Material Matters: Bulks, Oil And Updated Metal Market Views

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– Bulk commodity views updated
– Citi adjusts coal price forecasts
– Stainless steel output to rise
– Oil weakness due to both fundamental and technical factors
– Morgan Stanley updates its metal market views 
 

By Chris Shaw

The past few trading days have seen some volatility in bulk commodity prices, Goldman Sachs noting premium hard coking coal prices have risen on the back of limited spot availability thanks to an industrial dispute between the BHP Billiton ((BHP)) Mitsubishi Alliance and unions. At the same time, weak demand has seen thermal coal and iron ore prices soften.

In the view of Goldman Sachs the demand side of the bulk commodity market continues to look subdued, meaning supply side dynamics will be increasingly relevant for prices. Some trends likely to impact on supply in the future according to Goldman Sachs are diesel costs in Australia, ongoing signs of caution with respect to new investment in thermal coal and the impact on margins and prices of recent weakness in the Australian dollar relative to the US dollar.

With respect to the thermal coal market, Goldman Sachs views Rio Tinto's ((RIO)) decision to put the Mt Pleasant project under review as a sign rising costs and falling productivity in the Australian coal sector are offering significant challenges for greenfields developments.

The thermal coal market globally also faces other challenges, as South Korea's recent decision to adopt a national cap-and-trade system to start in 2015 show regulatory uncertainty is likely to continue to impact on thermal coal demand.

In terms of diesel rebates in Australia, Goldman Sachs notes the rebate to mining companies is expected to fall to 32c per litre from 38c from July 1. The broker estimates diesel consumption accounts for 10-17% of production costs in an opencast thermal coal mine, so the change in rebate is unlikely to have a significant impact on costs across the sector.

With respect to currency movements, Goldman Sachs suggests a weaker Australian dollar would benefit iron ore producers the most given they are low cost suppliers relative to marginal producers in China. For both metallurgical and thermal coal producers a weaker Australian dollar could erode some price support in the broker's view.

Further on iron ore, BA Merrill Lynch notes the big producers such as BHP Billiton and Rio Tinto are now rationing project capex given capital intensity continues to increase. As an example of this capital intensity, BA-ML's numbers suggest Grange Resources ((GRR)), Gindalbie ((GBG)) and Fortescue ((FMG)) have capex demand relative to market share ranging from 83%-350%. 

This ratio falls to a range of 36%-39% for the likes of BHP Billiton, Rio Tinto and Atlas Iron ((AGO)), while capex demands relative to market cap are lowest for BC Iron ((BCI)) and Mount Gibson iron ((MGX)) at 2%-5%.

For those in the first group in particular, capex inflation is a risk in the view of BA-ML, so decisions to stagger and moderate capex plans are likely to be an ongoing trend. On the plus side BA-ML notes margins remain high, with commodity prices in general and iron ore prices in particular remaining at historically high levels.

In line with view of Goldman Sachs, Citi also suggests demand is something of an issue for the iron ore market at present. As Citi notes, the spread between 62% and 58% iron ore (CFR China) has fallen below US$10 per tonne in recent weeks. This implies limited appetite for high quality iron ore at present. While Citi notes a weak premium is not an impediment to higher iron ore prices, an improvement in the spread would be supportive to the maintenance of higher iron ore prices. 

With respect to where the best value is among Australia's iron ore majors, Credit Suisse suggests the decision now comes down to either Rio Tinto or Fortescue given BHP Billiton has greater earnings diversity.

A closer look suggests in terms of iron ore quality, Rio Tinto has the edge at present on size, grade and cost terms. Having said that, Credit Suisse points out the cost difference is not as great as some in the market perceive.

Unit costs for Fortescue remain sensitive to volumes, which are increasing, while the start-up of the low stripping ratio Solomon mine should push costs down further. As well, Credit Suisse suggests Fortescue may enjoy cheaper rail and ship-loading than does Rio Tinto.

While noting Rio Tinto has a more profitable iron ore division than Fortescue but taking a company-wide view, Credit Suisse points out Fortescue has better EBITDA (earnings before interest, tax, depreciation and amortisation) margins and return on equity metrics as Rio Tinto's earnings are being impacted by the aluminium division.

This means those with a bullish outlook on the iron ore market are likely to favour Fortescue, though as Credit Suisse notes such an investment comes with higher risk given peak capex at present as expansion plans are put in place.

Adding Atlas Iron into the argument, Credit Suisse notes Fortescue continues to have the fastest growth trajectory, this in part because Atlas Iron is being constrained by the timing of port allocations at Port Hedland.

