Material Matters: Oil, Copper, Coal And Iron Ore

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-Oil recovery more like a W
-Hope for copper with China's grid
-Newcastle coal stocks depleted
-But scarcity unlikely to last
-Big iron ore still making money
 

By Eva Brocklehurst

Oil

The recent rally in crude is driven by positioning rather than supply and demand, in JP Morgan's view. Hence, the rally is likely to reverse in coming weeks. The analysts point to storage economics – although a re-emergence of floating storage lessens the likelihood of a capacity-driven dumping of crude into the market in coming weeks – and falling rig counts in US unconventional production as reasons to be cautious about the rally.

Data for January indicates that non-commercial short positions in West Texas Intermediate (WTI) futures are at the highest level since September 2010. The analysts believe participants are focused on the bullish implications of lower capex and less focused on bearish factors in the short term. The commodities team is still predicting a low for Brent crude of US$38/bbl in March, driven by refinery maintenance, but concede this forecast could be a little pessimistic.

What shape will an eventual recovery in oil take? Citi suspects the trajectory may look like a W. Continuing growth in US oil supply and encroaching storage constraints means Citi's commodities analysts envisage a risk for oil to go below US$40/bbl in the June quarter. Longer term, they consider US$50/bbl for oil is unsustainable. More than 50% of proposed new projects are uneconomic at these prices, while corporate cash flows would not be enough to support debt repayments and growth. The broker downgrades 2015 Brent oil forecasts by 14% to US$54/bbl and 2016 forecasts by 1.0% to US$69/bbl.

A recovery is expected to emerge by mid year, when markets start to re-balance. Firstly with an end to inventory build up, and, later, with a period of sustained draw on inventories. As low prices squeeze shale oil output, a price recovery resulting in a robust US supply response will create another dip before a recovery to a new equilibrium is found. The broker suspects prices could fall to around US$45/bbl for Brent and US$35/bbl for WTI, lingering before recovering again.

The broker suspects the oil price is becoming more influenced by the shale revolution than the machinations at Organisation of Petroleum Exporting Countries. OPEC is unlikely to return to its old ways of doing business. Sharp price break-outs are not new, as the inelasticity of supply and demand creates sharp spikes or dips in oil and, for the past 40 years, OPEC has short-circuited any adjustment by cutting output. Now, Citi maintains, unconventional – particularly US share oil – has become the most disruptive geopolitical factor in the markets since the 1970s. As these projects have become more commercially viable they have presented a market share dilemma for the oil producers, particularly Saudi Arabia, robbing them of pricing power.

China, copper and coal

Are there any likeable commodities? That is the question Credit Suisse asks. Chinese steel prices are at 10-year lows and this has pressured iron ore and coking (metallurgical) coal. The broker observes, outside the ferrous metals, copper has succumbed to downside pressure while both aluminium and nickel are depressed. Once Chinese aluminium curtailments take place Credit Suisse suspects alumina prices could fall to US$320/t.

The broker considers copper's fall may be overdone. If the price stays low then forecasts for 1.7mt of refined copper generated from scrap would need to be sharply reduced. Forecast surpluses would then given way to deficits. Credit Suisse expects China's copper demand will increase as the state grid expansion gets underway in the spring, drawing the red metal into China.

Strange as it may seem, a coal scarcity is plaguing Newcastle ports. Credit Suisse notes that thermal coal prices are rising, despite the apparent poor demand and ongoing oversupply. The reason is buyers are having to bid up prices to secure volumes at Newcastle while the scarcity is attributed to a shutdown over Christmas by Glencore that depleted stocks. Buyers have turned to South Africa to fill some of the void and Glencore is now discussing closing its South African Optimum mine so prices may be encouraged further. Credit Suisse does not expect the coal scarcity to last and prices will fall back unless more tonnage exits the seaborne market. One avenue of demand appears to be fading, as Indian coal producers ramp up volumes.

Iron Ore

ANZ analysts observe the 60% fall in iron ore prices may appear excessive but, even at these much lower prices, 85% of the seaborne industry is making money. A perfect storm of substantial new supply and a weakened demand environment has hit more quickly than expected. Traditional high cost Chinese iron ore supply is also not responding.

A key indicator to watch, in the analysts' view, is steel mill profits. Chinese iron ore supply is not expected to be a good barometer for iron ore prices while government taxes are being reduced and mill owners protect output. A high level of vertical integration exists in Chinese steel mills with many owning domestic iron ore supplies. The sharp fall in the past 12 months in the iron ore price has had little impact on their profits.

For the analysts, the next best indicator for iron ore prices is high cost seaborne supply and the rate that it exits the market. The analysts find it difficult to conclude the market is oversold and believe, while large volumes of low-cost supply continue to be commissioned and big miners take a more realistic view on margins, the floor price and long-term assumptions need to be lowered. The analysts are making substantial downgrades to forecasts, expecting 2015 iron ore CIF China will average US$58/t and in 2016 and 2017 it will not track any higher than US$63/t.

The seaborne industry needs to make way for expanded lower cost output and the analysts observe. With the big Australian companies, including BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)), maintaining a 50% market share, and the other large low cost producer Vale unlikely to budge on supply, it will be up to the remaining 25% of producers to rebalance the market.
 

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