year. Tata Steel, which is only partially dependent on third party sources for raw materials, will be the most insulated, except for the fortunes of its much bigger European subsidiary. Companies such as SAIL and JSW Steel that buy coking coal or iron ore from third party could take a bigger hit. A similar fate lies in store for base metal producers such as Hindalco, Sterlite, Nalco and Hindustan Zinc. In fact, these companies could experience greater volatility in their quarterly profits as unlike steel, base metals, such as aluminium, copper and zinc, are actively traded on exchanges and their prices fluctuate widely on a daily basis. Hindustan Zinc, the world’s least cost producer, is most protected from a fall in zinc prices. And if you are looking for a contra-pick in aluminium sector, Hindalco seems to be the best bet. The country’s largest aluminium producer has the most diversified product base and with the acquisition of Novelis, it now has a big presence in the consumer market for aluminium products. This cushions it from the fluctuation in the commodity price of aluminium.
CEMENT
The cement industry, unlike other commodity industries, is largely dependent on domestic demand and supply factors. The cement industry has been grappling with a difficult operating environment, especially in the southern region due to sluggish demand conditions, at a time when output has been expanding in this region. The industry’s total capacity utilisation at the end of March 2010 was at 85% levels, at a time when its capacity had grown 12.4% on a y-o-y basis to nearly 245 million tonne. In the cement industry, where players typically raise prices when capacity utilisation crosses 85%, witnessed prices actually wilt in southern and western regions.
The industry is expected to see addition of 50 million tonne capacity in FY11, followed by another 30 million tonne in FY12, which could depress capacity utilisation levels and pull the prices lower.
CRUDE OIL
Crude oil prices crashed to $70 level from $85 during May 2010 as uncertainties about oil demand re-surfaced amid concerns about impact of Europe’s debt crisis. Speculative activity in the crude futures market declined as money managers cut net long positions by almost 60%, as mentions OPEC’s latest report.
The global crude oil industry is facing an oversupply situation that can keep its prices under pressure throughout FY11. Global oil inventories have grown substantially to near-historic levels, while the OPEC’s production capacity has grown substantially higher than what is necessary.
India’s largest oil producer ONGC is little affected by the changes in oil prices since it has to share part of the marketing companies’ subsidy. However, the net realisation of private producers, such as Cairn India, can remain depressed if the oil prices stay range-bound.
The stock market performance of commodity companies have strongly been linked to the commodity price cycles in the past. The reversal in the cycle has pulled the valuations of these companies lower. However, a further downside still remains for them. Further clarity is also needed on Europe’s health and China’s growth momentum. Hence, investors should postpone their investment decisions in these companies till the second half of FY11, when some reversal is expected.