Material Matters: Commodity Outlook, Steel, Coking Coal, Gold And Base Metals

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

-Is Chinese demand improving?
-Some turnaround signals emerging
-Coking coal price could fall further
-Gold price stabilising
-More nickel closures needed
-Zinc closures doing the job
 

By Eva Brocklehurst

Commodity Outlook

Morgan Stanley envisages better cyclical demand for commodities on the way and historically attractive valuations should turn the tide for resources. The broker has raised its industry view on the sector to Attractive from In-Line and upgraded Rio Tinto ((RIO)) and BHP Billiton ((BHP)) to Overweight.

The basis for the broker's more upbeat outlook is more stable data emanating from China, and a potential uplift form recent financial and administrative policies. The broker is more convinced of a commodity price uplift of 19% by 2017. Morgan Stanley's analysis of outperforming European metals and mining equities before the super cycle began shows the current valuations are very near those periods.

In the next few months Morgan Stanley expects perceptions around Chinese demand will improve. Ahead of the northern winter metal  processing industries de-stock in September and October and this seasonal headwind could mask some of the underlying improvements that are developing to support a recovery in commodity prices.

Iron ore remains a critical cash-flow driver and Morgan Stanley expects seaborne iron ore supply growth will exceed growth in China's steel consumption. To mitigate the impact of the risks the broker's Overweight-rated stocks have either strong balance sheets or continue to generate free cash flow at spot commodity prices.

Fundamentals are not enough to drive equity outperformance and supply discipline is critical to support rising commodity prices but Morgan Stanley expects discipline will be maintained. The broker does not believe all cost savings made to date will be sustainable and expects a partial reversal in cost reductions to further support supply discipline. 

The sector is in need of momentum, Citi maintains. Arguably the large miners are now pricing in an earnings recovery when comparing spot earnings against price/earnings ratios.

The broker notes Rio Tinto is an exception, where consensus earnings are below spot and have been flat-lining for the past five months. Citi suspects this is because of bearish forecasts for iron ore in particular, relative to the spot price. The broker expects that resources share prices have tracked profitability closely and a recovery in earnings could lead to share prices performing more positively.

This is the fourth year of the current downturn and this phase of the cycle has been frustratingly slow, in Morgans' view. There has been a delay in re-balancing of supply because of too much optimism and cost and currency buffers, as well as the rise of China's influence on the supply side.

The broker's analysis suggests that mining equities are pricing in no tangible upside to commodity prices, but considers this is overly bearish. Yet, the broker concedes investors need to witness at least some reversal in current commodity trends to price in recovery scenarios.

A pick-up in cash acquisitions is the strongest positive signal Morgans has observed so far. The broker is not calling the next upturn with any precision but recognises market signals are on the way to confirming the cycle has turned.

There may be further wash-up from the downturn, but equity markets are quite likely to re-rate resources ahead of a slower moving recovery in fundamentals and Morgans is watching closely for those signals to appear.

UBS suspects a bottom may be forming in the market. Year to date the sector is down 8.0% versus the ASX200 which is down 4.0%, and the broker expects a slightly better performance in the final quarter of 2015. The sector continues to focus on cost control but this is getting harder to achieve. Meanwhile, prices may yet go lower before they rebound.

Chinese Steel

New steel export orders fell substantially in September. There were forced closures at steel mills for military celebrations but, even so, ANZ Bank analysts suspect the fall was excessive. October output will also be limited by national holidays. This pre-empts lower export volumes for the month.

Excess steel supply in China should mean lower domestic steel and seaborne iron ore prices, the analysts contend. However, domestic demand is weak and steel output inelastic. The mills continue to max production just to pay substantial debt obligations.

Metallurgical Coal

The price of hard coking (metallurgical) coal is down 28% in the year to date and Macquarie notes it has underperformed thermal coal, which has been historically less attractive. One of the main issues has been a lack of efficient supply adjustment, the broker maintains. Oversupply remains stubbornly high and need to be 10-15mtpa lower than current run rates to achieve a more balanced market.

The broker notes Chinese coking coal imports are subject to protection and have not fallen as much has thermal coal imports.

A more balanced market may be achieved through long-run US exports falling back to levels of the mid 2000's. The upshot is that Macquarie suspects prices have further to fall in 2016. The most likely upside risk at this stage is weather, or labour-related, supply disruption in Queensland, which is the source of around 55% of the world's seaborne trade in metallurgical coal.

Gold

UBS maintains gold price forecasts for 2016 and 2017 at US$1,250/oz, expecting the precious metal to eventually recover. The potential for US real rates to settle lower than in previous cycles could mean a friendlier environment for gold than what is currently being priced in.

The broker expects the Australian gold sector to continue to perform well, benefitting from a lift in the Australian dollar gold prices as well as ongoing improvements in operating costs and, for a few, some well timed acquisitions. The broker upgrades OceanaGold ((OGC)) to Neutral from Sell following a recent share price re-rating.

Base Metals

UBS has cut both copper and nickel price forecasts for 2016 and 2017. Copper forecasts are US$2.50/lb for 2016, reduced by 11%, and US$2.60/lb in 2017, reduced by 13%. While there is some evidence of support from a decline in scrap supply and some acceleration in China's consumption from higher spending on its grid, there is a risk that China's consumption pace remains sluggish. The broker downgrades OZ Minerals ((OZL)) to Neutral from Buy, given the recent share price re-rating.

The broker's revisions to nickel are more substantial. Nickel prices forecasts are downgraded by 31% to US$5.50/lb for 2016 and by 15% to US$6.40/lb for 2017. The broker expects it will take time to achieve the required reductions in production to balance the market. With half the industry loss making production shut-downs are needed.

Exacerbating this is demand growth, which has been soft as a result of weak end-markets for stainless steel. Nickel prices may be languishing at multi-year lows but, if a nadir is indeed emerging, then the broker believes Western Areas ((WSA)) should be on investor radars.

A total of 500,000 tonnes per annum of zinc and 100,000tpa of lead are being idled to preserve the value of Glencore's reserves in the ground, UBS observes. The Century mine is also around 4.0% of mine supply and, having closed, will finish processing stockpiles in the first quarter of 2016.

Price-driven temporary shut-downs are not necessarily a a sustainable driver of price upside but in this case UBS considers the prices of zinc and lead are oversold on the back of speculative factors and the mine closures underpin this view. UBS expects the zinc price will lift to US95c/lb in 2016 from US74c/lb.
 

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