Material Matters: Industrial Metals, Thermal Coal And Energy

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– Demand for industrial metals to remain firm
– Thermal coal prices also look resilient
– Cut to Chinese social housing unlikely to impact on commodity markets
– JP Morgan revises energy sector estimates and targets
– NAB sees modest metal price gains this year, flat prices in 2012

By Chris Shaw

As Deutsche Bank notes, in periods of extreme financial market dislocation such as has been experienced in recent sessions, industrial metals and energy have been the most vulnerable of the commodities. So given the current risk averse environment Deutsche has attempted to assess the potential downside risks for industrial metals prices.

To compare prices to long-term fair valuation, Deutsche has looked at an average of historical prices, long-run marginal cost and incentive pricing. On this basis, aluminium and zinc appear to be trading at a discount to long-term fair value. This suggests strong price support.

With respect to recent gains in the VIX index, which measures market volatility, Deutsche takes the view the latest correction in industrial metals prices is on a par with historical averages. This implies the complex is fairly priced for current conditions, though as Deutche notes if the VIX continues to climb further losses can be expected.

The recent correction in base metal prices is also on par with average price declines from the peak in equity markets to the start of recession. There is further downside risk if the US moves back to a mild recession, but this is not the central scenario Deutsche expects.

According to Deutsche, any further falls in prices are likely to open the LME/SHFE arbitrage window, which would encourage metals and in particular copper imports into China. On a relative value basis Deutche Bank at present favours aluminium, as this metal typically outperforms during risk aversion periods.

In copper, Deutsche points out prices continue to trade at a significant premium over the marginal cost of production. This means if deflationary forces intensify, the current premium could fall to around 120% from around 135% currently. This would suggest a copper price of around US$8,000 per tonne. 

Copper is currently estimated by Deutsche to be trading at a premium to long-term fair value of 72%, while for nickel the premium is estimated to be 24%. Nickel and zinc tend to suffer the most selling pressure in risk averse periods according to the analysis done by Deutsche Bank.

Looking ahead, falling prices and a start to restocking is likely to encourage a lift in imports to China. At the same time western world monetary policy is likely to remain accommodative, so Deutsche expects physical demand for industrial metals will remain strong over the next year.

Macquarie has conducted a similar analysis to determine how resilient thermal coal prices are to the current economic environment. The stockbroker's conclusion is downside risks don't appear too large at present, as market fundamentals continue to look supportive.

The thermal coal market is not entirely driven by China as Europe accounts for around 21% of seaborne coal demand, while Macquarie also notes the market is far more liquid than is the coking coal market.

What should continue to support the thermal coal market in Macquarie's view is the loss of nuclear generation in both Germany and Japan and the fact Chinese coal burn should remain strong in year-on-year terms, even with a slowdown in industrial production.

This suggests to Macquarie coal should remain one of the better performing commodities even in more bearish economic scenarios. In terms of actual market activity, Deutsche notes Indonesian exports picked up in May to their highest monthly level this year, while Chinese net imports fell slightly in June and remain below last year's figures year-to-date.

Deutsche notes 2011 year-to-date imports for India are also higher, currently up 18% from 2010 levels. Overall imports are likely to remain elevated, the broker expecting a total of around 102 million tonnes this year against the 75 million tonnes recorded in 2010. 

Returning to China, Macquarie notes there are reports suggesting social housing targets for 2012 could be cut by as much as 20% to eight million units. While this may be a negative for sentiment, Macquarie doesn't see any such cut as having a meaningful impact on construction activity or demand for commodities. 

On Macquarie's numbers, social housing construction accounts for around 2-3% of total Chinese steel demand and 6-7% of total cement demand. This supports the view any cut in social housing numbers will have only a limited impact.

What also supports Macquarie's view is the fact commodity construction has been the key driver of activity in the Chinese economy this year, while commercial construction has also been much stronger than last year.

As well, Macquarie notes any cut to social housing activity would take some time to work through the system, meaning it would likely take 12-18 months before any impact of slower starts was actually felt.

In energy, JP Morgan has revised oil, gas and forex assumptions, the latter to account for Australia's relative economic strength in the current environment. The result is a lift in expectations for the Australian dollar of US3-6c longer-term.

While there is no change to a long-term oil price forecast of US$90 per barrel, the broker now uses a price of US$90 per barrel in setting price targets, up from US$75 per barrel previously. In terms of yearly averages, JP Morgan is forecasting prices of US$112 per barrel in 2011 and US$124 per barrel in 2012 for Brent Crude, while for West Texas Intermediate forecasts stand at US$98 per barrel and US$114 per barrel respectively for 2011 and 2012.

The result is increases to price targets for most stocks in JP Morgan's coverage universe, with the target for Woodside ((WPL)) increasing to $44.07 from $43.05 and for Santos ((STO)) to $19.08 from $16.87.

Oil Search's ((OSH)) target increases to $8.12 from $6.88, while the target for Beach ((BPT)) climbs to $0.98 from $0.89. Australian Worldwide Exploration's ((AWE)) target increases to $1.88 from $1.60, while there is no change in the $0.38 target for Roc Oil ((ROC)). 

JP Morgan's ratings are unchanged, meaning Overweight recommendations for Santos and AWE, Neutral ratings for Oil Search and Beach and Underweight ratings on Woodside and Roc Oil. 

For a final word on commodity markets, National Australia Bank has released its monthly update for the various sectors. For oil, the bank has lowered forecasts from last month to reflect downward revisions to global economic growth in recent weeks. Global GDP for 2011 is now expected to be 4.0%, against 4.3% previously.

In Brent Crude terms NAB is now forecasting quarterly prices of US$109 per barrel in the September quarter and US$107 per barrel in the December quarter this year. In 2012, quarterly average prices are forecast at US$111 per barrel in 1Q, US$114 per barrel in 2Q, US$112 per barrel in 3Q and US$110 per barrel in 4Q. For WTI forecasts stand at US$93 per barrel and US$100 per barrel for the third and fourth quarters this year and US$108-$113 per barrel across 2012.

For the base metals, NAB notes prices were 4.2% higher in aggregate at the end of July than was the case at the end of 2010, while stocks of all major metals in LME warehouses remain well above long-run average levels.

NAB suggests the outlook for metals demand is now increasingly uncertain, this due to ongoing European sovereign debt issue and the US sovereign credit rating downgrade. But on the consumption side Chinese aluminium consumption has remained solid, as has copper production. 

Chinese demand for most base metals has been mixed in recent months, copper imports rising and alumina imports easing as power disruptions have affected operations at smelters. Net imports of lead ores and concentrates have also fallen sharply in recent months, this as authorities have phased out a large number of lead-acid batter producers, processors and recyclers.

On the supply side NAB notes copper has been impacted by industrial action and such labour tensions are expected to continue to support prices. Aluminium production in the June quarter was mixed, while reports for nickel producers in the period were more favourable. 

Factoring in the latest data sees no change to NAB's view the post-GFC recovery in metal prices has largely run its course. This means prices are expected to flatten out going forward, with strong fundamentals to offer support.

With the exception of copper NAB expects supply to outstrip demand for all metals over the next two years, something that is expected to see the NAB Base Metals Price Index rise by around 6% through to the end of the year. This is a slight trimming of previous forecasts as a reflection of a more benign outlook for the global economic recovery. In 2012 NAB expects the Base Metals Price Index will decline by around 2%.

Taking a broader view, the NAB Non-Rural Commodity Price Index is forecast to rise by 22% in US dollar terms through to the end of this year, before a decline of 7% in 2012. In Australian dollar terms this implies a gain in the index this year of 18% before broadly flat performance in 2012.

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