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Commodities 2005: A mixed bag

Dec 27, 2005

Year 2005 was a mixed bag for commodities. While those who had bet on the metals sector, especially steel, to continue to perform in 2005 would have ended the year with mixed feelings, those who had preferred to switch to a sector like cement at the end of 2004 would have been the happy lot. To put this in perspective in relation to the Sensex, while the BSE-Sensex has risen 44% in the last one year, the BSE Metals Index rose a paltry 11%. Further, while there is no BSE Cement Index currently, considering that an investor would have had invested an equal amount in each of the stocks mentioned in the cement table below, the average returns would be about 48% (57% without Grasim), which is higher than the Sensex returns in the last one year.

Our view at the end of 2004 (brief extracts)
"We continue to maintain our positive stance towards the aluminium sector for 2005. The aluminium sector will benefit from impressive growth in transport and construction sectors. Aluminium prices therefore, are unlikely to weaken much in the medium-term."

"As far as the steel sector is concerned, we must admit that the steel cycle has extended beyond our expectation. However, we continue to remain apprehensive on the steel sector for the medium-term. We believe that the steel cycle has peaked and the various domestic and global capacity expansion plans that are taking shape would put pressure on steel prices. At the current juncture, the risk-reward ratio in the sector is against the investor."

Note: While we had no dedicated article on cement at the end of 2004 in the 'Reflections' series, nonetheless, our positive stance on the cement sector was conveyed through our various cement sector/company articles in the 'Views on News' section.

How different was 2005 compared to our 2004-end expectations?
Aluminum: In the aluminium (and copper) space in 2005, China continued to be the deciding factor by virtue of its production and consumption power. With the Chinese economy not showing any signs of cooling off, the demand for metals continues to outpace supplies. While the year 2004 saw the global aluminium industry record a deficit in supply, thus pushing aluminium prices past 11-year highs, the scenario was not much different in the case of other non-ferrous metals like zinc (16-year highs) and lead (about 25-year highs) on account of depleting stockpiles and sustained demand. The situation was similar in the case of copper where prices too have soared to lifetime highs.

Steel: In line with our expectations, additional supplies led to the weakening of global steel prices (down by 20% to 30% in 2005 from its peak). The additional supplies were a factor of the significant ramp up in production by China, which led to the country reducing its dependence on imports and this additional steel found its way to other markets. However, on a YoY basis, average steel prices were higher by 10% YoY.

Cement: The year 2005 has gone down well for cement manufacturers, as expected. With cement prices having ruled firm on the back of a favourable demand-supply scenario (up 5% to 7% in 1HFY06), cement manufacturers benefited significantly. In fact, the performance would have been better but for the cold winter wave that hit the northern parts of the country in early 2005 and the floods that hit the western parts of the country in mid-2005.

Outperformers and laggards

Aluminium: Not too impressive
CompanyPrice on Dec 23, 2004 (Rs)Price on Dec 23, 2005 (Rs)% change
BSE-Sensex6,442 9,257 43.7%
BSE METALS5,699 6,349 11.4%
NALCO185 222 20.0%
HINDALCO133 140 4.8%
MALCO214 223 4.2%
INDIA FOILS15 14 -9.1%

Despite the positive developments witnessed in the aluminum sector in 2005, the same failed to reflect on stocks. One was the fact that the valuations at the start of 2005 had already captured in the future prospects. Secondly, Indian players reacted rather cautiously to sky-rocketing international aluminium prices in the beginning and thus, the price increase in domestic markets came into effect only in the last quarter of 2005, which would now start to reflect in the quarterly numbers going forward.

Steel: The underperformers
CompanyPrice on Dec 23, 2004 (Rs)Price on Dec 23, 2005 (Rs)% change
BSE METALS5,699 6,349 11.4%
SESA GOA505 1,045 106.8%
HIND. ZINC135 237 75.1%
JINDAL STEEL876 1,528 74.4%
ESSAR STEEL38 40 6.9%
TATA STEEL346 369 6.5%
SAIL59 54 -8.2%

Pure steel plays underperformed the markets in 2005, as their financial performance got severely affected owing to lower offtake of steel globally. Excess supply from China pressurised on domestic steel prices. However, it must be noted that while the performance of companies (Tata Steel) that are backward integrated combined with the contribution from value-add was better, companies like SAIL were affected the most.

Cement: Concrete gains
CompanyPrice on Dec 23, 2004 (Rs)Price on Dec 23, 2005 (Rs)% change
ACC317 540 70.1%
INDIA CEMENTS56 94 68.9%
GUJ. AMBUJA52 81 54.3%
MADRAS CEMENT 1,007 1,504 49.4%
ULTRATECH CEMCO308 433 40.5%
GRASIM 1,283 1,333 3.8%

Cement stocks logged in significant gains in 2005. Favourable pricing environment and strong demand for cement helped these companies report healthy financial performances, which was aptly rewarded by the stockmarkets. However, Grasim was an underperformer in 2005, as less than 50% of its standalone revenues are derived from cement, much of the balance being contributed by sponge iron (related to the steel sector) and textiles, which affected its overall performance.

What to expect in 2006 and beyond?
We continue to maintain our positive stance on the aluminium sector going into 2006, beyond which we could see some rationalisation in aluminium prices. Asia will continue to be the high consumption growth area, led by China. On the domestic front, with power, infrastructure and transportation accounting for almost 3/4th of domestic aluminium consumption and the government focusing towards attaining GDP growth rates above 8%, these industries are likely to lead the way.

As far as our view on the steel sector is concerned, we continue to believe that the threat of additional supplies of steel exercising pressure on steel prices in the medium-term remains. However, the downside would be capped if steel majors resort to production cuts or curtail their plans of increasing steel capacities.

In the case of cement, we believe that the story is not over yet. The industry is likely to grow at around 8% in the medium to long term. Government's initiatives on the infrastructure and housing sector fronts are likely to be the main drivers. With no major capacity expansion in the pipeline, the demand supply equation is expected to continue to improve and this will result in higher price realisations.

Also, it must be noted that while the markets may be positive on commodity stocks in light of lower price to earnings multiples, it has to be borne in mind that the P/E multiple of commodity stocks tend to be lower when the pricing environment is favourable, like it is now. Thus, the bottomline is to avoid commodity stocks when valuations are attractive (this scenario is more apt for the steel sector).

To read our thoughts on year 2005 and our view for 2006, click here - Reflections 2005.

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