Material Matters: New Pricing Points For Oil, Iron Ore

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By Chris Shaw

Having broken out of its previous trading range of US$70-$80 per barrel, oil prices are now consolidating around the mid US$80 per barrel level. This move is in line with the Barclays Capital view prices will establish a new trading range of US$80-$90 per barrel.

In the view of ANZ head of commodity markets Mark Pervan, this consolidation is a reflection of the market trying to again establish equilibrium. At present, Pervan sees two main factors the market needs to reconcile, these being slack short-term demand fundamentals given high US oil supply, and stronger emerging demand as China continues to lift its imports.

Barclays notes Chinese oil demand remains robust, expecting demand growth in this market to come in at around 620,000 barrels per day through 2010. This looks achievable as Commerzbank points out Chinese oil imports in March were 4.98 million barrels per day, which is up up 29% from last year. The strength of this demand may cause OPEC members to exceed output quotas in the bank's view.

What it has done is bring additional speculative interest to the oil market, Barclays noting non-commercial positions in the NYMEX crude market have risen by 11,000 lots in the past week to be approaching record levels.

Commerzbank also noted this trend, taking the view the increase in long positions in oil means traders continue to pursue a long oil/short natural gas strategy.

Having reviewed oil price activity for the first quarter, Macquarie notes prices were slightly stronger than it had forecast for the period. In coming months the broker sees price risk as to the upside given an optimistic view on global oil demand growth, especially given support from emerging economies and China. There is also the potential for US consumer spending to recover at a faster pace than currently expected.

Macquarie now expects oil will average US$87 per barrel in 2010, up from US$86.50 per barrel previously. Forecasts of average prices of US$90 per barrel in 2011 and US$98 per barrel in 2012 are unchanged.

The minor changes to Macquarie's oil price forecasts mean similarly modest increases in general to its earnings estimates across the energy sector. These have had little impact on price targets and Macquarie continues to prefer Oil Search ((OSH)) and Australian Worldwide Exploration ((AWE)). Both are rated as Outperform, as are Santos ((STO)), Beach ((BPT)), Tap Oil ((TAP)) and Nexus Energy ((NXS)).

In contrast, Macquarie rates Woodside ((WPL)) as Neutral given the stock is trading at a 4% premium to its estimated net present value. The broker also rates both Roc Oil ((ROC)) and Innamincka Petroleum ((INP)) as Neutral at current share price levels.

Just as oil has broken out of its previous trading range, there is a similar shift in iron ore pricing, with the market now moving away from annual benchmark contracts to quarterly pricing. Citi suggests eventually the move will be to index pricing, meaning a structural change in the market.

As prices move to shorter-term contracts, Citi suggests prices are likely to double in the second quarter of 2010 before rising further in the third quarter. Beyond this time the stockbroker expects an increase in Chinese production, higher scrap consumption and margin compression in the steel industry to pressure prices. On Citi's estimates oversupply in iron ore looms from 2012.

To reflect the new contract structure in iron ore, Citi has adjusted its forecasts, lifting its iron ore fines contract price estimate for June by 19% to US$143 per tonne. For the December quarter its forecast has risen 30% to US$130 per tonne, a level it expects will be maintained through 2011.

ANZ's Pervan is also positive on the iron ore price outlook shorter-term, expecting prices will gain as traders react positively to the new quarterly system for contract pricing.

Pervan suggests steel mills are viewing the data the same way as there is evidence of a drawing down on port stocks of iron ore. With the steel market entering what is typically a seasonal uptick in demand, he sees more upside on offer.

Following the changes to its contract price forecasts, Citi continues to rate BHP Billiton ((BHP)) and Rio Tinto ((RIO)) as Buys, lifting its price targets on both stocks to $55.00 from $50.00 and to $100.00 from $85.00 respectively.

For BHP, Citi likes that iron ore will be a major driver of group production growth in coming years. As well, the fact the proposed iron ore joint venture with Rio Tinto would deliver a number of synergies, but is only a minor negative if the deal doesn't receive regulatory approval also limits any downside.

With respect to Rio Tinto, Citi notes while the company has only now re-started work on Pilbara iron ore expansions there is still value on offer as the stock is trading at a discount to its estimate of net present value.

Among the Australian iron ore plays Citi also rates Fortescue Metals ((FMG)) as a Buy with an increased price target of $6.30, up from $5.60. For Fortescue it notes higher realised prices improve group cash flow, making the funding of expansion options easier.

RBS Australia also rates both BHP and Rio Tinto as Buys, although the broker suggests Rio Tinto is the significantly cheaper option at current levels. This partly reflects a larger iron ore business and less diversification with respect to group earnings on the part of Rio Tinto.

While RBS sees BHP as the superior company, the analysts suggest the discount at which Rio Tinto is currently trading to BHP is excessive, as it is around 20% on an earnings multiple basis. As well, on an EV/EBITDA (enterprise value to earnings before interest, tax, depreciation and amortisation) basis Rio Tinto is at an average discount to BHP of 18% through to 2013.

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