Material Matters: Thermal And Met Coal, Iron Ore, Oz Resource Juniors

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

– Thermal coal to benefit more from Japan
– Coal prices generally still heading higher
– Reasons to be bullish on iron ore
– Some value emerging in smaller Oz resource plays

By Chris Shaw

Japan is a major market for Australian coal exports, so the recent natural disasters in that country are likely to have some impact on Australian coal haulage operators. In the view of RBS Australia any potential benefits are most likely to be long-term in nature, as short-term limitations to steel production will largely prevent any immediate impact.

The biggest potential boost for the Australian coal industry according to RBS Australia will be a long-term underpinning of demand for thermal coal. This reflects the expectation Japan and other nations are now likely to reconsider plans for increasing levels of nuclear power production.

Two beneficiaries of increased Japanese coal demand are Asciano Group ((AIO)) and QR National ((QRN)), RBS Australia pointing out both are involved in the haulage of coal by rail. QR National dominates the Queensland market, while Asciano is the larger player in the New South Wales market.

As RBS Australia notes, this means Asciano is more exposed to thermal coal exports, while QR National's primary exposure is to metallurgical coal exports. This suggests Asciano has an advantage, as while steel production and so met coal demand is unlikely to be ramped up significantly, the issues with nuclear power suggest a stronger long-term demand outlook for thermal coal.

This is reflected in RBS Australia's ratings on the two companies, as Asciano is rated as Buy with a price target of $2.03, against a Hold rating and $2.96 price target for QR National. The FNArena database shows Sentiment Indicator readings of 0.5 for Asciano and minus 0.4 for QR National.

While there may be limited direct met coal benefits from the current issues in Japan it hasn't stopped prices strengthening, Goldman Sachs noting there are reports AngloCoal and Posco have settled June quarter PCI contracts at a headline price of US$275 per tonne FOB. This would represent a 53% increase from prevailing quarterly prices of US$180 per tonne.

The weighted average realised price for the quarter will be lower than US$275 per tonne, as the contracts are believed to be for new business only. As well, it is understood Anglo will be required to supply up to half of undelivered tonnage from the March quarter at the prior contract rate of US$180 per tonne.

Regardless, Goldman Sachs notes the PCI contracts for the June quarter would be record high contract prices and would price PCI coal at the upper end of the historical trading range relative to hard coking coal.

While not all contracts have been settled, including those of BHP Billiton ((BHP)), Goldman Sachs takes the view the June quarter settlements are a very positive outcome for met coal producers. 

Across in iron ore, steel industry consultant MEPS suggests under-reporting in the Chinese steel industry implies the market has underestimated China's iron ore demand by as much as 118 million tonnes over the next two years.

The under-reporting reflects the pressure on Chinese steel mills to meet government targets with respect to closing out-dated capacity. MEPS suggests this caused the mills to not fully declare their steel production levels.

Based on this scenario, MEPS estimates Chinese production of crude steel in 2010 may have been as high as 674 million tonnes. This compares to the 627 million tonnes as published by China's National Bureau of Statistics. Supporting the view of MEPS is recent production data, which suggests steel output is currently running at an annualised rate of 706 million tonnes.

If the Chinese steel industry is producing at even higher levels than expected there are ramifications for commodity prices according to MEPS, as strong steel output is likely to keep the cost of key ingredients coking coal and iron ore at high levels.

Australian iron ore players remain bullish in the view of BA Merrill Lynch, at least according to the tone of commentary at an iron ore conference in Western Australia attended by the broker.

Rio Tinto ((RIO)) was one to present on day one of the conference, commentary suggesting the market remains strong as market conditions remain tight. Medium-term the outlook is just as positive, Rio Tinto expecting steel demand will remain supported by reconstruction efforts in Japan. 

Comments by BHP Billiton ((BHP)) highlighted expectations industry expansion plans are falling short of expectations and will continue to do so for years into the future. As the company pointed out, in 2010 only 50% of planned production expansions were realised. 

By 2025 demand should be 1.5 times current levels, while supply will fall short as a result of labour shortages, political risk, capital cost inflation and infrastructure constraints.

Fortescue ((FMG)) was more company specific with its commentary, pointing out the current expansion to 55 million tonnes per annum is on track for commissioning in the June quarter. The target remains 155 million tonnes annually by 2014, with the Japanese situation unlikely to impact in this regard.

Among the Australian iron ore stocks covered by BA-ML, BHP, Rio Tinto, Fortescue, Atlas Iron ((AGO)), BC Iron ((BCI)), Gindalbie Metals ((GBG)) and Grange Resources ((GRR)) are rated as Buys, while Mount Gibson Iron ((MGX)) is rated as Underperform. 

Macquarie has looked more closely at the smaller end of the Australian resources market, attempting to identify value on the back of the recent correction in the commodities sector. A number of stocks have emerged as offering fundamental value at current levels.

Mount Gibson is one, as in contrast to BA-ML's Underperform rating, Macquarie rates the company as Outperform given scope for gains from funded and infrastructure supported near-term production growth.

Grange Resources is also rated as Outperform, Macquarie expecting benefits from continued tightness in the iron ore market thanks to the company's installed pellet production capacity. There is another potential catalyst from any positive outcome related to a possible adjustment in preliminary pellet prices.

While rating Aquila Resources ((AQA)) as Neutral, Macquarie sees value emerging at current levels given operations are in fundamentally tight coking coal and iron ore markets. Asset sales could also provide a boost, helping alleviate remaining funding and execution hurdles.

Macquarie rates Mincor Resources ((MCR)) as Outperform given the potential for near-term exploration success to extend current nickel operations and so act as a potential catalyst. A further potential positive is recent solid copper drilling results at Tottenham in New South Wales.

With respect to the stocks Macquarie suggests offer value at current levels, the FNArena database shows Sentiment Indicator readings of 0.5 for Mount Gibson, 1.0 for Grange Resources, minus 0.3 for Aquila and 0.0 for Mincor. 

Click to view our Glossary of Financial Terms