Material Matters: Oil, China, Thermal Coal And Iron Ore

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-Oil supply to remain elevated
-Copper, steel most positive in China
-Positive spin on coal settlement price
-But pressure renewed in coming months
-Bell Potter downgrades FMG to Hold
 

By Eva Brocklehurst

Oil

A lead indicator of US oil production, the Baker Oil Rig Count, has fallen 50% since October 2014, ANZ analysts observe. The decline in rig activity is considered a signal of tighter oil supply and has propped up prices in the March quarter. Nonetheless, the analysts note that a drop in output, expected as a result of the decline in rig activity, has not occurred. On the contrary, US tight oil production continues to rise, pushing up crude oil inventories to the highest levels since 1982. The analysts maintain there is a change in the relationship between oil rig activity and oil output in the US. While supply is likely to tighten over 2015, technological improvements and profitable hedging strategies mean this movement will be milder and/or delayed.

US oil producers now have much more pricing control on the global stage, with US oil supply increasing by 60% over the past three years. Moreover, a surge in the number of wells drilled and the backlog of wells to be completed since 2013 means oil supply is likely to remain elevated or even rise in the near term, the analysts maintain. The analysts forecast total tight oil production in 2015 will be at similar levels to 2014.

China

Macquarie analysts have returned from a visit to China and become more bearish. They conclude that a slowing of economic activity and a greater focus on the structural slowing of major end use sectors such as property will have an impact on commodity demand. Environmental restrictions are also a major theme, with plants shut down in Hebei and Shandong. The most positive stories emanate from steel, where industrial reforms and recent shutdowns have tightened the market, and the commitment on infrastructure, with modest growth in power distribution investment, which has positive implications for copper. Otherwise the broader slump in demand was at the forefront of the visit.

Effects of a slower housing market are showing up in the macro data and historical comparisons suggest China is moving into a softer growth phase. A view was also put to the visitors that low commodity prices would have more of a negative impact on China’s growth than a positive one. This stems from the fact that Chinese consumers are less exposed to items such as the oil price and their overall energy expenditure is lower. China is a major producer of commodities and lower corporate profits will mean less investment in return. This will also flow through to lower wage growth which, the analysts maintain, has potential to drag down consumption growth rates.

In order to lower production costs for producers, China is reducing industry use power price and iron ore resource tax rate, effective May 1. The government has also decided to reduce coal-fired electricity on grid pricing. The lower power price will be positive for aluminium producers that have higher dependency on grid power, in Morgan Stanley’s view, but as the power source varies among producers the cost reduction will also vary. The lower iron ore tax is not considered material but is expected to help struggling domestic producers.

Thermal Coal

The Japanese fiscal year thermal coal contract, a key earnings driver for Australian producers, has been settled at US$67.80/t, a year-on-year decline of US$14/t. Macquarie believes this should be interpreted as a triumph for Australian producers as in Australian dollar terms the settlement is marginally higher and, combined with lower cash costs, represents margin improvement in a very weak market. The settlement is also at a larger-than-usual premium to spot and forward Newcastle prices.

Macquarie notes the premium to the forward curve is particularly stark and the result of a dramatic shift in expectations for thermal coal over the past year. The analysts observe a market which appeared to be in almost perennial contango – future prices higher than spot prices –  is now firmly in backwardation – where the spot price is higher than the forward price. Macquarie believes the artificial tightness in the Newcastle spot market will disappear completely and spot prices will come under renewed pressure in coming months. The reasons for this involve Chinese market conditions and the cost curve.

Chinese contestable coal demand will come under increased pressure from a substantial build of UHV power lines from inland China’s coal fired power stations, while stricter quality checks at the ports, an import tax and orders to import less coal are showing no signs of being changed. Macquarie also notes, while the cost curve has fallen 15-20% recently, the market has traded well into the cost curve for 2-3 years yet almost no seaborne supply cuts materialised. Hence, the market needs to reduce tonnage and the broker expects spot prices to trade lower in the short to medium term.

UBS considers the outcome of the Japanese settlements reasonable, given a large portion of Australian coal mining costs are denominated in Australian dollars. While the currency continues to support Australian miners, the broker acknowledges the fundamental outlook is subdued for coal. China’s withdrawal from seaborne trade, cost cutting, producer loss tolerance and closure costs are culminating in more supply for longer across the US, Canada, Australia and China. Meanwhile, slowing demand growth looks like weighing on prices in the near term at least.

Iron Ore Producers

In Australia the Port Hedland Port Authority has released its March statistics revealing monthly iron ore shipments were up by 2.6% over the month at 36.6mt and up 6.3% year on year. Iron ore shipments to China amounted to 31.2mt. Bell Potter has decided to reduce Fortescue Metals ((FMG)) to Hold from Buy as iron ore prices have fallen a further 19% since March and the company has withdrawn its planned debt offering, which would have extended the maturity profile and reduced the interest cost. The broker remains of the view that Fortescue still has time to refinance or take up other options but acknowledges uncertainty has increased.

The broker retains a Hold, Speculative rating for BC Iron ((BCI)) as, while cash flow is negative at current prices, the company has sufficient funds to endure the current price of iron ore for at least 12 months. Meanwhile, Atlas Iron ((AGO)) is in voluntary trading suspension while undertaking a business review. The results of the review are expected in the next two weeks and negotiations with senior creditors are expected to drive the outcome. Bell Potter’s Sell, Speculative rating is unchanged.
 

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