Material Matters: Oil And Base Metal Forecasts Updated

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– Slowing in Chinese oil demand only temporary
– Oil, base metal price forecasts adjusted
– Earnings and target across oil sector also updated
– Chinese steel production to support coal, iron ore prices
 – Mineral sands market remains tight

By Chris Shaw

As had been anticipated, Deutsche Bank notes China is currently experiencing a mid-year softening in oil demand. The slowdown is expected to be only temporary, as Deutsche sees a recovery in oil use emerging in the final quarter of this year.

Numbers for June suggest Chinese oil demand for the month rose just 1.3% in year-on-year terms, the slowest rate of growth so far this year. It is also the slowest growth since January of 2009. Despite the slowdown, Deutsche notes total Chinese oil demand growth for the year is around 7%, which is in line with the five-year average growth rate.

China's total demand growth has been driven by diesel, Deutsche noting this category represents one-third of total primary oil use. Diesel demand through May showed an increase of 13.3% in year-on-year terms, while gasoline demand was up 10% and fuel oil demand has increased by 8.4% year-to-date over the first five months of the calendar year.

Deutsche suggests the current slowdown is partly a result of seasonal factors, as there is typically a short-term slowing in domestic demand during the summer. But with the impact of credit tightening and power shortages expected to dissipate in coming months, the stockbroker expects Chinese commodity demand in general and oil demand more specifically will recover.

Credit Suisse has also examined the oil market and subsequently revised its estimates, trimming the long-term forecast for West Texas Intermediate (WTI) to US$88.50 per barrel from US$90 per barrel previously. 

In annual terms Credit Suisse has adjusted its WTI forecasts to US$96.10 per barrel this year, US$91 per barrel in 2012 and US$102.30 per barrel in 2013. These compare to previous forecasts of US$94.50, US$92.50 and US$106.30 respectively.

Adding in some changes to foreign exchange assumptions has seen Credit Suisse also adjust earnings forecasts and price targets for Australian oil and gas plays. While there have been no changes in recommendations, targets have been trimmed for a number of companies. 

The biggest impact is felt by Aurora Oil and Gas ((AUT)), Credit Suisse's target falling to $3.70 from $4.00. Oil Search ((OSH)) has similarly seen a cut in target to $7.45 from $7.80. Key picks for Credit Suisse remain Santos ((STO)) and Origin ((ORG)) among the large cap plays and Australian Worldwide Exploration ((AWE)) among the smaller caps.

Woodside ((WPL)), Karoon Gas ((KAR)), Eastern Star Gas ((ESG)), Tap Oil ((TAP)) and Molopo ((MPO)) also score Outperform ratings, while Credit Suisse rates Oil Search as Neutral and Caltex ((CTX)) as Underperform.

JP Morgan has similarly revised its numbers, noting the changes have delivered somewhat substantial earnings impacts but done little to affect valuations given long-term oil price estimates are largely unchanged.

Forecasts have moved higher, JP Morgan taking the view the recent strategic release of reserves was a reflection of the lack of any supply cushion for the market to fall back on. With the International Energy Agency release expected to have a limited impact on prices, JP Morgan sees the upside risks to prices in 2012 as having materially increased.

For JP Morgan, WTI price forecasts have moved to US$98 per barrel this year and US$114 per barrel in 2012. Previous forecasts were US$99.40 and US$109 per barrel respectively. Similar changes have been made to Brent Crude assumptions, forecasts increasing to US$112 per barrel this year and US$124 per barrel next year from US$109.90 and US$110 per barrel respectively.

The changes to numbers have also not impacted on ratings for JP Morgan, with Santos, Australian Worldwide and Eastern Star Gas all retained as Overweight. Santos is the top sector pick given the upside potential from new projects.

JP Morgan continues to rate Oil Search and Beach ((BPT)) as Neutral, while Woodside and Roc Oil ((ROC)) are rated as Underweight. For Woodside the negative view reflects too much value being priced in for uncertain growth projects.

Turning to steel, Citi notes Chinese production continues to hit record highs, output coming in at more than two million tonnes per day over the last 10 days of June. Steel production for the June half for China was 352 million tonnes, a year-on-year increase of 9%.

As Citi points out, if Chinese production continued at the same run rate over the remainder of the year, output would significantly exceed its forecast of 650 million tonnes. This would imply a materially higher market deficit for iron ore but a more muted impact on the coking coal market.

If Chinese steel production rose to more than 700 million tonnes this year, a level Citi sees as possible, it would imply an iron ore market deficit of 62 million tonnes, This compares to a current estimate of a shortfall of 13 million tonnes. 

On balance, Citi suggests with the risk of any Chinese hard landing diminishing and as social housing demand picks up, iron ore and coal markets should stay tight through the remainder of 2011. This should support prices in both markets. 

To reflect this bullish view Citi recently lifted coal price expectations, the moved based on the expectation the combination of rapidly growing emerging market demand, infrastructure constraints and permanent cost increases will prove supportive.

The magnitude of the increases was significant, Citi's thermal coal forecasts being lifted by 10-15% and hard coking coal estimates being increased by up to 30% over the next 10 years. Long-term estimates have also increased, Citi's new long-term forecast for hard coking coal coming in at US$200 per tonne and for semi-soft benchmark coal at US$130 per tonne. These compare to previous forecasts of US$170 and US$110 per tonne respectively. 

At the same time, Citi has also lifted mineral sands price estimates, this due to ongoing tight markets thanks to strong demand growth and limited supply increases. Rutile forecasts have risen by 21-47% between now and 2015, while Citi's zircon forecasts have increased by as much as 20% over the same period.

The primary exposure to mineral sands prices on the Australian market is Iluka Resources ((ILU)). Citi rates Iluka as a Buy with a price target of $22.00, while the FNArena database shows six Buys ratings and two Holds with a consensus price target of $19.83.

Looking at the base metal markets, Citi notes the last month has seen significant divergence between prices and LME stock levels. While the likes of nickel and zinc have seen bouts of short covering, copper and lead have seen fresh longs established and aluminium has experienced some liquidation of long positions.

While the shifting of stocks is making it difficult to accurately interpret supply and demand, Citi suggests from here the LME complex is likely to make only modest gains at best. This reflects the fact demand may be muted thanks to governments taking their time to restore budgets and concerns with respect to local government debt levels in China.

Changes to metal price forecasts by Citi have been relatively modest, while in outlook terms the broker expects copper will continue to range trade and the aluminium price to rebound as demand stays relatively firm.

For nickel, Citi suggests the price recovery over the past month was largely short-covering as stainless steel demand remains sluggish and supply, particularly of Chinese nickel pig-iron, remains firm. Lead appears fully priced, while Citi suggests zinc is only likely to add to recent gains if Chinese production is cut and or global economic conditions improve by more than currently expected. 

Citi is currently forecasting 0-3 month prices in US dollars per tonne of $2,575 for aluminium, $9,750 for copper, $2,750 for lead, $24,500 for nickel, $27,500 for tin and $2,350 for zinc. Forecasts for 6-12 months stand at $2,650 for aluminium, $9,000 for copper, $2,600 for lead, $24,500 for nickel, $26,000 for tin and $2,350 for zinc.

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