Commodities | Jul 28 2011
– Precious metals may gain short-term, likely to ease over medium-term
– Transport bottlenecks the key for Chinese thermal coal demand
– Higher raw material costs impacting on steel in developing markets
– Rising cost pressures an issue for mining companies
By Chris Shaw
With European sovereign debt issues continuing to impact on investor sentiment, RBS notes both gold and silver prices have been well supported. With any long-term solution to the debt issue seen as some time away, investment demand should continue to drive the gold price in particular. RBS suggests there is scope for further gains in precious metal prices shorter-term.
Medium-term RBS retains a cautious stance, reflecting the view the precious metals appear richly priced, especially silver at prices close to US$40 per ounce. This suggests some underperformance relative to industrial metals going forward.
Citi has also looked more closely at silver, forecasting mine production will increase from 738.5 million ounces in 2010 to 793 million ounces this year and 837 million ounces in 2012. Latin America will be the biggest contributor to this growth in production, with silver output being boosted thanks to growth from gold by-product mines.
On the demand side Citi expects a slowing in industrial demand growth following an aggressive bounce in 2010. Industrial demand is forecast to be up by around 7% this year, while jewellery demand is forecast to rise by 4% this year against a 6% gain last year.
Some of the increase in jewellery demand is likely to come from substitution away from gold jewellery given the high gold price at present. Given such an outlook, Citi expects the silver price will hold its recent range above US$30 per ounce through the September quarter before easing below this level by year's end.
Turning to the bulk materials, Deutsche Bank takes the view ongoing improvements in China's rail capacity and production increases in general will see net imports of thermal coal remain stable at around the 100 million tonne level over the next five years.
The existing rail transport bottleneck is not expected to be resolved until 2013-14, but Deutsche sees scope for the situation to start easing next year. When increased output from Mongolia and Shanxi also flowing through, Deutsche expects production growth will largely match domestic demand growth in coming years.
This implies a less bullish case in comparison to Deutsche's previous estimates, which had assumed further growth in Chinese thermal coal net import requirements.
While Deutsche sees current transport bottlenecks as being overcome, Citi is more cautious and suggests such an achievement won't be easy. In part this reflects the fact while there is significant potential for production increases at more prospective coal basins such as Xianjiang, such regions are a significant distance from electricity producing regions.
The need to move material large distances will put pressure on China's transport system, something Citi expects will continue to constrain domestic output. There are likely to be some cost issues as well, especially as Citi notes imported coal at present remains competitive with domestic coal on both a price and cost basis.
So while annual Chinese coal production is forecast to hit 4,000 million tonnes by 2015 and 5,200 million tonnes by 2020, this is still expected to fall short of increasing domestic demand. Citi estimates if China wanted to cap coal imports at a maximum of 100 million tonnes per year, domestic coal production would need to increase at a compound annual growth rate of 8% over the next decade.
This is enough for Citi to forecast Chinese thermal coal imports will grow to 150 million tonnes annually over the next few years. Citi is forecasting annual average thermal coal prices of US$139 per tonne this year, US$148 per tonne in 2012 and US$152.30 per tonne in 2013.
Steel industry consultant MEPS point out increases in raw material costs are having the effect of unsettling price sentiment in most developing markets. In Brazil for example, pricing positions have been influenced by not only rising raw material costs but also the strength of the currency.
Higher interest rates are now undermining procurement activity and causing imports to be closely watched. MEPS notes distributor inventories are in excess of four months worth of consumption for some product forms.
In Mexico, the steel industry retains a bullish outlook given solid underlying demand thanks to strong shipments to the automotive and construction sectors. In Russia, MEPS notes while buying volumes have been lower than expected, rising production costs and minimal price competition has seen higher quotes in July.
The outlook for the Ukraine steel industry remains positive according to MEPS, this thanks to stronger export demand. Local producers are currently operating at an average utilisation rate of 85% given scheduled maintenance work and some raw material shortages.
For Indian producers MEPS suggest the issue is whether to ride out the current monsoons or downgrade planned production. Raw material shortages are also impacting, MEPS noting distributors in the market are bearish with respect to the potential for a strengthening in steel demand in the period to late September.
Prices were volatile in the Turkish market in July, MEPS noting the market saw low buying levels post recent parliamentary elections. Long product producers have issued higher selling figures following some delayed purchases but MEPS points out distributors are currently divided over the sustainability of current transaction values.
Steel demand in the UAE has stagnated, MEPS noting local trading houses have remained bearish and now plan to carry lower inventories through the Ramadan period. Slow domestic sales mean some producers are looking to export some July/August output, this a reflection of the weak domestic market and ongoing pressure from low-cost foreign supplies.
Looking at the Chinese economy in general, Macquarie notes the flash reading of the HSBC/Markit PMI, which is based on a panel of 400 firms, fell below the critical 50 level. A level of 50 is the line separating expansion from contraction.
As Macquarie notes, Markit sees the survey as representative of the manufacturing sector in general. This implies the belief in a two-sector economy, where the SMEs are weak and state firms are strong, is widespread and is being shared by government officials.
Macquarie expects more concern with respect to overall growth will come if the official PMI falls below 50, an outcome the broker expects will happen. Policy wise such a development is manageable if inflation falls, with data for July more positive in this regard than were the numbers for June.
Taking a broad view on commodity markets, Citi sees costs becoming a big issue given cash costs have increased by more than 10% annually for the past decade and by mid-teen rates over the past five years.
Driving increases in cash costs has been falling grades, higher labour prices, higher fuel and consumable costs, higher strip ratios at older mines and currency appreciation. The coal, copper and iron ore segments have suffered the highest increase in average industry costs.
If, as expected, commodity prices were to stabilise around current levels Citi suggests cost increases could present a major downside risk to earnings. Cost pressures are unlikely to ease, especially given increases to royalty rates around the world and other costs such as carbon taxes.
Citi notes industry cost curves from third party providers suggest cost inflation for 2010-2015 to come in at 2-3% annually, which would be a result broadly in-line with inflation. But Citi's forecasts are for a greater impact, the broker estimating annual cost increases are likely to run from minus 5% to plus 12%.
Assuming historical industry cost inflation rather than its own forecasts, Citi suggests earnings for resource companies would drop by 3-6% annually. For every year costs continue to escalate at historical levels there would be a 3-5% fall in estimated net present value.
In general, Citi notes industries with steeper cost curves deliver better margins, as top cost producers are more inclined to shut production when in a loss making position. This means less supply overhang and greater stability in prices.
As examples, Citi points out steeper cost curves in both the iron ore and copper markets have delivered higher average industry margins than has been achieved in aluminium, alumina or zinc.
As different companies in different commodities have different types of operations and are at different stages with respect to mine life, production and other variables, assessing the magnitude of cost pressures is a difficult task.
As a guide, Citi suggests the general cost composition for the mining sector is labour represents 20-50% of costs, maintenance accounts for about 15-20%, energy accounts for 10-25%, raw materials between 20-50% and other costs between 5-15%.
The weaker US dollar has also impacted, as the corresponding strength in the commodity currencies is causing an escalation in cash costs as a greater proportion of US dollar revenue needs to be paid out in the domestic currency to meet wage and raw material requirements.
Higher taxation of miners is emerging as a popular political platform in countries such as Australia, Brazil, China and Russia and Citi takes the view this theme is unlikely to disappear. As royalties shift this will alter the returns needed to invest capital in a region, which Citi notes will mean either commodity prices will need to increase further or margins will come under increasing pressure.
