Material Matters: China And BHP, Coal, Fertiliser And Incitec Pivot

This story features INCITEC PIVOT LIMITED. For more info SHARE ANALYSIS: IPL

-Not yet Overweight BHP for Credit Suisse
-Coal market worsens
-Potash looks resilient long term
-DAP prices under pressure
-Incitec Pivot's DAP cost base threatened
 

By Eva Brocklehurst

It's not yet the time to be overweight on BHP Billiton ((BHP)). That's the opinion of Credit Suisse. The stock has outperformed the broader market this month, falling only 4.7% against 9% for the ASX200. Petroleum is fundamental for BHP, accounting for 37% of the asset base and 30% of earnings. So, even if China is not a driver of energy prices, that makes 70% of the business largely being driven by what's going on in China. The outlook is not that great.

Credit Suisse has looked at the data coming out of China and found electricity output growth slowed to 5.3% from 7.4% and export growth was 1% in the latest month. Infrastructure and housing appear to be cooling. The yield curve has inverted, suggesting bond market participants view the financial conditions as too tight, prefacing an impending slowdown. Credit Suisse suggests this could get worse before it gets better. Therefore commodity prices have further to fall and this suggests BHP's valuation is not sufficiently compelling.

Credit Suisse's strategy team believes mining stocks, while cheap relative to commodities, are not ready for a positive call on the sector. The analysts are more bearish on 2014 commodity prices than consensus forecasts and, in turn, more bearish on BHP's earnings forecasts. In terms of China, the catalyst will be any fiscal stimulus designed to turn the growth trajectory around. The Chinese authorities are broadly comfortable with a lower rate of growth, in Credit Suisse's view, and will likely only get going when compelled to prop up employment. Credit Suisse expects 6.6% GDP growth for China through the second half of the year.

Coal is taking a turn for the worse. That's Macquarie's view. The analysts expect the forthcoming quarterly hard coking coal contract to settle at a level not seen since the last annual contract in 2009 and the price of US$150 per tonne looks increasingly realistic for the rest of the year. Also, European delivered thermal coal prices have fallen below US$80/t, now at a substantial discount to Asian prices. This may not be sustainable because of low stocks and Macquarie sees this as a buying opportunity for physical and financial market operators.The common theme in both these markets is the US producers with an export bias. They are going to feel the pain.

BHP is reportedly offering July shipments of metallurgical coal at US$147-148/t FOB Australia, down US$5/t on the June price. Macquarie thinks, given Q3 contract negotiations are current, that these reported prices will set a precedent for the market. The forecast for Q3 is US$165/t but the likelihood of a settlement below US$150/t is increasing. The September quarter is expected to mark the lowest hard coking coal contract since the system began in 2010. These levels of settlement will cause pain for both marginal Australian and US exporters. Australian supply has recovered gradually to trend back above 2010 peak levels and US exports have remained strong as they battle for market share in the Pacific.

Something has to give. Macquarie believes the market needs to remove immediate supply to provide a balance in an environment where falling Chinese steel production means there's no "release valve". At the thermal coal face the disparity between European prices and Chinese prices has widened to reflect European prices at a US$20/t discount. This situation has been seen before, but at a time when the Asian coal market and output was relatively strong. This is not the case recently. US exporters look like finding the going tough. There's also an arbitrage opportunity in the market as South Africa's implied spread between the Richards Bay price and the thermal DES ARA price is now heavily negative. One outcome from this is that South Africa is expected to divert more coal towards the Pacific Basin.

There's been further developments on the Chinese proposal for restricting low calorific value coal imports. The speculation comes with great regularity but Macquarie has noted reports that several authorities are working together to draft specific regulations. This is being construed as the clearest signal yet that the ban will be introduced. It looks bearish for the global thermal coal market, in Macquarie's view, and bullish for Chinese producers.

The population of the globe keeps growing but arable land doesn't. On that basis Goldman Sachs is comfortable that the need for fertilisers will continue. Potash will be most resilient.The increased use of fertiliser has been uneven across the three macro nutrients. Global consumption over the period 1980-2010 has grown fastest for nitrogen, followed by phosphate and potash. Different types of soils and crops will require a different balance of nutrients, but Goldman notes soils in China, the southern provinces in particular, are known to be deficient in potassium. At the same time, China is an important producer of vegetables, around 50% of global production, which require more potash than most other crops.

Producer discipline has delivered consistently high margins for potash in recent years and this should continue to sustain prices well above cost support. Beyond the current crop cycle Goldman Sachs expects prices to average US$520/t over 2014-2017. The grip of the two main marketing organisations should weaken as new entrants expand production but will remain in place until 2020 at least.

The two marketers, Canpotex and BPC, compete against each other and sell into the Chinese market in a disorderly fashion. Producers outside this oligopoly enjoy the benefit of the maintenance of high prices but without the restraint on production volumes. Goldman forecasts production capacity to rise to 83mtpa in 2020, from 64mtpa in 2013. The increased competitiveness of the supply side should eventually drive prices to converge towards what Goldman believes is the inducement price level of US$475 in 2018 US dollar terms.

Another fertiliser, diammonium phosphate, is under pressure. Declining prices and new low-cost capacity expansion have increased the importance of the player positions in this market. Incitec Pivot ((IPL)) has cash cost below the non-integrated operators – those without their own supply of phosphate rock or which import phosphoric acid – but at the top end of integrated players. Non-integrated producers account for 25% of global DAP product. Citi analysts estimate the FY13 DAP cash cost of US$430/mt positions Incitec Pivot in the third quartile of producers. The problem is the current DAP price, US$530/mt, has fallen below the cost of production for the non-integrated or marginal producer.

At nameplate, Incitec Pivot's costs should fall to around US$390/mt but they are ahead of US and Chinese producers, which are benefitting from falling input costs. Loss of cheap sulphur and gas could add US$55/t to the company's DAP cash cost, in Citi's view. Cheaper supply is making inroads into the cost curve, helping marginal producers. The average cash cost of production is under US$250/mt, given the benefit of low cost phosphate rock and subsidised gas and sulphur as a by-product from oil production. It all spells pressure for Incitec Pivot to maintain its position on the cost curve.

Factors which are affecting Incitec Pivot's longer-term DAP earnings, in particular, relate to global supply. This is led by low cost North African and Middle East expansion, while China is increasing its exports of fertilisers. The company's cost base has risen significantly, pressured by competition for labour and resources in Australia's mining boom and the high Australian dollar. It has also lowered the realised fertiliser price in Australian dollars. Citi believes that, given the dynamic nature of DAP markets, it is important that Incitec Pivot endeavours to remain low on the cost curve to ensure competitiveness is sustained. The future price of phosphate rock will be a key determinant for marginal producers. Morocco's OCP is the largest exporter of rock to non-integrated producers.
 

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.

Click to view our Glossary of Financial Terms