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Material Matters: Bulks, Copper, Zinc And Chinese Tightening

Commodities | Feb 24 2011

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

– Push for monthly coal price contracts
– Fundamentals remain supportive for copper, iron ore, not for zinc
– Chinese monetary tightening not a big threat to commodity prices

By Chris Shaw

A trend in bulk commodity markets in recent months has been a shift to shorter-term contracts, with UBS noting recent moves by BHP Billiton ((BHP)) imply pressure is now being applied to achieve a similar shift in pricing in the metallurgical coal market.

Currently met coal is priced on a quarterly contract basis, but BHP has informed its Japanese steel industry customers of its intent to move to monthly contracts from April. UBS expects the new mechanism would likely be a rolling monthly-lagged average price based on a daily reported index.

To encourage such changes UBS sees BHP as likely to offer monthly contracts at a discount to formal quarterly prices, which the broker sees as offering some modest downside risk to short-term price forecasts.

UBS expects BHP will be at least partially successful in such a move, given the company at present controls around 25% of met coal supply. Goldman Sachs agrees, expecting the most likely outcome at present is a headline price of about US$300 per tonne FOB for low volatility hard coking coal. 

Goldman Sachs also expects an increase in the use of hybrid contacts, which incorporate some monthly and some quarterly priced tonnage. Such a change would be helpful for BHP as at present the company faces some volume risks from recent flooding of mines in the Bowen Basin in Queensland. An increase in prices by a move to monthly contracts would therefore offset lower production in 2011.

The end game in the view of UBS is an eventual move to spot pricing, as BHP is strongly in favour of spot pricing for all bulk commodities given the view this represents a more equitable and efficient signal than annual benchmark price contracts. 

Still on bulks, Citi expects iron ore prices will remain strong for some time given the market is entering a sweet spot for demand and there continue to be constraints on the supply side. If current prices last through the end of February Citi expects 2Q11 contracts will be set at around US$182 per tonne, well up from its forecast of a price around US$160 per tonne and market consensus of US$130-$140 per tonne.

While short-term there are some signs Chinese steel mills are baulking at paying current prices for iron ore, Citi's expectation of a market deficit of around six million tonnes this year and 33 million tonnes next year should continue to support prices. 

Also supportive is the ongoing ban on Indian iron ore exports, as this means exports from this market won't be normalised before China's peak demand period. Supply concerns for Australian producers are also evident thanks to adverse weather conditions, while producers in Brazil are dealing with heavy rainfall. 

This leads Citi to suggest iron ore spot prices will remain at current levels until late in the second quarter of this year, by which time Indian exports should resume and demand eases. Any price weakness is expected to be modest, Citi forecasting relatively stable prices of around US$150-$160 per tonne over the next couple of years. 

In the base metals, Goldman Sachs continues to argue there is a compelling case for copper given on a 12-month view demand should outpace supply and inventories should fall. This is likely to see demand rationed to create a more balanced market.

Driving copper prices has been emerging market demand, with China the driving force behind the copper market's recovery. As evidence, Goldman Sachs estimates while OECD demand for the metal increased by more than 6% last year, this compares to a 9.3% increase in emerging market consumption.

Chinese copper consumption may slow to growth of 7.5% in 2011 on Goldman Sachs's numbers, but this should still be well above expectations of 4.7% consumption growth in Western Europe and 2.5% in the US. On the supply side Goldman Sachs suggests the issues of declining grades and a lack of large, greenfields projects should prevent supply from keeping pace with demand shorter-term. 

Higher prices late last year and early this year have seen some de-stocking in China, but Goldman Sachs expects demand will normalise by the middle of the year, which should result in a market deficit of around 600,000 tonnes in 2011.

This supports price forecasts of US464c per pound this year and US494c per pound in 2012, though Goldman Sachs sees scope for a price spike to levels well above these forecasts. To reflect this, forecasts currently factor in prices of more than US500c per pound in the final quarter of this year and the first two quarters of 2012.

