By Raymond Chan

In September, we exercised our caution in short term stock market performance. It’s proven to be right with the ASX 200 (XJO) down 0.58% for the month of September. We’re now expecting a better October in the lead-up to the AGM season.

This month, Latte with Ray would like to draw your attention to the Resource Sector. Our analyst Adrian Prendergast has been accurate in calling the resource sector and here are our latest thoughts.

Is there value in resources after peak cost-out?

There is still value on offer in resources, but it is harder to find now that: 1) the majority of resource industries have reached peak cost-out levels (with only incremental gains or cost inflation on offer from here), and 2) after the large ‘relief rally’ from recovering commodity prices that has carried sector valuations to multi-year highs. With the easy gains in the sector now made, we still see value in two areas: 1) those companies already holding value-accretive volume growth options (OSH, BHP, RIO), and 2) resource companies with earnings in an upgrade cycle (where spot prices are above current consensus forecasts – i.e. raw materials, base metals and now oil).

Time to take a breather

Even though we see the recovery cycle as remaining on track, we also see potential for the sector to take a short ‘breather’ in some areas in the fourth quarter after posting strong gains during 2017. Short-term demand conditions, particularly for raw materials like iron ore, look significantly weaker heading into the December quarter. We see aggregate consumption of the important steel additive as likely to be impacted by Beijing’s efforts to suppress pollution ahead of China’s 19th National Congress in mid-October. We also see some fresh tightening of liquidity in China also likely to hurt short-term demand for metals.

Changes to commodity forecasts

We have marked-to-market our CY18 forecasts, which continue to see an upgrade trend remain on outperforming metal prices. Post the northern hemisphere winter (where we expect volatility), we believe positive demand fundamentals across key manufacturing and construction regions will support metal prices at healthy levels. The pace and focus of China’s industry reforms also remains an area of focus for us that could further impact our forecasts (although in the case of aluminium this appears to be already factored in). In the oil and gas sector, we have trimmed our CY17-19 oil price forecasts to factor in a longer range-bound period before recovery (which we expect to be dictated by the duration of tier 1 shale reserves that remain an important contributor to marginal cost). We forecast the oil price to improve as the low-cost shale reserves are drilled out.

How to play the sector

Share prices of our large-cap miners have (so far) proved resilient against some pull back in metal prices. However, our expectation for weaker fourth quarter conditions could see selling pressure increase over the coming months. Given our forecasts for a continuation of the recovery cycle for metals (beyond Q4), we would view any sell-off as having potential to create a buying opportunity in our preferred sector exposures. Meanwhile the quality of earnings/management/assets in oil & gas remain much more varied and a case-by-case proposition.