Material Matters: Coal, Iron Ore And Contractors

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-Supply cuts support coking coal
-But further reductions unlikely
-Iron ore pricing steadies
-Soft contractor revenue likely
 

By Eva Brocklehurst

Coal

Coal prices have been increasing because of production cuts in China, supported by the numerous policies of the central government. One policy Macquarie believes has had the greatest impact is the 276 days policy. The move to 276 days from 330 days for re-identification of approved coal mining capacities has resulted in the reduction of 686mt to approved capacity, accounting for 13% of last year's national total capacity.

Macquarie suspects, if this policy is implemented 100%, coal production will be cut by the equivalent of 13% of 2015 annual production. Questions centre on how long the policy will exist and whether prices go up, as well as whether there are any violations of the policy. The broker finds it hard to envisage policy-driven production cuts will go deeper and, if prices do rise, there should be more recovery in coal output.

Thermal (energy) coal appears to be in a better position than coking (metallurgical) coal in terms of near-term changes to demand. Thermal coal usage is coming into peak season with summer, while steel production is set for its seasonal downturn.

Yet, while Macquarie envisages near-term momentum for thermal coal, prices are expected to ease after the summer re-stocking finishes. Meanwhile, coking coal prices are firm but coke producers are pushing for lower prices, given their deteriorating profit margins. The broker finds it hard to believe supply will fall further but demand should ease, and coking coal prices will have to follow coke prices with some time lag.

Metallurgical coal contracts have settled for the third quarter, with hard coking coal increases of 10% to US$92.50/t, semi soft up 5.7% to US$74/t and low volume PCI coal up 3% to US$75/t. These settlements are above UBS estimates.

UBS believes the stronger steel prices and margins and near-record steel output in the second quarter in China have driven the better demand and prices for coking coal. The broker notes Chinese domestic supply cuts are re-balancing the coking coal markets.

The broker remains cautious about the sustainability of the strong demand, prices and margins in steel and suspects, if demand slows in the second half, that coking coal demand will ease. At the same time new supply in Australia and Mozambique, plus under-utilised capacity in China, could easily pressure prices lower.

All up, the contract outcome is a handy boost for miners but UBS does not expect prices to rally aggressively. Settlements put upward pressure on the broker's 2016 coal price forecast of US$84/t but are not expected to affect 2017 estimates of US$88.50/t.

Iron Ore

Prices for iron ore on the spot market have steadied since late May at around US$49-53/t CFR China, Macquarie observes. The broker believes the risk of a near-term fall below US$50/t has abated, because of a gradual de-stocking at steel mills. The disappearance of a measure of higher-cost supply that emerged early in the second quarter is also a factor.

While some higher-cost supply has eased quickly, India's supply to China has continued to rise, reaching 1.64mt in May, its highest since July 2012. Yet Indian volumes are expected to fall soon because of the impending monsoon. In general, Macquarie also does not expect a substantial lift in near-term export volumes from the big three suppliers.

The broker envisages limited room for steel mills to aggressively cut their purchases of iron ore, with inventory at mills already being drawn back below average levels. With no rise in supply pressures, Macquarie maintains a US$50/t CFR China price remains fundamentally justifiable as an average for 2016.

Contractors

Ord Minnett suspects the contractor sector has run too hard, too early. The sector has rallied 35% since February 12 while the value of contract wins announced in the second half of FY16 is more than 50% below the five-year average per half. This signals revenue is likely to be soft in FY17.

There is potential for guidance at the FY16 results to fail to live up to the 6.6% earnings growth that consensus estimates are factoring in for the sector, the broker suggests. Exceptions exist and Ord Minnett prefers stocks with recurring revenue streams while NBN and solar power construction appear to be the strongest areas of growth in FY17.

Stocks considered likely to outperform include Service Stream ((SSM)) and Mineral Resources ((MIN)). Service Stream has had the best contract win rate in FY16 and is leveraged to growth markets, with the recent pullback in the price seen as a buying opportunity. Mineral Resources has a near-term catalyst in the update on its lithium resource and should post a stand-out result in FY16, the broker contends.

Stocks with potential to disappoint include UGL ((UGL)), Decmil ((DCG)) and RCR Tomlinson ((RCR)). Ord Minnett downgrades RCR to Hold as the share price has rallied hard on the back of recent contract wins. Decmil is also downgraded, to Lighten, with a lack of contract wins likely to be a feature of FY17.
 

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