To play copper Goldman Sachs prefers PanAust ((PNA)) Equinox ((EQN)) and Sandfire ((SFR)) among the pure plays and BHP Billiton and Rio tinto ((RIO)) among the diversifieds. Sentiment indicator readings for these companies according to the FNArena database stand at 0.3 for PanAust, 0.6 for Equinox, 1.0 for Sandfire and Rio Tinto and, 0.8 for BHP.

In contrast to copper, RBS suggests the fundamentals for zinc remain dismal given an 800,000 tonne surplus in 2010. This brings total surpluses since 2007 to more than 2.3 million tonnes, or about 20% of expected 2011 output.

A further surplus is expected in 2011 and RBS doesn't expect the market will return to a deficit prior to 2013. What won't help the market is the existence of at least 1.5 million tonnes of unreported stock, most likely to be in China. 

Despite these poor fundamentals the zinc price has performed strongly, rising by more than 140% from its low in 2008. But the state of the market sees RBS suggest zinc prices are likely to range trade at best between US$2,000-$2,500 per tonne in 2011/12.

The weakness of the zinc market fundamentals suggest zinc will underperform the other base metals, so RBS suggests the balance of risk favours a short zinc trade at present. 

With respect to nickel, Goldman Sachs suggests stronger prices have increased the chances of some mine restarts in Western Australia. Norilsk has already confirmed it plans to re-commence production at its Lake Johnston project in Western Australia during the June half, while output could also resume from the Black Swan mine as well. In addition, Poseidon Nickel ((POS)) is understood to be considering restarting the Mt Windarra mine.

A recent mineral sands conference was attended by Deutsche Bank and the broker notes presentations at the event supported a positive outlook for market fundamentals for titanium dioxide. The market had been through 20 years of oversupply and weak pricing power but capacity shutdowns in 2008/09 changed the market's balance, this at the same time as demand rebounded.

The acceleration in demand was primarily in emerging markets, driven by a growing middle class and rising per capita incomes pushing up demand for quality of life products. The expense of new greenfield projects means capacity has lagged demand over the past couple of years, so with global inventories at their lowest levels for the past 10 years, Deutsche remains positive on the price outlook for titanium dioxide. Forecasts currently call for price gains of more than 10% through 2012.

This is supportive for the earnings profile for Iluka ((ILU)) in Deutsche's view, so there is no change to the broker's Hold rating. The FNArena database shows Deutsche is among the more conservative on the stock as Iluka is rated as Buy six times, Hold once and Sell once. The consensus price target for Iluka according to the database is $9.22, which compares to a current share price of around $9.85. 

As a final word in terms of a broad outlook for commodity prices, Citi suggests higher reserve requirement ratios in China mean investors should be more cautious over the shorter-term. While the changes in requirements have to date shown no signs of impacting on Chinese growth and therefore demand fundamentals for commodities, the extent of recent price gains warrants some additional caution in Citi's view.

As well, Citi suggests the ongoing correction in emerging market equities could at some point spread to commodities markets given their link to emerging market growth, so forecasts now factor in some short-term price weakness. 

Deutsche Bank has taken this a little further and examined how previous monetary tightenings in China impacted on the commodity complex, the analysis showing mixed results. Three times commodity prices were rising in the run-up to a tightening in policy and only once did prices trade lower in anticipation of rate hikes.

Commodity price performance during rate hike programs has also been inconclusive, though the most relevant appears to be the 2006 tightening cycle. In that period, Deutsche notes crude oil and gold outperformed the industrial metals. 

Deutsche's conclusion is that given monetary tightening to date has been relatively modest and with expectations any growth slowdown will also be modest, any possible negative impact on commodity prices is likely to be limited. 

What supports this view is that supply constraints have tightened certain markets meaningfully, particularly with respect to copper and iron ore. If on the other hand the market starts to punish those commodities most reliant on Chinese demand, Deutsche suggests iron ore, copper and aluminium could be most at risk of price weakness. Uranium, corn and met coal would likely be most resilient in such conditions.

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