Material Matters: Enery Substitution, Oz Steel, Oil Upgrades, Copper, Silver and Gold

This story features BLUESCOPE STEEL LIMITED, and other companies. For more info SHARE ANALYSIS: BSL

– Japan's nuclear issues to see large scale energy substitution
– Oz steel plays
– Oil price forecasts lifted
– Copper prices and demand
– Silver more vulnerable to near-term reversal

By Chris Shaw

According to BA Merrill Lynch, the earthquake in Japan is likely to have a relatively limited impact on total Japanese energy demand. What is likely to result is large scale energy substitution, with LNG and oil use in electricity likely to grow in the near-term.

As BA-ML points out, the quake and resulting tsunami has shut down 9.7GW of nuclear power, with much of this capacity not likely to come back in the next 12 months at least. This should see a pick up in LNG imports to as much as 7.1mmtpa, which equates to around 1bcf/d. 

As well, demand for low sulphur (sweet) fuels for power generation should increase by at least 140,000 barrels per day at least temporarily. BA-ML also suggests Japanese thermal coal demand could increase by a modest one to two million tonnes in 2011.

Major accidents such as the Three Mile Island disaster in 1979 can significantly alter long-term energy policy and, while early, BA-ML sees scope for the current issues at the Fukushima nuclear plant in Japan to have a similar impact.

While China has indicated it will continue with plans to increase its nuclear energy capacity, Germany has announced a moratorium on the extension of 17 old nuclear plants. While reaching any long-term conclusion is difficult, BA-ML suggests one possibility is upward pressure on UK natural gas, thermal coal and European carbon emissions prices.

In terms of the outlook for Japanese GDP, BA-ML notes a recent World Bank study shows earthquakes don't have a significant effect on GDP growth, especially in developed economies. While Japanese GDP cold temporarily rebound on reconstruction, the broker's analysis suggests the economic effect is likely to fade after two years.

The earthquake may have a greater impact on bulk material markets, as BA-ML notes Japan is a major steel producer accounting for about 8% of global production. Shorter-term, severe port damage and ongoing power shortages may result in steel production losses, but excess capacity in Japan as well as China and Korea is likely to provide an offset.

Near-term imports of thermal coal may slip as Japan has lost about 7.5GW of thermal coal power generation and 15mtpa of thermal coal demand. With limited ability to lift thermal coal power production at other facilities, BA-ML suggests LNG may be better placed to fill this gap.

Post the earthquake BA-ML has maintained a price forecast of US$125 per tonne, while the broker's long-term thermal coal price forecast is retained at US$100 per tonne. For met coal BA-ML is forecasting prices to ease to US$300 per tonne following the recent record settlement of US$330 per tonne. 

Iron ore prices are forecast to ease to US$140 per tonne over the June quarter from current spot prices of around US$167 per tonne. As BA-ML notes, China and India remain the major drivers of prices in bulk commodity markets.

In terms of the impact on Australian steel plays from changes to steel and iron ore price expectations, Deutsche Bank suggests BlueScope Steel ((BSL)) remains profitable at current prices, costs and currency levels.

Assuming increases in hot rolled coil and iron ore prices in the second half of this year, Deutsche expects a significant turnaround in earnings for BlueScope. Second half of 2011 net profit after tax is expected to be $65 million, compared to a loss of $55 million in the first half.

Bluescope is Deutsche's pick in the sector, being rated as Buy, while both OneSteel ((OST)) and Sims Group ((SGM)) are rated as Holds. Sentiment Indicator readings for the three stocks according to the FNArena database stand at 0.7 for BlueScope and OneSteel and minus 0.1 for Sims. 

Elsewhere in commodities, BA-ML has lifted oil price forecasts for Brent crude to US$122 per barrel for the June quarter, This is up from a previous forecast of US$86 per barrel and reflect the recent Libyan oil supply disruptions. For 2011 overall the broker is forecasting an average Brent price of US$108 per barrel, up from US$86 previously.

UBS has also adjusted oil price assumptions, lifting it 2011 Brent forecast to US$103.75 per barrel and its long-term forecast to US$95 per barrel. These compare to previous forecasts of US$85 per barrel in both cases and reflect the view both stronger demand and increased sensitivity around geopolitical risks to supply. Both factors suggest higher prices are appropriate.

The changes to oil price expectations have an impact on earnings forecasts among the Australian oil plays in UBS's coverage universe, with estimates being increased for both large cap and mid cap producers.

Among the large cap plays, UBS notes Oil Search ((OSH)) gains the strongest earnings benefit, while Woodside ((WPL)) and Santos ((STO)) gain most from a valuation and price target perspective. In the smaller caps the broker sees strong oil price leverage for both Tap Oil ((TAP)) and Beach Energy ((BPT)). 

Following the sector review UBS has upgraded Australian Worldwide Energy ((AWE)), Beach and Roc Oil ((ROC)) to Buy ratings from Neutral previously. Horizon Oil ((HZN)), Oil Search, Santos, Tap and Woodside remain as Buys, while the broker continues to rate Caltex ((CTX)) as Neutral. With the exception of Caltex price targets have also been increased.

The FNArena database shows Sentiment Indicator readings for the stocks of 0.9 for Santos, 0.8 for Horizon, 0.5 for Oil Search, 0.4 for Australian Worldwide, 0.3 for Roc, 0.2 for Beach and 0.0 for both Tap and Caltex.

Turning to metals, for some time Goldman Sachs has had a preference for copper among base metals given expectations of a tight market for the foreseeable future. This has supported Buy ratings on both BHP Billiton ((BHP)) and Rio Tinto ((RIO)), copper making up 18% of the broker's value for the former and 12% for the latter.

But assuming a tight market, does this mean prices rise to ration demand because there is not enough supply, or is there a supply response? Goldman Sachs is at present forecasting a price that effectively destroys demand until, as new projects come on-line, the market moves into an oversupply position. This will cause a subsequent fall in prices.

Goldman Sachs is forecasting a long-term copper price of US$2.28 per pound in 2016 dollars and using this price expects BHP Billiton will likely to adopt a 'steady as she goes' strategy. This suggests maintenance of production, incremental growth though increased concentrators and some phased growth. Longer-dated, more capital intensive and technically challenged projects such as Olympic Dam are likely to be continually pushed back under such a scenario.

In Rio Tinto's case, Goldman Sachs expects a bit more pushing of the curve as the company continues to look for growth outside of its iron ore operations. But the fact both companies also offer exposure to strong steelmaking raw material prices as well leads Goldman Sachs to suggest both stocks should outperform more pure copper plays.

Most in the market agree, with BHP Billiton scoring a 0.8 Sentiment Indicator reading in the FNArena database and Rio Tinto a 1.0 reading.

On precious metals, Citi has looked at the relationship between gold and silver prices, particularly in light of silver having outperformed gold significantly since the start of the economic upturn. Partly this is because silver is less liquid than gold, meaning the weight of money effect has been stronger when compared to gold.

In Citi's view this reflects both a growing investor appetite for silver given the metal is much cheaper than gold, as well as silver benefiting from rapidly expanding use in applications such as electronics, solar panels, batteries and plasma screens.

Silver's key supply and demand statistics looks strong, Citi noting silver's industrial applications now consume 60% of mine supply, up from 50% before the credit crisis. While supply should increase this year, so too will industrial and investment demand in the view of Citi.

Based on its estimates, Citi suggests silver's strong fundamentals are now being priced in by the market. As evidence of this the broker notes the gold/silver ratio has fallen to its lowest level in many years.

This change in relative value has, in Citi's view, left silver more vulnerable to a near-term reversal.  

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