Atlas Iron has the highest costs and offers little in the way of size benefits, as it doesn't and never will own its own rail assets and operates at a multi-user port with limited loading capacity. Add in lower grade mines and truck haulage costs, and Credit Suisse suggests Atlas Iron has the weakest metrics of the iron ore plays.

This leaves Fortescue as slightly cheaper than Rio Tinto on earnings multiples, but this higher return comes with higher risk. Credit Suisse rates all four of the iron ore stocks as Outperform. 

On the flip side, oversupply fears in thermal coal are pressuring thermal coal prices, Citi suggesting while coal's competitiveness against gas should offer some support significant inventories will weigh on prices for the foreseeable future.

In met coal Citi notes as much as three million tonnes of hard coking coal has been lost to strikes and production disruptions this year, this coming at a time when demand has been subdued. With signs now emerging of a pick-up in Asian demand, Citi expects an improving outlook for hard coking coal prices.

In general, Citi suggests coal stocks at present are pricing in significant amount of bad news, as weak fundamentals and regulatory risk in Indonesia continues to impact on market sentiment. A pick up in demand is not expected until later this year, when domestic shortages in India are addressed, all of Japan's coal-fired capacity comes back on line and Chinese industrial activity improves.

To reflect market conditions, Citi has trimmed its price forecasts, thermal coal estimates falling 5% this year and 2% in 2013 to US$119 per tonne and US$136 per tonne respectively, while the broker's 2014 price estimate increases 2% to US$148 per tonne.

In steel, industry consultant MEPS is predicting record high stainless steel output in 2012, with production expected to increase by almost 6% to 34 million tonnes.

The 32.1 million tonnes produced in 2011 was driven by an 11.9% increase in Chinese output according to China Iron and Steel (CISA) figures, while in the rest of the world only South Korea and the EU lifted output above 2010 levels.

Chinese production is expected to increase by a further 10% in 2012, with MEPS suggesting risk to this number is to the upside given significant under-reporting of production as a number of producers are not CISA members. Adding in an estimate of under-reported production, MEPS estimates global stainless steel production this year could be as high as 36.8 million tonnes.

MEPS notes production trends highlight Western world and Far Eastern output has fallen significantly from peak levels achieved in 2006, with this trend expected to continue this year as well. Over the same period Chinese output has grown by 138%. 

Turning to oil, Citi suggests while crude prices have weakened so far this month, just as occurred in both 2011 and 2010, this year the sell-down is due not only to macroeconomic issues and actually has more to do with prices breaking through key technical support levels.

From a fundamental perspective Citi notes US crude inventories are high at present and global inventories have been building, this as demand is going through a trough period and the market is seeing a peak in terms of global refinery turnarounds.

Going forward, Citi sees upside tail risks from supply disruptions as a real threat and something that should help the market move out of its current doldrums. With refinery demand expected to pick up over the next 6-8 weeks Citi remains bullish on oil prices, forecasting 3Q12 prices for Brent crude of US$130 per barrel.

Morgan Stanley also picked up on the recent decline in crude oil prices, seeing the falls as a response to a flurry of weak economic data adding to weakness in market fundamentals. Fundamental appear to offer little respite, as indications are supply is adequate at present.

In Morgan Stanley's view the path of least resistance for oil continues to be lower prices, as bearish catalysts such as OPEC indicating US$100 per barrel was something of a target price and rising inventories continue to emerge.

Bearish 1Q12 inventory builds are help OECD nations restock low inventories, leading Morgan Stanley to suggest for inventories to follow their normal seasonal paths OPEC will need to cut output by around one million barrels per day.

At the same time while demand growth is likely to be slightly above normal in 3Q12, Morgan Stanley expects it will fall short of current International Energy Agency (IEA) estimates. 

In the precious metals, Morgan Stanley continues to prefer gold given negative real interest rates, the potential of further monetary policy easing and heightened political tensions in the Middle East. While the liquidity trade has eased this is only part of the investment case for the metal in the broker's view, as ongoing physical demand growth is creating upside potential for prices. It is a similar argument in favour of silver, though not to the same extent as for gold according to Morgan Stanley.

A large supply overhang in aluminium is enough for Morgan Stanley to remain bearish on the metal, though the broker does expect prices will rise given the pressure of rising production costs. Copper remains the preferred base metal exposure given expected market deficits both this year and in 2013, while the nickel outlook is mixed due to relatively poor demand prospects at present. Zinc also requires a pick up in demand for Morgan Stanley to take a more positive view, while lead demand growth should be more positive and so support prices in coming years.  

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