Material Matters: China & The Commodity Outlook, Coal And Copper

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-China's demand recovery slugglish
-Commodities rally still fragile
-Thermal coal oversupply looms
-Physical copper not yet tight

By Eva Brocklehurst

China And Commodities Outlook

Morgan Stanley has garnered information on revenue trends in China from the announcements by listed multinationals in terms of earnings and guidance. In aggregate, current conditions are deteriorating, as around 50% of the sample reported conditions as adverse in the fourth quarter earnings season compared with only 37% a year earlier.

The worst outlook is for industrials, IT, materials and staples companies. The most positive outlook is for pharmaceutical and discretionary product companies.

From a commodities perspective, much of the current enthusiasm appears to be relating to Chinese demand, which Macquarie observes has improved in February-March. Nevertheless, the broker still maintains that markets ex China appear to be leading the nascent recovery in industrial production.

The broker still believes the underlying demand improvement in China is a recovery to trend, which suggests 1-2% annual growth for base metals and slightly negative growth for bulks. Fundamentals have improved, Macquarie observes, to a lesser extent.

The most interesting finding in the broker's opinion is that future production expectations are now rising strongly and this creates a risk that the supply response quickly matches demand growth over coming months, thus curbing the current rally.

The first quarter rally in commodities came earlier than Deutsche Bank expected and propelled the asset class into the best performer year to date. The broker considers the rally is fragile in some cases, prematurely pricing in a balanced market.

Deutsche Bank is confident that the process of re-balancing in crude oil is under way although the strength of the rally may fade as surpluses remain sizeable in the second quarter. In natural gas, the outlook is for tight markets and a deficit for the balance of the year large enough to justify an expected narrowing of storage surplus and eventually higher spot prices.

The broker finds limited catalysts to push gold higher than its first quarter tops. The prevalence of negative interest rates and a more dovish US Federal Reserve also means gold is unlikely to go below US$1000/oz.

Base metals in the meantime appear well supplied. Investors perceive the downward currency-commodity deflationary spiral has ended but Deutsche Bank believes further supply cuts are required to balance markets or draw down inventories. The exception is zinc, where natural resource decline has assisted the supply reductions.

Coal

Metallurgical coal contract settlements for hard coking coal in the second quarter are reportedly being agreed at around $84/tonne free on board. If confirmed, this is in line with Macquarie's recent forecasts and represents the first increase in contract pricing since the fourth quarter of 2013.

Does this augur well? Macquarie observes the prices of steel making raw materials have increased year to date on the back of an improvement in Chinese sentiment. Steel orders from end users are up and profits are now positive for many mills. This impact has been amplified by low inventories.

Still, the broker suspects this is a seasonal phenomenon heading into peak second quarter demand. One way Macquarie describes the current scenario is that the market is simply moving back to trend. Moreover, the broker does not witness enough structural improvement to suggest the market is bottoming and suspects the rally may lose steam in the second half of the year.

Macquarie believes producers are ignoring the fundamentals in thermal (steaming) coal. Glencore, the world's largest thermal coal exporter, is currently attempting to secure a $60/t Newcastle FOB prices for the Japanese financial year, but spot prices for the coal have averaged around $50/t year to date.

Meanwhile, Peabody has flagged its current structure is unmanageable and the question is now more about when rather than if the business goes into Chapter 11, the broker maintains.

Macquarie expects four additional Australia projects, one greenfield and three brownfield, are either going ahead or being seriously considered, despite lacklustre market conditions. These include Salim Group's Mt Pleasant, Whitehaven Coal's ((WHC)) Maules Creek expansion, New Hope Coal's ((NHC)) New Acland stage 3 and Yancoal's ((YAL)) Moolarben underground stage 2.

The broker envisages more than 20mtpa, 10% of Australia's thermal coal exports, could be added in the next three years to an already oversupplied market, further depressing prices.

The broker retains a negative outlook for coal, particularly thermal coal, preferring Rio Tinto ((RIO)) over BHP Billiton ((BHP)) and South32 ((S32)) with further possible negatives expected for South32, New Hope and Whitehaven based on Australian dollar moves.

Copper

Speculative buying is contributing to the lift in copper prices in 2016, UBS notes, to US$2.30/lb. Optimism has increased regarding China's fiscal and monetary policy amid expectations for further easing to achieve economic growth aims. Sentiment has been helped by uniformly strong property data in January-February.

UBS notes the optimism has supported the copper price but the physical market is not yet reflecting a tightening market. Merchant premia have been falling in China, visible inventory is lifting and cancelled warrants are stable and low.

Trade flows appear strong but the broker suspects this may be driven by a lift in mine supply. The broker envisages downside risks from a copper surplus and deflating cost curves and forecasts US$1.95/lb for 2016.
 

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