Commodities | Dec 06 2011
– Too early to turn bullish on zinc
– Marginal production costs to underpin aluminium prices
– Seasonal factors supportive for steam coal
– Positive outlook for fertiliser markets
By Chris Shaw
Nearby zinc spreads traded on the Shanghai Futures Exchange (SHFE) have tightened over the past few weeks, to the extent the market has moved into a small backwardation. Barclays Capital notes the spread between the SHFE and the LME has also improved in recent months, raising the question of whether the zinc market is showing signs of turning.
This question becomes relevant given Barclays has been least positive on zinc among the base metals for some time, this due to a persistent market surplus and ample levels of supply. But global inventories have stopped building, suggesting the market is moving closer to balance than surplus.
Barclays attributes this change in the market to something of a supply response to lower prices emerging in China. This response has taken two forms, the first being producers, miners and suppliers have held off selling at lower prices. This response is seen as more of a temporary measure, Barclays noting limited credit will restrict the ability of producers to finance inventory for any period of time. Regardless, it has tightened the market to some extent.
The second response has been the closure of some smaller mines in China's northern provinces, this due to weak market conditions. The effect of these closures has been to reduce spot supply, so further tightening the domestic market.
As spreads tighten Barclays sees scope for unreported inventory to be attracted to SHFE warehouses and for concentrate imports to be supported in coming months. As long as any weakening in demand doesn't outpace the tightening in supply, Barclays expects this will cushion the downside for prices should the global macro environment weaken further.
But, Barclays concludes, this is not reason enough to turn fundamentally bullish on zinc at this point in time.
Still on base metals, Deutsche Bank notes while aluminium prices have fallen by around 13% so far this year, this leaves the metal the best performed of the base metals year-to-date in relative terms.
Looking ahead, Deutsche's view is downside risks for aluminium should be limited in the near-term, this due to a return of cost concerns in the market and the potential for production cuts in coming months.
Positive US macro data and the re-emergence of geopolitical risks in the Middle East should keep energy prices elevated in Deutsche's view, while increases to power tariffs in China are likely to add to cost pressures in the sector. This rise in marginal production costs is expected to underpin aluminium prices.
On the supply side of the market Deutsche notes producers have shown little discipline to date. Output curbs could gather pace if global deflationary fears were to intensify, as Deutsche estimates the marginal cost of aluminium production this year is US$2,100 per tonne.
This means many producers are operating at a cash loss at current prices, but production cuts are made more difficult by long-term power contracts and the length of time needed to shut and re-start smelters. Even allowing for this, Deutsche suggests if prices trade below the marginal cost of production for a few more months, high cost producers are likely to face increasing pressure on margins and so may lower output.
Positioning-wise, Deutsche sees net shorts at relatively high levels at present. Given industrial metals have priced in a significant amount of bad news at present, an improvement in the global market outlook could see a reduction in net short positions. Liquidity risks may also be a concern leading into the end of the year according to Deutsche.
In the bulk materials market, Barclays suggests the upcoming winter season is likely to act as a sanctuary for steam coal prices, this the result of strong seasonal consumption and adverse weather-related supply issues.
Barclays expects winter weather risks should see steam coal prices stay range bound for the next couple of months, before the market restarts the search for a new, lower price equilibrium.
At present, Atlantic Basin inventories are at comfortable levels and a delayed start to winter has limited incremental buying. This has the market well positioned to buffer any price effect from a sudden jump in consumption levels.
In the Pacific Basin the Chinese have been active buyers of limited quantities in recent weeks, Barclays noting this has contributed to a filling up in southern post and end-user stocks. While robust power demand continues in China, coal burn is likely to be capped by current power prices.
Fresh imports into India are only likely to resume once current port stocks are cleared, something Barclays suggests looks more difficult given prices currently being offered to utilities and the impact of the depreciating rupee.
On the supply side Barclays notes the South African market appears in solid shape given ample inventories and improved rail transport, while Australian suppliers also appear well prepared. Russian supply is the most vulnerable in the view of Barclays, this given a combination of rail management and weather issues.
Turning to basic materials, Citi suggests the outlook for fertiliser prices remains positive given still robust demand, this despite the financial issues in Europe. Also positive is application rates are increasing given attractive farmer returns, evidence of some cost push price inflation in the market and traders running tighter inventory levels.
Looking to next year, Citi notes US and Canadian crop acreages are likely to be higher than the high levels seen this year, while strong crop nutrient demand is expected in the final quarter of 2011. Latin American demand is also expected to be solid in this period.
From a farmer perspective returns are still supportive of robust levels of fertiliser use, especially as farm margins are healthy at current grain prices. Citi points out prices are actually high enough at present to provide farmers with the incentive to increase the yield per hectare through increased use of fertilisers.
Citi expects some fertiliser distributors and retailers may delay purchases as late as possible to ensure minimal inventories given current volatility in global markets. Capital is also less available this year than last year, which supports the move to limit inventories. This does increase the risk of traders losing business if demand proves to be stronger than expected, notes Citi's.
With input costs placing upward pressure on fertiliser prices, Citi remains positive on both Orica ((ORI)) and Incitec Pivot ((IPL)). Both stocks are rated as Buy, with Citi setting price targets of $30.00 on Orica and $4.30 on Incitec Pivot.
With respect to how this compares to others in the market, the FNArena database shows Sentiment Indicator readings for Orica of 0.6 and for Incitec Pivot of 0.5. Consensus price targets stand at $28.67 and $3.93 respectively.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
