Material Matters: Iron Ore, Steel, Thermal Coal And Nickel

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-Iron ore mid caps fully valued
-Steel production rebounding
-But iron ore volumes will weigh
-Downward pressure for thermal coal
-Underestimating new nickel supply?

By Eva Brocklehurst

China should benefit from improved terms of trade and lower inflationary pressure with weaker commodity prices. A higher trade surplus would reduce the need for large-scale policy easing, in BA-Merrill Lynch's view, because capital inflows from the current account surplus will keep liquidity conditions relatively loose. Major commodity prices have fallen in recent months. In particular, Brent crude has dropped around 26%. As a net importer China should benefit, but there will be winners and losers as upstream industries may suffer a squeeze on margins while downstream industries benefit from lower costs.

Both crude and iron ore are key ingredients in China's terms of trade. China accounted for around 11% of oil consumption worldwide in 2013, according to OPEC data. China is also the largest net importer of iron ore, buying 69% of total seaborne supply in 2013. Merrills believes the divergence in profit growth for upstream and downstream industries in China could widen if commodity prices soften further.

UBS believes a new era of lower iron ore prices is dawning. Historically, the market has been highly concentrated and this has allowed for high margins. New entrants have arrived and oversupply is now enforcing a price correction. BHP Billiton ((BHP)) and Rio Tinto ((RIO)) have low-cost expansions in progress which will allow them to dominate market share, but those that entered the market on the assumption prices would average US$90/t CFR or better will now need to find a way to survive.

UBS has determined break-even prices for iron ore exposed equities but takes this one step further and looks at the price implied by the company's share price. This estimates the iron ore price from today that is needed to make the discounted cash flow valuation equal the share price. Atlas Iron ((AGO)) and Grange Resources ((GRR)) require a price of US$77/t, while Mount Gibson ((MGX)) and Fortescue Metals ((FMG)) require US$75/t and BC Iron ((BCI)) requires US$72/t. Against the broker's long-term iron ore price of US$75/t this suggests these companies are now fully valued.

Goldman Sachs also observes that the shift to oversupply in iron ore has been gradual but the price decline has been abrupt. Low volatility seems to reflect a resistance level among Chinese iron ore producers at around RMB750/t and a substantial price discount on imported material that the market requires. Goldman suspects the market needs to absorb around 100mt of surplus in 2015, roughly double the surplus it absorbed this year via mine closures and re-stocking at Chinese ports. Further pressure on Chinese production is expected as the price differential with imported ore eventually narrows. Should the market continue to require a substantial discount on seaborne ore, and/or capacity closures in China drop below expectations, the adjustment will have to come from seaborne producers and below-trend prices over 2015/16.

Macquarie's survey of China's steel trade shows modest improvement in conditions in October with better sales and falling inventory. Mill orders are contracting less quickly, while profitability appears to be stabilising. Still, purchasing plans remain muted in terms of raw materials. Macquarie expects construction order will improve slightly in coming months. The analysts observe August and September volumes have risen from a trough in July in the cities where high frequency data is available. If this rebound holds up then the "mini" cycle will be remarkable, in the broker's view, for having the highest trough level in the history of the survey data.

The analysts also maintain iron ore price movements are now likely to be determined not only by when mills re-stock but also by where they source their material. Iron ore inventory at the mills is low by historical standards but traders and Chinese miners are still holding large volumes. This has the potential to suppress any upside to spot prices as mill re-stocking is met more by a transfer of stock rather than by sourcing new material from the spot market.

Iron ore is very much the main focus as Merrills reviews commodity prices. The broker expects 2015 and 2016 prices to average US$80/t, with US$70/t possible in the third quarter of 2015 and even a "6 handle" some time during 2015. Meanwhile, Merrills also finds thermal coal prices are challenged by the recent import tariffs imposed by China, which are likely to put downward pressure on global seaborne markets. As China's domestic thermal coal market is more than four time the size of the seaborne market, leverage to policy changes has the potential to be quite extreme, in Merrills' view.

With the Indonesian nickel ore export ban on stream, the challenge is now for China's downstream industry to find other sources. Commonwealth Bank analysts note this is being achieved via high-grade nickel ore imports from the Philippines, developing high-grade nickel pig iron capacity in Indonesia and importing ferronickel from other countries. Stainless steel producers are also changing their mix of nickel inputs. Stainless steel accounts for around two thirds of nickel demand.

London Metal Exchange inventories have risen as banks lose their appetite to finance Chinese nickel imports. This is a a temporary adjustment and will only serve to delay the inevitable tightening of the nickel market, in the analysts' view. This tightness will then give way to a surplus. Beyond the immediate impact of the ban, world nickel output is set to lift as projects commissioned over recent years ramp up production. The analysts suspect the market may be underestimating this new supply and a surplus will emerge by 2016. The analysts are comfortable with a long-term real price of US$10.18/lb for nickel, consistent with the incentive pricing for new nickel projects and a view that nickel laterite projects, which are more costly to operate and develop, will become key contributors to growth in the longer term.
 

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