Material Matters: Coal Positives, Iron Ore Juniors, And Gold

This story features MOUNT GIBSON IRON LIMITED. For more info SHARE ANALYSIS: MGX

– China's power supply issues may boost thermal coal imports
– Demand likely to offer support for met coal prices
– Initiation of coverage of a number of iron ore juniors
– Some downside risks for the gold price

By Chris Shaw

While inflation and tighter monetary policy have been concerns for China for some time, power shortages are now emerging as an additional challenge. As Deutsche Bank notes, many cities in China are experiencing their worst power shortages for at least seven years. 

These shortages are forcing some provinces to ration electricity to energy-intensive manufacturing sectors. This is causing activity to moderate in three of these energy intensive sectors – steel, non-ferrous smelting and chemicals.

Deutsche Bank suggests there is a risk of a serious power squeeze over the next few months, this due to continued strong demand, ongoing challenges for independent power producers, drought conditions in much of China that are impacting on hydroelectric production and continued infrastructure bottlenecks. There are also signs of low thermal coal stocks. 

Any of these factors could contribute to material tightness in the Chinese power market in Deutsche Bank's view, something that would have a number of potential impacts. These include lower aluminium output, a fall in nickel pig iron production, weaker steel output levels and higher imports of thermal coal. 

Commonwealth Bank agrees, seeing the combination of low coal stocks and power shortages as a good recipe for increased Chinese imports of thermal coal in coming months. 

Still on coal, Citi notes metallurgical coal prices have come under pressure in recent weeks as some low quality coal has hit the Asian market at the same time as Japanese buyers have stepped back. Chinese imports have also been lower as Australian imports have been priced out of the market.

This has been enough to push prices below US$300 per tonne for the first time since floods hit producers in Queensland. Despite this short-term dynamic, Citi remains of the view demand for premium hard coking coal remains high.

To Citi this means current contract negotiations should reveal pent-up demand for such premium material, especially given ongoing supply side issues. The stockbroker expects this will keep contract prices for hard coking coal above the US$300 per tonne level for the rest of this year.

Turning to iron ore, JP Morgan last week initiated coverage on five mid-cap WA-based iron ore producers, rating Atlas Iron ((AGO)) and Mount Gibson Iron ((MGX)) as Overweight and Aquila Resources ((AQA)), Gindalbie Metals ((GBG)) and Murchison Metals ((MMX)) as Neutral.

The key themes factored in by JP Morgan are that companies with potential capital requirements are higher risk investments, while a preference has been given to companies already beyond the commissioning stage of development.

Those companies offering greater leverage to near-term iron ore prices are seen as more attractive, while access to their own infrastructure is also viewed positively. When potential upcoming catalysts and valuation are also factored in, Atlas Iron and Mount Gibson come out on top.

More specifically, Atlas Iron owns the Pardoo and Wodgina mines in the Northern Pilbara, while also developing a number of other projects around the proposed “Turner River Hub” processing facility. Mount Gibson has two hematite deposits at Tallering Peak and Koolan Island, while the Extension Hill project may also be brought into production this year.

Comparing the JP Morgan view to that of the rest of the market, the FNArena database shows Sentiment Indicator readings for the five companies of 0.9 for Mount Gibson, 0.7 for Atlas Iron and Gindalbie, 0.3 for Murchison and minus 0.5 for Aquila. This makes the latter one of the lowest rated stocks in the Australian share market.

In the precious metals, RBS notes World Gold Council figures show 63% of world jewellery demand in the first quarter of 2011 was accounted for by China and India. This represents demand of 349 tonnes out of a total of 557 tonnes in the period. Adding in bar and coin investment gives a similar picture of demand being dominated by these two countries.

With investment a major driver of demand in recent months, RBS has looked more closely at this figures to determine a more accurate measure of true investment flows. Price-elastic/investment grade jewellery demand grew from 477 tonnes in the first quarter of 2010 to 529 tonnes in the same quarter this year, almost all of this due to the impact of China and India.

Taking out China and India and RBS notes world jewellery demand has been relatively stable, but is yet to recover from from the sharp fall seen during the Global Financial Crisis of 2008. In contrast, demand for investment products has continued to increase.

RBS estimates combined grass roots investment purchases and price-elastic jewellery demand are up 25% in tonnage terms year-on-year, the increase a more impressive 55% in dollar terms. In contrast, gold ETF holdings soared in the second quarter of 2010 before the accretion rate subsequently slowed.

In 2011, RBS notes gold ETF investors have been net sellers of more than 70 tonnes so far this month, which is the largest monthly redemption on record. RBS suggests this reflects the view of some high profile gold investors the market is finally topping out.

On RBS's numbers, for the March quarter of 2011 the gold market was in deficit of 128 tonnes, which compares to a surplus in the December quarter of 2010 of 175 tonnes. The swing reflects increased jewellery, bar and coin demand and a 40 tonne reduction in mine production. There was also a 149 tonne swing in net official sector transactions, while scrap return fell 107 tonnes.

This fall in scrap can be attributed to the January price fall according to RBS, as well as potential sellers holding off in the expectation of a price recovery. This adds to the RBS view the gold price is topping out, with any further gains likely to tease out additional physical supplies of the metal.

For gold in general, RBS suggests the latest World Gold Council review implies while the average investor may be expecting higher prices, the financial investment community appears to have little scope for much more inward investment.

There is no change to RBS's view the gold price is discounting a lot of bad news at current levels. There may still be some upside volatility, but headwinds are building and a lower price is considered likely.

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