Commodities | Nov 03 2016
Outlook for Chinese demand for metals and steel inputs; Factors in coal price rise; what is underpinning iron ore prices?
-Upside risks for aluminium, steel and coal prices from China's supply-side reforms
-Coal price correction after the peak season may be mild
-Iron ore benefitting from depreciating Chinese currency
By Eva Brocklehurst
China Outlook
The rebound of the Chinese property market has been an important driver of the improvement in demand for most metals, Deutsche Bank observes. The measures to cool the market being introduced by the government are relatively mild compared with previous property cycles, according to the developers the broker met on its visit to China. The outlook for infrastructure construction is also robust.
The Chinese government appears serious about supply-side reform, the broker observes. The 276-day policy has instilled a belief in industries which are at over-capacity that supply discipline can improve profitability. Deutsche Bank is skeptical supply discipline will last forever – and in some cases the supply chain has been disrupted by logistics constraints – yet for now believes this poses upside risks for the aluminium, alumina, steel, thermal and coking (metallurgical) coal balances.
While Deutsche Bank expects Chinese domestic coal prices will remain elevated into the lunar new year, there are troubling signs the fundamentals have not kept pace with the price rise. The decline in European demand has outpaced the rise in Chinese import demand through the month of September.
Seaborne export prices have now risen in excess of the domestic Chinese price increase, suggesting Chinese demand should not rise much further. A supply response is expected to eventually be realised towards the end of the year from the government's looser restrictions on 789 mines, allowing them to produce up to the 330-day level. Higher output from export producers is likely to be limited, the broker asserts, as many are skeptical of the longevity of current prices.
Steel
Deutsche Bank has become more bullish on the near-term outlook for steel. Upside risk to the broker's 2017 steel demand forecasts in China is driven by increasing demand for infrastructure construction, aided by the increase in public-private partnership funding. Over the medium term, steel demand is still expected to ease, with long products most at risk.
The broker believes steel demand, driven by the property segment, may not decline as much as originally expected. Based on the broker's observations, 2017 steel demand forecasts are upgraded to be flat versus prior expectations of a 2.9% decline. Because of the upgrading of demand growth the broker believes the profitability of steel mills will be similar to 2016.
China Coal
The main message Deutsche Bank garnered from coal producers in China is that they cannot ramp up production very quickly, and only around 50% of the production that was shut can be re-started in the December quarter and March quarter of next year. Deutsche Bank also observes a reluctance by smaller coal companies to re-hire labour.
The expectation remains for coal prices to remain robust and possibly appreciate into the December quarter. Deutsche Bank's calculations imply year-end monthly coal production might be at a level that is still about 6-10% lower than in previous winters. The low inventory suggests to the broker the coal price correction after the peak season may be mild.
Macquarie notes, since China announced a relaxation of production controls on coal, spot Newcastle coal is up more than $20 a tonne and spot Australian hard coking coal is up $42/t. These price moves may be counter-intuitive but suggest to the broker the market is sceptical that production is actually increasing. Inventories remain at low levels and, even if a production increase did materialise, it may not bridge the entire supply gap.
As a result, Macquarie makes material upgrades to hard coking coal and thermal price forecasts for the next two to three quarters. The broker maintains a bearish trajectory in its forecasts, expecting a supply response will eventually materialise and put prices under pressure next year.
As a fair level for thermal coal, the broker makes reference to China's earlier guidance that it wants thermal coal prices to fall back towards RMB450/t during industry restructuring, which is a Newcastle price equivalent of $60–65/t. For metallurgical coal Macquarie assumes contract prices will fall back towards a fair level of $120/t, which is around the top of the seaborne cost curve.
Macquarie is also receiving questions on how the coal price rise is affecting the aluminium market. The broker reports that those buying grid power have witnessed no impact. Those that suffer from a competitive perspective are smelters that buy spot coal to generate their own power – around one-third of Chinese capacity.
Such smelters have seen costs rise by more than RMB2,500/t from the lows in the first quarter, although more than half of this relates to increasing gains on alumina prices. The main winners are those located close to coal production bases, such as in Xinjiang and Inner Mongolia. These are the regions Macquarie expects will make capacity additions in aluminium over the coming two years.
Manganese ore has been on a substantial bull run but Macquarie does not believe the gains are sustainable. Australia excluded, most global supply that shut down in early 2016 has now been re-instated.
Iron Ore
Goldman Sachs observes that since the Chinese market re-opened after holidays in October, ferrous prices have increased significantly. Iron ore is up 22% and rebar 15%. The broker believes growth expectations and supply/demand fundamentals are unlikely to be the explanation. Iron ore inventory has been building and shipments from Australia and Brazil have been rising.
Higher coal prices cannot explain the increase in iron ore either. Historical data suggests that higher coal prices should affect rebar and aluminium prices the most but have a negligible impact on iron ore.
Goldman Sachs believes a weaker Chinese currency maybe the most important driver of the iron ore price increase. The Chinese currency has resumed its depreciation against the US dollar, which has broken RMB6.7 for the first time since 2010 and is now approaching RMB6.8, pushing onshore investors to diversify into dollar-linked assets.
Iron ore may be the first in line to benefit from such investment flows. To the extent that a higher US dollar also leads to a weaker local currency on a trade-weighted basis, iron ore may benefit from higher Chinese steel exports. Additionally, rebar and iron ore are the most traded commodities in the onshore futures exchanges.
By the broker's estimates, about 60% of the iron ore price rally in October can be explained by the depreciation in the Chinese currency.
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