Metal Matters: Prices, Iron Ore Miners And Copper

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-Financial markets over-react to data
-Exchange traded commodities more affected
-Investors value yield over growth
-Step up in copper production plans
 

By Eva Brocklehurst

There's something that should be taken on board after the recent hammering of metals' prices. Macquarie has observed that, whenever there are sudden, sharp movements in commodity prices it can be helpful to compare exchange and non-exchange traded prices. This is because, in the short term, the former can be driven by fund flows responding to shifting market sentiment and technical trading. The latter depends primarily on physical market balances and business for price discovery. So, if exchange-traded commodities move more sharply over a short space of time comparatively, this could be a signal that financial markets have over-reacted to a change in physical market conditions.

Exchange-traded commodities have fared worst over the last week prior to Anzac Day, with an average fall of over 5%. Prices for non-exchange traded commodities sustained an average fall of less than 2%. It appears financial markets may have over-reacted to the economic data coming out of China, which was supposed to have triggered the falls.

Comparisons of nickel and ferrochrome prices can be similarly instructive, in Macquarie's view. The majority of primary nickel and ferrochrome units are used in stainless steel production. Yet the nickel price is determined by London Metal Exchange (LME) trading while there is no exchange price for ferrochrome. It depends entirely on physical market trading for its price. When prices for these two commodities diverge for reasons that cannot be explained by supply-side differences it's necessary to take a look at what's happening to the nickel price.

When the LME nickel price spiked last September but ferrochrome prices continued to fall it raised suspicions of financial inflation in the LME, which Macquarie says turned out to be the case. More recently, nickel prices have continued to decline even as ferrochrome prices have remained fairly steady. This might point to financial market investors selling exchange-traded commodities more aggressively than warranted by any recent change in underlying physical balances. Still, it's never black and white and Macquarie adds a note of caution. In the case of ferrochrome, there are increasing reports of more recent price falls that may not yet be reflected in published price estimates.

In summary, Macquarie thinks balances in most markets are less supportive of prices than was the case a year or so ago. With supply increasing in most markets, even as demand growth slows, there appears to be little prospect of prices for most commodities being bid up in the coming months. The attention is now squarely focused on cost support.

Now we know that, let's look at iron ore miners and their costs in the face of a lower iron ore price. Credit Suisse has used an iron ore index price of US$100 per tonne and parity in the Australian/US dollar to ascertain which companies can withstand the changes. BHP Billiton ((BHP)) and Rio Tinto's ((RIO)) margins remain a long way ahead of other Australian miners because of higher grades and lump premiums. In the middle bracket is Fortescue Metals ((FMG)), whose cash margins are still less than half  those of BHP and Rio Tinto. Credit Suisse thinks Fortescue will finish its capital spend in 2013, well ahead of Rio Tinto, and free cash flow yield will double Rio Tinto's in 2015. Despite Fortescue's costs falling with the lower-cost Solomon ore bodies, the high stripping ratio of the Chichester mines, lower iron grades and a lack of lump will not enable a challenge to the margins of the other two.

Key junior iron ore miner margins are another step below Fortescue. Atlas Iron's ((AGO)) ore grade is lower than the others. Its Atlas Blend used to be 57.5% but is now gradually being replaced by 57.0% in newer contracts. Atlas has found an appetite for lower grades from steel mills, and providing a lower grade allows a rationing of limited quantities of high-grade from mines such as Mt Dove, and therefore create more saleable tonnes. If iron ore prices fall below US$100/t, Atlas Iron's costs will need to fall to remain cash positive.

Mount Gibson Iron ((MGX)) has strong headline grades of at least 59% for all mines and also sells lump at a small premium. The received price for high grade is only $2/t below BHP and Rio Tinto but Mount Gibson will be selling some mineralised waste in the second half grading about 54% from Koolan Island, and also from Tallering Peak as the high grade orebody at the latter is exhausted. The company's mining costs are very high with undertaking pre-stripping at Koolan Island until 2017. While this is occurring, the low stripping ratio mine at Extension Hill will have to provide the cashflow.

Gindalbie Metals ((GBG)) has a 50% share in the Karara mine, with plans to ship 8mtpa of magnetite and 2mtpa hematite. Provided that the Karara magnetite ultimately delivers concentrate at the expected 68% grade and in line with cost guidance, the operation will have a solid cash margin for the stage 1 magnetite mine that Credit Suisse has modeled. The broker finds the hematite operations  are very unprofitable at US$100/t. On an earnings basis they might break even at US$110/t iron ore price, but overall, Credit Suisse would be looking for US$120/t for all-in costs including a pro-rata share of fixed costs.

Credit Suisse also maintains investors are becoming less tolerant of companies paying paltry dividends while retaining cashflow to expand production. This is especially the case in iron ore. Commodity analysts widely predict the planned expansions are too large and supply will overwhelm demand, causing the iron ore price to collapse. As a case in point, Credit Suisse highlights the recent share price jump for Woodside ((WPL)) after the company announced an increased dividend. This suggests investors now greatly value yield over growth plans. If this is the case, then companies that are completing expansions and producing an increase in free cash flow would be preferred.

The largest Australian iron ore producer, Rio Tinto, remains in the midst of iron ore growth plans. Credit Suisse finds the free cashflow yield looks to be weak through to 2016 on current plans, thus it would have little capacity to greatly increase dividends or reduce gearing with operating cashflow alone. This could change, as Rio Tinto has not yet committed the capex to expand iron ore production beyond 290 mtpa. Fortescue's Kings mine is due to be ramped up by the end of 2014 and Credit Suisse thinks free cash flow yield will expand to over 10% in 2015 and 2016, the years of a forecast trough in iron ore prices of US$90/t CFR nominal. Some of this will be used to repay debt rather than expand dividends but the increased cashflow will be viewed as increasing value for shareholders rather than gambling on future iron ore demand.

Let's look at the copper surplus. The global copper market moved into surplus during the second half of 2012 and Citi expects this to increase over 2013, primarily from slower Chinese consumption as well as the start-up, or ramp-up, of many new and established projects. Projects in Chile, Peru, and Mongolia are expected to account for around 14% of global mine production by 2014, according to Citi's estimates.

Chinese copper consumption growth underwhelmed in 2012 but there remains a widely held belief that higher growth rates will return, driven again by urbanisation and related infrastructure. Over the last decade global copper demand was largely driven by the acceleration of China as a manufacturing base as well as Chinese urbanisation. This might not be as clear cut as once assumed. Chinese authorities intend to move the engine of growth in the economy to more domestic, consumer based areas and this suggests to Citi that consumption growth rates are more likely to moderate.

Expecting a new lower copper price environment out to 2015, Citi has made adjustments to forecasts and now expects prices to average US$6,775/t in 2014 and US$6,800/t in 2015. This will bring into focus the viability of many copper projects that are planned for later this decade. In Chile, plans are afoot to boost copper mine production to 8m tonnes by 2020 from 5.5mt in 2012. Completion of these projects may be thwarted by opposition from local communities and there remains the question of scarce water and energy.

Peru aims to produce more than 6mt of copper by 2020. Again, environmental concerns and protests over water usage will be challenges to overcome. Citi expects Peru's copper production will reach 2mt by 2015 and grow at a steady rate of 2.6% until 2020. In the Democratic Republic of Congo the recently discovered Kamoa deposit has been hailed as a resource for copper and cobalt. The government estimates the country can produce around 1.46 billion tonnes of copper by 2015. Lastly, Zambia aims to produce 1.5mt of copper by 2015. The country's infrastructure is the most serious impediment and Citi estimates production could reach 1.12mt by 2013.
 

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