Material Matters: Iron Ore, Thermal Coal, And Base Metals

This story features MOUNT GIBSON IRON LIMITED, and other companies. For more info SHARE ANALYSIS: MGX

– Tight supply to keep iron ore prices elevated
– Germany phasing out nuclear power a positive for thermal coal
– Possible changes to aluminium warehousing regulations
 – Macquarie updates on lead

By Chris Shaw

According to BA Merrill Lynch, iron ore supply is likely to disappoint on the downside near-term as miners continue to struggle with project bottlenecks on previously announced expansion plans. Cuts to production estimates have been particularly aggressive in the more labour and infrastructure constrained markets such as Australia and Brazil, with most cuts to supply coming from the major producers in these regions.

With China dominating high cost production in bulk commodities generally and iron ore in particular, the price responsive nature of operations meaning China acts as a balancing item for the global market. BA-ML expects this trend will continue, with Chinese output filling in any gap in the market while also supporting a continuation of higher prices over the next three years.

This volume impact is a positive for prices over the medium-term. BA-ML has lifted its iron ore fines price forecasts by 20% in 2011 to US$174 per tonne and in 2012 by 31% to US$170 per tonne. Forecasts in 2013 have been lifted 33% to US$160 per tonne. BA-ML also has a new long-term price of US$90 per tonne, up from US$75 previously.

What this means, according to BA-ML, is iron ore producers will enjoy significant net benefits, as the price increases are enough to offset lower production expectations. Earnings forecasts and price targets have been adjusted to reflect this, with BA-ML's targets rising across the sector with the exception of Mount Gibson ((MGX)). 

The largest increases are for BC Iron, where BA-ML's target has risen 10%, and for Gindalbie ((GBG)) and Grange Resources ((GRR)), where price targets have increased by 11%. The impact for the larger plays such as BHP Billiton ((BHP)) and Rio Tinto ((RIO)) is more modest, with targets rising 2% and 4% respectively.

Preferred plays in the sector for BA-ML are Atlas Iron ((AGO)) and Fortescue Metals ((FMG)), as both companies have low execution risk in reaching their production targets with funding and infrastructure secured. 

In the steel sector BA-ML sees little associated impact, as higher input costs from increases to iron ore prices will be passed through to customers. BA-ML has made minor cuts to forecasts for BlueScope ((BSL)) and lifted estimates for OneSteel ((OST)) slightly, while retaining respective ratings of Neutral and Buy. With little earnings impact on Sims Group ((SGM)), BA-ML retains a Buy rating.

Elsewhere in the iron ore plays, Morgan Stanley has upgraded to an Overweight rating on Fortescue. This is within an attractive view on the Australia Metals and Mining sector.

For Morgan Stanley, the current Fortescue share price is discounting long-term production of around 130Mt annually from FY14. This is well below the broker's forecast for output by this time of 150Mt per annum and guidance from Fortescue of output of 155Mt.

A relatively bullish view on iron prices is also supportive, as Morgan Stanley expects tight supply will continue to keep prices at elevated levels. An iron ore fines forecast price of US$178 per tonne for FY12 is about 5% above market consensus.

This implies value for Fortescue, as Morgan Stanley's numbers suggest an earnings multiple of around 4.0 times in FY14, this compared to a peer average of around 7.0 times. While management has offered a bullish case for a potential expansion in output it is too early to price this in according to Morgan Stanley, though success would add a further $3.40 per share to valuation.

The potential upside in Fortescue is being recognised by the market, as the FNArena database shows a Sentiment Indicator reading on the stock of 0.6. The consensus price target according to the database is $7.98, which implies upside of better than 26% from current levels.

Still on bulk commodities, Citi sees the decision by Germany to phase out all nuclear power plants by 2022 as a positive for coal demand longer-term. There will also be a shorter-term impact, as Citi estimates European imports of thermal coal should increase by around 10Mt in 2011.

The combination of persistent supply-side constraints and strong demand from a pick-up in industrial activity should keep the thermal coal market tight for some time, the broker forecasting market deficits of 10Mt this year and 4Mt in 2012.

This implies some upside risk to Citi's current forecast, which is a 6-12 month target of $130 per tonne for Newcastle FOB.

Turning to base metals, Deutsche Bank notes for many years metal warehousing was a business characterised by short periods of decent profitability interrupting long periods where margins were weak. But with cheap money the storage business has changed, as financial and trading institutions have acquired warehouse companies over the past year. 

Warehousing returns are maximised when large volumes of metal sit in storage for a long period of time, with the necessary circumstances for higher than normal returns including low interest rates, periodic availability of metal, a sustained contango in the forward market and the ability to build large physical stockpiles.

For aluminium specifically, Deutsche Bank notes stocks have risen to unprecedented levels in absolute terms, with the metal concentrated in a few LME warehouses. This implies while physical availability of aluminium appears high, in fact it is not.

This is due to load-out regulations, which require a minimum volume of 1,500 tonnes per day of metal that can be shipped out of a warehouse. This can create a bottleneck, as there is no limit to how much metal can come into the warehouse.

The load-out bottleneck has seen warehouse companies out-compete others in the market in bidding for metal, as critical mass of metal held in the warehouse allows for high premiums to be offered for additional metal. Deutsche suggests these premiums are not necessarily justified based on fundamentals alone.

In an undistorted market the difference in warranted metal and spot deliverable metals can be arbitraged, but this is not possible when the queue to take metal out of a warehouse is sufficiently long. Given this, an investigation by Europe Economics has suggested adjustments to the load-out rule should be made. 

If these recommendations are implemented Deutsche suggests the greatest impact could be on aluminium premiums in the US as a reduction in guaranteed yield may make warehouses less aggressive in bidding on new volumes.

Alone though, Deutsche doesn't expect such changes will reduce inventories held in warehouses nor impact on financing deals that have tied up significant volumes of metal. Inventories should continue to reflect global supply and demand, meaning Chinese aluminium production is likely to be far more important in determining physical availability of the metal.

In lead, Macquarie notes Chinese authorities have indicated a number of lead-acid battery plants may be shut down due to pollution issues. Such a move has potential to negatively impact on lead demand and prices.

Macquarie takes the view end demand for lead metal remains solid, particularly as automotive output continues to increase in key countries. If Chinese battery exports were to decline it would mean more demand for batteries made elsewhere, something Macquarie suggests would be a positive for lead demand ex-China.

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