Material Matters: Copper, Zinc, Iron Ore And Coal

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-Copper demand unusually strong
-Zinc price should improve
-Iron ore demand looks robust
-Lower quality thermal coals key to China
-Chinese coal oversupply easing?
 

By Eva Brocklehurst

Copper demand continued unabated in the September quarter and JP Morgan has now upgraded demand growth forecasts for 2013 to 10%. What the analysts find remarkable is that this occurred in a year when one of the biggest stories was the slowdown in the Chinese economy. China now represents about 44% of global copper use, up from 26% in 2007. Stronger-than-expected demand implies a tighter 2013 global copper balance. OK, China's copper demand is slowing down this quarter, even as production and imports remain strong. This implies inventory accumulation and the fact that global copper inventory is likely to become increasingly concentrated in China by the end of the year. JP Morgan estimates China's share of global inventory was 51% at the end of the September quarter compared with just 15% in 2006, although off the 54% peak seen at the end of 2012.

The analysts do not think copper imports will return to the lows seen in April this year, even when the current re-stocking phase ends. This is because Chinese buyers will be facing a more general global recovery and stronger competition for the metal. JP Morgan analysts expect higher copper cash prices towards the end of the year. Pockets of weakness could occur and what merits ongoing attention is the mine supply growth outside of China.

Morgan Stanley has become more bullish on copper prices. The analysts believes 2014 consensus copper estimates imply the highest global supply in over a decade. This is likely to be optimistic. In fact, the analysts believe the current copper situation is reminiscent of the iron ore market over the past year. Stronger Chinese demand was always a key factor for iron ore but the market also overestimated the producer ability to deliver timely output. At this stage, strength in the Chinese power infrastructure sector is unlikely to offset the copper supply that's coming to market and copper prices are expected to remain flat. Having said that, the analysts believe there is upside to consensus price estimates, which appear to call for the lowest copper price since 2009.

Then there's zinc. Morgan Stanley expects the zinc price could start to perform better earlier than expected. There's a modest pick up in the emerging market and Chinese demand and slower refined metal growth should help soak up the surplus by the end of the year. The analysts believe zinc has one of the best fundamental metal outlooks among the LME complex and, along with lead, sizeable market deficits are expected in 2014. The medium term is about whether supply keeps pace with demand. Many major mines are set to close by the end of 2016 and prospective miners and existing producers face financing challenges and capex constraints. This is offset by a pick up in Chinese construction where demand has outstripped supply and the rebound in domestic output has fallen short. Morgan Stanley notes China is on track to record the largest net import numbers for refined zinc since 2009.

Chinese steel demand continues to surprise to the upside. Apparent steel consumption in September grew at 12% annualised. Underpinning this, Credit Suisse came away from a visit to China with the view that the government intends to accelerate infrastructure development in tier 2 and 3 cities, paying heed to ports, metros and rail. Year-to-date imports of iron ore by China now total 601mt, up 9% on last year. The analysts still expect a moderation in China steel production rates towards the end of the year and with iron ore on the water, port inventories should continue to rise from recent low levels.

Credit Suisse's base case assumes China steel production in 2014 of 805mt and the flex case assumes 840mt. All else is unchanged. What's the pricing impact? The forward curve is pointing to an average price for China iron ore fines of US$121/t in 2014 and this compares with Credit Suisse's base case of US$104/t. If the flex case is correct, then US$120/t looks achievable in 2014 and the analysts would expect prices to average around US$110/t in 2015. It spells out a strong case for Australia's iron ore majors with Fortescue Metals ((FMG)) having the most leverage followed by Rio Tinto ((RIO)) and BHP Billiton ((BHP)).

Macquarie has reviewed the thermal coal import arbitrage into China, comparing the high quality coal differential would suggest little impetus for imports. Yet imports have hit record levels. Macquarie suspects the sub-bituminous and off-spec coals offer a more valid comparison. Macquarie has questioned the durability of the current rebound in the price of thermal coal, given Chinese prices have eroded well into the domestic cost curve since the middle of the year. Nevertheless, heading into winter, where reliance on coal-fired power generation is high, the recent price rebound suggests that, on arbitrage alone, demand for imported coal should remain resilient.

Making this point, the commonly noted arbitrage between the Chinese domestic 5,500kcal coal and FOB 6,000kcal benchmark is not representative of current trade flows. Macquarie believes the 6,000kcal Australian coal is of little relevance to the Chinese market. It primarily ends up further east, in Japan. Chinese utilities are bargain hunters and, until any import restrictions are imposed on low-spec coals, they are open to nearly all coal qualities if the price is right. Hence, more accurate arbitrage calculations involve looking at Indonesian sub-bituminous and Australian mid-CV/high ash coals. The wash up is that current import fundamentals are mixed. The arbitrage to import is there but may fade if the rally in Chinese prices is not maintained. Seasonality should be supportive, but Macquarie suspects stocking cycles are not aligning in the way some market participants would have been hoping for.

Morgan Stanley's take on Chinese coal is that the proposed changes that focus on safety should ease persistent concerns about oversupply. Furthermore, these measures could also help mitigate potential negative market impacts of the proposed abolition of the 10% export coal tax and reduce the risk that excess domestic production will flow into international markets. One item is particularly significant. This is the proposal to shut down 2000 operating (small) coal mines by the end of 2015. In addition, approval for new, small coal mines and medium-sized coal and gas outburst mines will cease. The analysts estimate that around 10% of  China's current production will eventually be affected by this measure. 

The two key coal provinces (Shanxi and Inner Mongolia) already have a minimum size limit of 1.2mtpa. Shanxi has already moved to stop all mines that are under construction and overhaul safety procedures. This proposal is positive for coal prices and should slow production growth, but the changes are likely to be more positive for seaborne metallurgical (coking) coal than for thermal coal, given the specific measures aimed at Shanxi province in recent days. Shanxi is the most significant coking coal province. The effect on thermal supply is likely to be felt only after the abolition of the export coal tax in January.
 

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