Material Matters: Coal, Iron Ore And Copper

This story features RIO TINTO LIMITED. For more info SHARE ANALYSIS: RIO

-Thermal coal struggling
-Coking coal supply returns
-Iron ore oversupply coming
-Credit Suisse bearish on copper
 

By Eva Brocklehurst

Earning a return on incremental investment in thermal coal mining and infrastructure capacity is becoming increasingly difficult. A sharp deterioration in seaborne demand in the short term means the market has moved into oversupply and caused a downward shift in the cost curve. Goldman Sachs has therefore downgraded price forecasts to US$83/tonne for 2014 and US$85/t for 2015. The outlook is flat until 2017.

Mines are long-lived assets with a long pay-back and investment decisions made today are subject to projections a decade hence. Goldman Sachs believes the position of thermal coal atop the fuel mix for global power generation is going to be gradually eroded. This will come from environmental regulations that discourage coal fired generation, strong competition from gas and renewables and improvements in energy efficiency. The prospect of weaker demand growth and seaborne prices that are near marginal production costs suggest most thermal coal growth projects will struggle to achieve positive returns.

This is why diversified mining companies are now reallocating capital back to more attractive sectors. Even when carbon prices are low or non-existent the downside risks of future regulation can offset the cost advantage of thermal coal relative to alternatives. Demand for coal-fired power generation remains strong in India and Southeast Asia but the number of new plants is expected to decline by the end of the decade. The energy sources Goldman sees having the most potential upside include gas and solar.

What about metallurgical (coking) coal? Macquarie notes prices continue to hover at levels that are 35% lower than at this time last year. Supply is ample and Macquarie suspects this has been the case since late 2011 as Australian exports recovered. Based on the current situation over 50m tonnes of supply needs to be cut to bring balance. It is not new seaborne supply that is the problem, it's the return of existing supply, according to Macquarie. Despite a fall in price, metallurgical coal demand is at record levels. This is almost completely attributable to China as global blast furnace output, ex China, is down 1.1% and the traditional metallurgical coal buying countries are relatively weak. The market has therefore being increasingly reliant on Chinese imports. 

Macquarie notes this demand is not pulling in the global supply so readily. International providers have to compete with Chinese domestic material. Nevertheless, with Chinese domestic hard coking coal prices having dropped below RMB1,000/t for the first time since 2007 there should be some supply response in the near term. It could come from the US, where around 20mt appears to be loss making on delivery to Asia. With major Australian suppliers set to keep contract pricing at current levels, Macquarie suspects the main hope these producers have is that the Chinese domestic supply is cut first.

In  the iron ore market Macquarie finds there are two important themes. The first is that real steel demand has been extremely strong over the first half of 2013 and the other is that the iron ore inventory cycle and steel production cycle are out of sync. Steel production in China has run ahead of expectations and is up 8.6% for the first half, on Macquarie's estimates. There was concern that a lot of this production was ending up in inventory but the second quarter has seen an almost unprecedented rate of steel de-stocking. As a result, total deliverable steel inventory at the end of June was down 5.6% year on year.

Despite this strength the mills de-stocked iron ore aggressively over the first half such that days-of-use inventory at smaller mills was just over 20 days by the end of June. This month this has turned around and the number of days has risen to 23.3, resulting in a significant lift in purchasing activity for iron ore. At this stage, Macquarie does not expect mills to fully replenish inventory and steel production cuts are still expected to occur. What the analysts suspect is that mills are anticipating better supply of iron ore towards the end of the year which should allow for easy re-stocking in the fourth quarter. This will be underpinned by ramped up supply from Brazil and Australia.

Goldman has made significant changes to iron ore pricing forecasts. While fundamentals are adequate in the near term the analysts believe the balance of power has shifted and a structural oversupply should become apparent in the first half of 2014 and with it the absence of a meaningful re-stocking cycle. Goldman analysts forecast 2013/14 prices to be down 5-7% to US$129-108/t.

The International Copper Study group has released data for the copper market balance through April. A refined copper market surplus has persisted in the first four months of the year and to date the estimate is a surplus of 322,000 tonnes, adjusted for seasonality. Macquarie thinks this is overstated. Seasonally the copper market is typically tighter in the first half of the year because of strong manufacturing activity in major western economies. The study does not account for changes in Chinese bonded warehouses in the analysis and these stocks have been falling.

 Macquarie adjusts for the 200,000t fall in Chinese inventory outside of the Shanghai exchange and finds the copper surplus is more around 70,000t. Having said that, Macquarie acknowledges that the study supports the view that the copper surplus will grow substantially over the next 12 months with a negative impact on price. China still represents the greatest copper demand growth and consumption, according to Macquarie's estimates, increased by 12% year to date. This is the only driver of global consumption growth as Europe's consumption is shrinking. European copper consumption fell by 3.4% in 2013 to April. Fiscal austerity is likely to prevent a strong rebound in growth in 2013 although Macquarie is hopeful that European copper consumption will be back in positive territory by the end of the year.

Credit Suisse expects performance by copper producers has set the stage for output to grow by 4% this year, even allowing for the unforeseen disruptions at some mines. The scale of the disruptions, namely at Rio Tinto's ((RIO)) Bingham Canyon and Freeport's Grasberg have been more modest than first thought. Consequently the surplus for the year appears likely to exceed Credit Suisse's forecast 347,000 tonnes. Credit Suisse applies a disruption factor of 6% to world mine supply in 2014 and this removes a hypothetical 1.1mt from the raw annual supply tally and 1.4mt from 2015. If unforeseen losses come in greater than a disruption factor of 6% of world mine supply in 2014 then surpluses could be considerably greater in 2014/15 than the amount projected for 2013.

Combine this with disappointing demand momentum in China and it reinforces the analysts' bearish stance on the copper price for 2013/14. Credit Suisse admits that trying to short copper outright and stay short has been problematic recently. Nevertheless, holding back from entering a short position carries a risk of missing a sharp turn lower in the market. As a result, Credit Suisse suggests investors look at longer tenor options as a way to express a bearish view.
 

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