Material Matters: Coal And Iron Ore Markets Remain Tight

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– Coal and iron ore markets expected to remain tight
– Tight market conditions should support prices 
– Existing producers preferred in both markets

By Chris Shaw

Wet weather continues to cause problems for Australian coal producers, with Hunter Valley thermal coal mines the latest to struggle with rainfalls in the current wet season. As this is coming at the same time as a strike in Queensland and higher royalties in Indonesia, there is an impact on Asia-Pacific supply.

As Citi points out, these supply issues are emerging just as Asian buyers appear to be picking up their market activity. There are reports of new buying from China, while Japan's TEPCO has also delivered its first orders for thermal coal since the recent nuclear crisis.

This is likely to see a tightening in the Asia-Pacific market over the the next couple of months, Citi expecting thermal coal prices will push back above the JFY11 reference price of US$130 per tonne in coming months.

In metallurgical coal, UBS notes Anglo American has become the quarterly contract price setter in the market given BHP Billiton's ((BHP)) focus on monthly contracts at present. Last week Anglo settled 3Q11 prices with Asian customers for hard coking coal at US$315 per tonne fob, which was above the broker's forecast of US$280 per tonne.

UBS expects this will become the benchmark for other 3Q transactions. What should support prices are ongoing labour disputes at some mines and the continued recovery process from flood issues at Australian mines in the first quarter of this year.

By the end of the year prices are expected to ease, UBS forecasting a final quarter price of US$220 per tonne and a June quarter 2012 price of US$205 per tonne.

Taking a long-term view of the coking coal market, Goldman Sachs expects the market will remain structurally tight as market demand will be met by new production that is both expensive and requires significant infrastructure.

Given such an outlook, Goldman Sachs suggests currently operating mines should see their mine lives extended and relative costs become more competitive. This is because the cost of new production is likely to rise.

To play this thematic Goldman Sachs favours exposure to companies with current production and with the ability to expand production cheaply or through existing infrastructure channels. Australian stocks preferred are Macarthur Coal ((MCC)) and Bathurst Resources ((BTU)), the former given current production and growth and the latter given the quality of its coal reserves.

Both Macarthur and Bathurst are rated Buy at Goldman Sachs, while elsewhere in the sector Aston Resources ((AZT)) and Whitehaven Coal ((WHC)) are rated as Hold on valuation grounds.

In iron ore Goldman Sachs also sees a tight market, a condition expected to continue for the next few years after which the market is then likely to move into over-supply. This reflects the importance of Chinese steel production and demand to the iron ore market, with Chinese intensity of steel use currently expected to mature by 2014.

As with coal, iron ore is moving towards shorter contract periods, UBS noting while it is only 14 months since quarterly pricing was introduced by the iron ore majors, this mechanism is already being replaced by a mix of monthly and spot contracts.

UBS doesn't see this as too supportive for iron ore prices in the short-term, the broker being a 3-month bear on seaborne prices as India returns to trade, China is sitting on high inventories at present and as the northern summer brings an easing in steel production rates.

Beyond this period UBS remains a modest bull, seeing a relatively stable price outlook of US$140-$180 per tonne through 2012-13. As with Goldman Sachs, the view of UBS is by 2014 a rapidly expanding supply side will weigh on prices.

Macquarie notes the recent Metal Bulletin Iron Ore Symposium in Geneva saw some usual concerns raised. These included pricing mechanisms, the feasibility of some junior mining projects, China's sustainability and the development of financial markets.

What caught Macquarie's eye was an apparently growing divide between the haves and the have-nots in terms of projects and between believers and non-believers in terms of the need for financial iron ore markets.

With respect to pricing, Macquarie notes the producers presenting at the symposium agreed the annual benchmark system was dead. Some producers continue to favour quarterly pricing and some a portfolio of mechanisms and contract lengths and the development of lump and pellet market indices. Macquarie sees these divergent views as offering some opportunities for customers shorter-term.

On the production side, Macquarie notes an increasingly important issue is the ability to execute, as project slippages remain common. The divide is obvious between the majors, who have enough capital to spend on expansion, and the juniors, who are struggling with both cost increases and long lead times for equipment.

Macquarie takes the view over time, the lower cost structure of the majors and an ever-steepening cost curve should provide the larger players with an ongoing advantage.

One area every attendee at the symposium agreed upon was the demand side, Macquarie noting all expectations are for above trend growth to continue. Even Chinese player Sinosteel agreed, suggesting there is limited room for any further monetary tightening in China. 

Combined with low inventory levels, Sinosteel expects a re-acceleration in demand and upward price momentum in the third quarter, with prices likely to approach US$200 per tonne. This view is similar to that of Macquarie.

To play the iron ore market Goldman Sachs also prefers existing producers, as they are enjoying strong cash flows that are surprising on the upside. Also preferred are companies currently executing expansions to existing operations.

BHP Billiton ((BHP)) remains a conviction Buy, Goldman Sachs rating the stock as the best quality exposure to the Chinese demand thematic given underlying organic production growth across both later and early cycle commodities.

Rio Tinto ((RIO)) is also preferred as a Buy, while in iron ore specifically Goldman Sachs also rates Fortescue ((FMG)) as a Buy. Both Mount Gibson Iron ((MGX)) and Murchison Metals ((MMX)) are rated as Hold.

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