Material Matters: Iron Ore, Coal Price Expectations Improving, Value In Australian Steel Plays

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By Chris Shaw

To account for recent increases in the capital intensity of iron ore projects, RBS Australia has lifted its long-term iron ore price forecast. The broker has further adjusted its model to account for stronger than forecast spot prices, impacting on its shorter-term estimates as well.

As a result RBS Australia is now forecasting an average price for 1Q11 for iron ore FOB Australia of US$140 per tonne, up from its previous estimate of US$127 per tonne. FOB stands for Free On Board, which means the buyer has to bear all transport and insurance costs from the time the goods pass the ship's rail at the named port of shipment.

Prices are now forecast to strengthen to US$155 per tonne in the second quarter of 2011, before finishing the year at US$136 per tonne. RBS expects prices will be relatively steady in 2012, ending the year at US$129 per tonne, before easing to end 2013 at US$116 per tonne.

The increase in its short-term forecast also sees RBS lift its iron ore price forecast curve through 2015, the result being its long-term FOB price for Western Australian iron ore has increased to US$70 per tonne from US$60 per tonne previously.

At the same time RBS Australia has undertaken a review of Chinese steel demand and now expects this will reach between 1,000Mtpa and 1,110Mtpa in 2020. This suggests increased potential for the seaborne iron ore market to remain tight over the medium term. This would be a positive for global iron ore producers, so RBS Australia retains its overweight recommendation on the iron ore sector.

Preferred exposures for Australian investors according to RBS Australia are Fortescue Metals ((FMG)), Rio Tinto ((RIO)) and Gindalbie Metals ((GBG)), all of which the broker rates as Buys. Rio Tinto is preferred to BHP Billiton ((BHP)) given a cheaper valuation and greater earnings leverage, though BHP is also rated as a Buy.

Fortescue is RBS Australia's preferred pure play given around 30% potential upside to its valuation, while Gindalbie is also viewed positively thanks to a valuation discount, a long mine life and solid expansion potential.

Elsewhere in the iron ore and steel sector RBS Australia rates Iluka ((ILU)) as a Buy, while Mount Gibson ((MGX)) and Atlas Iron ((AGO)), are rated as Holds and Aquila ((AQA)) has been downgraded to Sell from Hold on valuation grounds. Both OneSteel ((OST)) and BlueScope Steel ((BSL)) are rated as Buys, while Sims Metal Management is rated as a Hold.

Credit Suisse has the same ratings on OneSteel and BlueScope but is more positive on Sims, rating that stock as Outperform as well. This follows a review of the sector, which showed the Australian listed steel stocks offer 35-74% valuation upside potential on what the broker suggests are reasonably conservative return scenarios.

The issue for investors according to Credit Suisse is while on a mid-cycle scenario the stocks offer value, how long it will take for the cycle to improve remains uncertain.

For BlueScope, Credit Suisse notes the market is currently implying returns fade from 1% this year to minus 2% by 2015. As this is inconsistent with current consensus earnings estimates there is clear longer-term upside from current levels in the broker's view.

It is a similar story for OneSteel, as Credit Suisse's analysis suggests the market is implying returns ease from 7.4% in 2011 to 2.6% by 2015. This is unlikely in the broker's view as a return of 2.6% would be a lower annual return than the stock has ever generated.

The current Sims Metal share price leads Credit Suisse to suggest the market is implying returns decline from 6% in 2011 to 5.2% by 2015. While this is not a significant fall it does imply weak returns relative to historical levels.

Compared to the positive views of Credit Suisse, the FNArena database shows Sentiment Indicator readings for BlueScope and OneSteel of 0.7 and for Sims of 0.1.

Turning to coal, Deutsche Bank notes a briefing sessions held by energy, mining and metals consultant Wood Mackenzie was mostly positive, as in the group's view there remains potential for further upside in both thermal and metallurgical coal in the early part of 2011. This is primarily due to weather events and currency movements, with the fundamentals slightly in favour of thermal coal at present.

Over the course of 2011 Deutsche Bank's expectation is now for flat pricing for thermal coal, which compares to a previous expectation of prices easing through next year. For met coal the broker's focus is on the longer-term, Deutsche expecting prices could ease between 2011 and 2015 as supply increases, but from 2016 the broker expects demand will outpace supply.

In terms of specific price forecasts, Deutsche Bank is expecting contract thermal coal prices of US$98 per tonne this year, US$110 per tonne in 2011 an US$120 per tonne in 2012. For Hard coking coal the broker's forecasts stand at US$203 per tonne this year, US$238 per tonne in 2011 and US$250 per tonne in 2012.

With respect to its stock coverage, among the Australian plays Deutsche Bank rates both Macarthur Coal ((MCC)) and Whitehaven Coal ((WHC)) as Holds, with respective price targets of $12.80 and $6.90 per share. Consensus price targets according to the FNArena database stand at $12.80 and $7.19, while Sentiment Indicator ratings for both stocks are 0.1 and 0.3 respectively.

Citi points out the heavy rains in Queensland have led to some questions with respect to potential production impacts for the Australian coal plays, with Macarthur and Cockatoo Coal ((COK)) among those most likely to be impacted.

Macarthur is likely to see a 10% loss of production across 2011 on Citi's numbers, which could result in a cut to its net profit after tax forecast of around 13%. There is scope for this to be offset by higher prices though, Citi noting a US$20 per tonne increase in the price of PCI coal would negate the loss of volumes.

For Cockatoo there could also be as much as a 10% impact on output from wet weather, which would see a 26% cut in the broker's net profit after tax forecast to around $3.3 million from $4.4 million previously. Again, this could be offset by higher PCI coal prices in coming months, something Citi sees as possible given lower shipments from Australia are likely to pressure prices higher.

The final word on the coal and iron ore sectors comes from UBS, which has been holding a conference covering the sectors over the past couple of days. With iron ore companies taking centre stage on Day 2 of the conference, UBS notes a key point of interest is infrastructure.

This is especially the case for iron ore juniors, where access to infrastructure continues to be more difficult to achieve than for similarly sized companies in the Australian coal sector. The next producers among the iron ore juniors in Australia are likely to be Gindalbie and BC Iron ((BCI)), with UBS suggesting companies set to produce in the next couple of years are better placed than those where production won't start until 2015 or beyond. UBS rates Gindalbie as a Buy but doesn't cover BC Iron.

For many juniors UBS sees the Oakajee Port and Rail project being undertaken by Murchison Metals ((MMX)) as a key, as this will open up haulage and access for others in the sector as well. A bankable feasibility study for the project is expected in the second quarter of 2011, with first shipments set for late in 2014 or early in 2015.

In the Australian coal sector UBS suggests while infrastructure growth is coming, it will be limited prior to 2012. Much of this will come from the Newcastle Port, while PWCS (Port Waratah Coal Services) is also expanding its capacity. PWCS has indicated only 123.6 million tonnes of an expansion to capacity of 145 million tonnes per annum offers an opportunity for Aston Resources ((AZT)) in particular.

The company has applied for 10.8 million tonnes per annum of capacity at PWCS, with a decision due net month. UBS rates Aston Resources as Neutral, having recently initiated coverage. Overall the FNArena database shows Aston is rated as Buy twice and Neutral once.

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