Basic Materials: Amid Trade Tensions, We See Several Opportunities

The Morningstar US Materials Index has underperformed the broader market by about 3% year to date (Exhibit 1), as trade tensions with China continued to escalate. As a result, nearly 30% of our North American materials sector coverage now trades in 4- and 5-star territory (Exhibit 2).

US Materials Index vs. US Equity Index. - source: Morningstar

Underperformance has pushed about 30% of materials into 4 or 5 stars. - source: Morningstar

The Trump administration has continued an aggressive approach to renegotiating trade with China, pushing for what it says are fairer terms. These tensions have weighed on much of the basic materials sector. A resolution still looks uncertain, as the two sides continue to posture for political purposes and delay negotiations.

The economic consequences of the dispute have increased, leading the Federal Reserve to revert to interest-rate cuts. Driven by surging investor demand, gold prices have spiked, reaching more than $1,500 per ounce (Exhibit 3). However, today’s investor demand is tomorrow’s recycled supply. We continue to forecast a midcycle price of $1,300 per ounce, limiting opportunities among gold miners.

Gold has rallied amid rate cuts and geopolitical uncertainty. - source: Morningstar

We see more attractive options in agriculture, uranium, and lithium. In agriculture, heavy rains have flooded farmland across much of the Midwest, leading to the lowest total U.S. acres planted in more than a decade (Exhibit 4). Fewer acres planted will likely result in lower volumes for seeds, crop chemicals, and fertilizers in 2019. However, we expect the profit impacts to be short-lived as we forecast a full recovery in demand in 2020.

Flooded farmland has led to lowest U.S. acres planted in a decade. - source: Morningstar

Through 2019, uranium spot prices have fallen nearly 15% to roughly $25 per pound amid weak purchasing activity. The market-implied price of uranium stocks suggests little recovery on the horizon. We disagree. We expect production discipline will continue to help address industry oversupply, lifting prices to $65 per pound by 2021.

We remain relatively bullish on lithium. Although we forecast that long-term lithium carbonate prices will be somewhat lower than today in real terms—$12,000 per metric ton versus a price of $12,915 (Chilean export basis)—we are well above the consensus-implied long-term price of $8,000 as a result of our electric vehicle adoption forecast of 15% in 2028 versus consensus of 11.1%.

Top Picks

Nutrien (NTR)
Economic Moat: Narrow
Fair Value Estimate: $68
Fair Value Uncertainty: High
Nutrien is our top agriculture pick. As a fertilizer producer and the largest U.S. agriculture retailer, 2019 profits will be affected by the lowest U.S. acres planted in over a decade. However, we forecast a full recovery in retail profits in 2020 as agriculture demand is restored. Further, as a low-cost potash and nitrogen producer, Nutrien should benefit from stable prices over the next several years as the company continues to reduce its unit production costs in both businesses.

Cameco (CCJ)
Economic Moat: Narrow
Fair Value Estimate:  $16.50
Fair Value Uncertainty: High
The uranium market remains plagued by subdued activity, which has weighed on the uranium price in 2019. However, at today’s prices, significant production would be operating at a loss and only continues to operate due to long-term contracts signed at higher prices. Not only could current prices fail to meet existing demand, they could also fail to meet future demand arising from China’s continued nuclear fleet expansion. The still-improving supply/demand balance will help drive higher uranium prices, allowing Cameco to eventually resume full operations at more attractive margins.

Albemarle (ALB)
Economic Moat: Narrow
Fair Value Estimate: $130
Fair Value Uncertainty: High
Narrow-moat Albemarle currently trades at a nearly 50% discount to our $130 fair value estimate, as the market is concerned that lower lithium prices will weigh on future profits. However, with nearly all lithium volumes under contract through 2021, Albemarle should generate steady profits. We contend that higher lithium prices will be needed to encourage lower-quality supply to meet demand from growing electric vehicle adoption. With low-cost lithium production, Albemarle is well positioned to grow profits. We view current share prices as an attractive entry point for a quality lithium producer.