Is the Metals and Mining Rally Showing Signs of Rust?

Metals and mining stocks have been on a tear.

The MSCI World Metals and Mining Index surged more than 56% last year; the index is up 8.7% this year as of this writing. A yearlong rise in commodity prices amid robust Chinese demand gets the credit.

However, analysts suggest the party may be winding down. They say the market is oversupplied and demand growth is likely to subside.

"The market appears to be valuing mining stocks as if prevailing commodity prices are sustainable," wrote Daniel Rohr, director of basic materials research at Morningstar, in a recent research note. "We doubt that will be the case."

Prices for commodities such as metallurgical coal and copper are already well above the cost of production, and "with most commodities suffering structural overcapacity, it shouldn't take too long for high prices to induce curtailed supply back to the market," he said.

As such, is there any investment opportunity left in metals and mining stocks?

Chinese Demand Propels Metals Stocks China, the biggest consumer of commodities, has been trying to evolve to a consumer and service-led economy and away from industrial production expansion, while still maintaining modest growth.

But last year, China deprioritized economic reforms in favor of short-term spending on sectors that are heavy on industrial metals, require relatively low skill levels, and are more capital intensive, such as construction.

Thus, industrial commodities enjoyed an outstanding year. The coking coal price quadrupled, iron ore and thermal coal doubled, copper rose about 35%, and zinc skyrocketed more than 60%, according to Morningstar and Bloomberg data. But since late 2016, prices have started to rust.

Metallurgical coal prices tripled early in 2016 after the Chinese government cut working hours for coal miners. By the end of the year China relaxed the 276-day limit on operations and prices dipped.

Copper prices, at times used as a barometer for economic growth, have held up due to halt in operations in two of the world's largest mines, but are expected to ease as rising Chinese inventories, falling price premiums, and slowing activity in several sectors are likely to pressure the metal later this year, according to a Feb. 24 Bank of America Merrill Lynch research note.

Iron ore prices rose by 135% in 2016 and are up by 17% so far this year, a surge that has led to an increase in supply, according to a recent Capital Economics research note. Vale's massive recently inaugurated low-cost S11D iron ore mine in Brazil will start ramping up production this year to a staggering 90 million tonnes of annual capacity by 2020, while Australian supply is expected to grow further, Rohr said in his note.

Expect Fleeting Gains China's demand for metals isn't likely to continue at the same rate in 2017: The government announced in early March a more modest economic growth target of 6.5% for 2017 from 6.7% last year.

With slowing demand from the world's largest metals consumer, high commodity prices will be unsustainable.

"We see continued downside for almost all of these commodities, iron ore, coal and copper, as demand from China is going to decrease over the next couple of years as the country moves to more service oriented growth," said David Wang, equity analyst at Morningstar.

Meanwhile gold prices, which rose by single digits last year, have been one of the weakest performers among major metals in 2017, up 3.8% since the start of the year as of this writing and trading around $1,200 per troy ounce.

Gold prices are likely to remain subdued as the U.S. Federal Reserve raised interest rates Wednesday and is expected to increase them twice more in 2017, said Kristoffer Inton, equity analyst for Morningstar. Higher rates make gold less attractive as the metal doesn't pay interest, and it cost money to store.

"Even with a rally over the last few months, we are cautious that gold will come down from here which will hurt all miner stocks," said Inton.

"Gold stocks typically are reflecting gold prices of $1,250 an ounce extended on a real basis, but we expect gold to fall to $1,100 by the end of the year, and then rise to $1,300 by 2020 when jewelry demand picks up," Inton added.

China and India, with rising economies and incomes, are the largest consumers of gold for jewelry, yet jewelry demand will be slow to replace gold for financial investment, Inton said.

Some Opportunities Today According to Morningstar's Market Fair Value Graph, the metal and mining sector overall is overvalued. Yet there are a few pockets of opportunity.

Narrow-moat

The company reported poor 2016 results as lower uranium prices pressured profits. Yet 2017 will likely mark a turning point as market conditions tighten, said Wang.

"China's structural slowdown portends the end of a decadelong boom for most commodities--but not for uranium," Wang said in his latest company's report.

Morningstar expects global uranium demand to rise roughly 40% by 2025, fueled by a quadrupling of China's reactor fleet, moving into nuclear, and reducing the country's heavy reliance on coal. As such, Morningstar expects uranium prices to rise from about $20 a pound currently to $65 a pound (constant dollars), Wang said.

Though undervalued, this stock isn't for the faint of heart.

"We'd reiterate our very high uncertainty rating, exacerbated not only by volatility in the gold price, but Eldorado’s production concentrated in just a few mines, compared to other gold miners," says Inton.

Lastly,

"Over the last few months, Goldcorp has been one of the strongest performers among gold miners, which we believe is attributable to growing recognition of the company’s burgeoning free cash flow generation," he says.

Manuela Badawy is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.