Material Matters: Miner Taxes, Steel And Oil

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-More tax uncertainty for miners
-Steel price hikes not sustainable
-Aust oil producers price-in lower Brent
-Russia fine tunes oil strategy
 

By Eva Brocklehurst

A change at the helm of Australia's government has signalled more uncertainty for miners. The return of Kevin Rudd to the role of Prime Minister will bring changes to the Mineral Resources Rent Tax (MRRT) and the carbon tax in an attempt to stave off a disaster for Labor at the upcoming election, in UBS' view. Furthermore, the Liberal opposition will repeal those taxes if it wins the election.

Of the two, MRRT has the biggest impact on iron ore miners. UBS estimates it is only being paid when iron ore prices rise above US$120/tonne and principally by the higher margin producers. This means BHP Billiton ((BHP)) and Rio Tinto ((RIO)) pay most. The tax, since introduction in July 2012, has delivered less than the government expected as iron ore prices declined significantly and mining costs rose. The worst case scenario for the miners, in UBS' view, is if Mr Rudd seeks to repair Treasury's balance sheet by imposing a more punitive tax, such as the original Super Profits Tax he proposed as Prime Minister in 2010. No other Australian iron ore producer is expected to pay MRRT, given higher cost bases and lower margins. The coal industry is also not expected to pay. Hence, there is no material impact from removing the MRRT on valuations for the sector.

In the case of the carbon tax, UBS suspects Mr Rudd may move to a floating tax sooner than the current scheme allows (2015). This should be good for business and coal miners, the most affected, should be the biggest beneficiaries. At the time the scheme was launched the Australian government expected the carbon price would be over $25/tonne by 2014. It now estimates it will be more like $12-15/t. At present, coal companies are sustaining an average US$1.50-2.00/t increase to their cost base.

If a Coalition government under Tony Abbott remove the taxes UBS expects a positive impact of around 3% on the earnings of Rio Tinto and BHP in 2013-15. The removal of the carbon tax should impact earnings of Glencore Xstrata by 2-3% and Anglo American by 1%. The removal of the carbon tax could also help Rio Tinto exit the Australian alumina/aluminium business, Pacific Aluminium.

Steel markets have more regional price and demand dynamics compared with commodities such iron ore but ultimately price divergence leads to exports increasing from lower-priced regions. Therefore, Citi contends that the recent price hikes implemented by US producers are really only sustainable if global dynamics remain supportive. European hot rolled coal prices are at their lowest since early 2010 and the market is seasonally quiet. The current spread to the US is US$95/t.

Citi expects European producers will be looking to offload volume into the more lucrative US market. Meanwhile, Chinese prices are around US$500/t, the lowest since late 2009, and this adds further pressure to the market. Citi notes a similar price divergence in late 2012 was followed by a decline in US prices and improvement in European and Chinese pricing. In the absence of improving demand prospects in China and Europe, a normalisation of pricing between regions is the more probable outcome.

Oil demand in emerging markets is under pressure. The oil price is now at record levels in local currency terms for India and Brazil. A potential credit crunch could pressure Brent crude pricing but in BA-Merill Lynch's view the market is becoming overly pessimistic, particularly given the positive impact of the weakening Australian dollar. The analysts forecast Brent at US$105.41/bbl in 2013 and US$100/bbl in the long term. For West Texas Intermediate the price forecast is US$92.4/bbl in 2013 and US$90/bbl over the longer term.

On this basis, valuations for Australian oil sector stocks are seen well supported by current prices. BA-Merrill Lynch finds, aside from Woodside Petroleum ((WPL)) at a 7% premium and Oil Search ((OSH)) at a 1% premium, all stocks are trading a a discount to core net present value.

The commodities team at BA-Merrill Lynch sees an increasing possibility that Brent will slip to US$90/bbl because of changes to the US Federal Reserve's zero interest rate policy, a credit crunch in China and weaker emerging market currencies. While the US may be ready for higher rates, the global economy faces declining aggregate demand growth and high energy prices. The Fed appears to be less concerned about any side effects outside the US of a change in policy.

Chinese buyers are the only ones facing lower oil prices in local currency terms compared with the US. BA-Merill Lynch's analysis suggests that demand in China for resources is closely connected to conditions in loan growth. If the credit crunch continues, commodity demand will invariably suffer. The developments in China are a concern as this country represents anywhere between 10-60% of the market for many commodities. Moreover, other emerging markets are potentially facing a cash squeeze over the next few months and commodity demand could suffer because of a stronger US dollar and weaker credit growth.

Of comfort is the fact that Australian names are pricing in the pessimistic scenario for Brent. Among the large caps the implied Brent price is 17-21% below spot. For the smaller caps it is 19-47% below. Moving to the more bearish US$90/bbl scenario, this discount still persists with implied Brent pricing at 7-40% below this level. On this basis BA-Merrill Lynch considers the sector oversold.

More on the oil theme and it appears Russian demand has been hit by slowing industrial production. A pick-up in growth is expected in the second half but longer term initiatives to lower oil use in transport could weigh on demand. For JP Morgan the most significant development lies in Russia's refinery modernisation. Russia's diesel and gasoline output is expected to meet Euro 4 and 5 standards by 2015. Higher gasoline quality would imply less naphtha consumption. This could lead to sustained tightness in fuel oil and sour crude markets west of Suez.

Oil market dynamics are centring around the deceleration of emerging market demand growth and the rise in North American unconventional crude production. This is pressuring OPEC output amidst rising capacity and spare capacity is building in the group for the first time in years.

Russia has historically been a large exporter of crude and refinery feedstock but is being challenged in the west and the country is increasingly looking to Asian markets. Developing new markets in Asia, following completion of the East Siberia Pacific Ocean (ESPO) pipeline and long-term forward sale agreements with Chinese oil companies are an aspect of this reality, JP Morgan observes. So too are initiatives to switch demand to natural gas from oil at home.

In JP Morgan's opinion Russia needs to invest in greenfield capacity and carefully manage its mature or heavily depleted fields, which are dragging down aggregate production, in order to stay a major presence in the market. The government's tax structure and fiscal incentives are viewed as necessary to keep output on a steady upward trajectory.
 

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