Material Matters: Iron Ore, AUD And The End Of De-Rating

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– Near term softness for iron ore
– Lower AUD bringing miners back to profitability
– UBS like BHP best on lower AUD
– The sector has found its new valuation base

By Andrew Nelson

As per usual, the outlook for iron ore is a difficult puzzle to put together. Macquarie reports that fundamentals are mixed at present, with steel production remaining solid, but seasonality suggesting it will likely start to fall soon. Iron ore inventories are admittedly low, but not critically so, while steel inventories have come off significantly, but still remain at elevated levels.

Chinese steel production has continued apace over the 2Q, although not as hot as what was seen at the beginning of the year. This is a departure form the norm, Macquarie noting output in April and May usually runs around 5% lower than early year levels. The broker guesses output has been constrained by what are difficult market conditions. That being said, Macquarie does admit that steel production and iron ore demand have run well ahead of expectations so far this year.

It looks like the 3Q is when the story will shift, the broker thinking output will by then start to come off some. Over the past three years, Macquarie points out that 3Q output tends to drop around 4% from 2Q levels. This would also fit in well with the current faltering Chinese economic outlook.

Steel inventories have continued to shrink despite the solid production levels, yet despite the pullback, Macquarie thinks steel inventories have only come back to the level where steel traders started to liquidate stock last year. And what’s worse is that as steel prices have started to firm over the past few weeks, inventory declines have slowed. Macquarie suspects traders are withholding stock from the market in hopes of better prices. This means transaction volumes have dropped.

Macquarie notes there are two conclusions that can be drawn from this. Firstly, it seems higher steel prices are currently not a function of demand pull, which means there’s less chance prices will hold. Secondly, it looks like traders don’t see the need to liquidate inventory based on prices.

The former assertion tells the broker that prices could easily roll over in the near term. The latter supports Macquarie’s view that while there will be further destocking in the 2H, the pace won’t need to be as aggressive as what has been seen over the past few weeks.

China’s current bout of extreme credit tightness could continue well into 3Q, which would be another spanner in the works and would drag down economic activity and thus lower the availability of working capital. The broker expects mills to keep inventories at low levels, or maybe even destock further. This would put an end to the current iron ore sweet spot and would likely mark another leg down before Macquarie thinks it could make a call for a sustainable recovery.

The broker has also taken look at the relationship between iron ore prices and the interest rate curve, noting liquidity expectations are also an influencing factor for iron ore prices. Macquarie points out the spread between 10-year and 2-year interest rate swaps is working as an indicator of how much more tightening or loosening the market is expecting at the front end of the curve. Thus a low spread indicates the market isn’t pricing in any near term tightness.

On this rationale, for iron ore prices to rise the interest rate spread would also have to rise. Thus, a widening spread would indicate monetary policy is easing and this could point to stronger commodities demand. The broker explains looser monetary policy reduces the cost of working capital financing, which increases the benefit for producers to hold inventory.

However, iron ore prices are lifting at the moment despite a widening spread. This tells Macquarie that the market is getting ahead of itself in looking for some form of monetary easing. This is a risky move given the broker expects China’s current liquidity squeeze to run into next month. That will likely indicate, at least to Chinese mills, that now is not the time to restock.

This has the broker predicting that iron ore prices will likely start to soften again, at least in the near term. After that, the broker says it will need to see a combination of rationalised steel production, cleared out inventories and looser monetary policy before we can expect a sustainable iron ore rally. Maybe next month, says the broker.

UBS pointed out in a different note that spot prices are range-trading between US$110-120, China’s steel inventories continue to be drawn down, China’s domestic import price differential is now running close to parity, while domestic output rates and import flows are solid. To UBS, the current situation points to stability and is consistent with a normal tail-end of Asia’s restocking season.

Yet while the broker labels the current iron ore market picture as being “Stable & Normal”, the broker also points out that normal also means a seasonal fall in Asia’s steel production rates in September through October. This will weaken iron ore prices and exposed equities going forward.

What to do? UBS points out that longer-term investors can disregard this type of short-term volatility, while tactical investors may see an expected Q3 iron ore price correction as a buy signal given 3Q softness is usually followed by a Q4 recovery on the back of a pre-winter restocking of bulk commodities.

In a separate note, UBS has cut its AUD forecasts from US$1.04 to US$0.97 for 2013, while 2014 is trimmed to US$0.92 from US$1.03 and 2015 is lowered to US$0.90 from US$0.97. Given commodities tend to be priced in USD, the lower Aussie generally improves AUD based revenue, which means higher earnings.

UBS says the near term upside will especially help out companies in coal, where margins are currently thin given the recent drop in coal prices. This is also the case for companies like BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)) that report earnings in USD. The broker notes earnings may be USD, but the cost base is AUD for the most part.

The broker made sector wide earnings adjustments yesterday and earnings were lifted across the broker’s entire coverage universe, with increases ranging from 10% to 300%. Admittedly, some of the big percentage changes were booked on small earnings bases, but in many cases, the weaker AUD is still pulling some companies back to profitability.

The broker’s view on commodity prices remains subdued, which means despite the AUD tailwind, current prices are pointing to further earnings downgrades if something doesn’t change. BHP and Rio’s low cost bases mean they are the broker’s top pick in the space. Alumina ((AWC)) also remains a Buy given the extra big boost from the weak Aussie. Whitehaven ((WHC)) stays at Buy until there’s news on Narrabri and Maules Creek, while Western Areas ((WSA)) remains UBS’ only nickel Buy.

Analysts at Goldman Sachs were feeling a bit optimistic yesterday, so much so they are predicting the structural de-rating that has been playing out in the mining sector over the past couple of years is now close to an end. The broker notes that after the re-basing seen over the past couple of years, returns are now back at the average levels seen over the 15 years prior to the super cycle.

The broker expects returns to now stabilise at current levels at least through to 2020, despite currently falling commodity prices. Thus, the sector has found its new base.

As far as how to play it, the broker notes currently higher returning stocks should continue to be higher returning through the cycle. To Goldmans, BHP screens the best, with Iluka Resources ((ILU)) and Regis Resources ((RRL)) also looking good. BHP is the stand-out stock in the broker’s coverage given a diverse asset stream, now very strong balance sheet, a much lower risk profile and a still attractive valuation.
 

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