Material Matters: Oz Steel, Oil, Coal And Iron Ore

This story features ORIGIN ENERGY LIMITED, and other companies. For more info SHARE ANALYSIS: ORG

– Strong AUD diminishes Oz Steel's competitive advantage
– Positive medium-term oil price outlook
– Citi offers order of preference for Aussie coal plays
– Brazilian iron ore exports likely to increase in 2H11

By Chris Shaw

As Australia's only domestic steel producers, both Bluescope ((BSL)) and OneSteel ((OST)) have traditionally had a competitive advantage over imported steel thanks to supply certainty, working capital benefits and the ability to price relative to import parity.

But as BA Merrill Lynch notes, the value of this competitive advantage diminishes in periods when the Australian dollar is stronger, as this lowers the import price parity. This gives customers increased reason to consider imports.

While the stronger Australian dollar is impacting on profitability for Australian steelmakers at present, BA-ML points out steel import volumes have slowed during 2H11. This means the relative share of imports as a percentage of domestic steel volumes has declined in the period.

For BA-ML this indicates BlueScope and OneSteel are not losing market share to imports, even while profitability is being impacted by the strength of the domestic currency. To reflect this, BA-ML continues to rate OneSteel as a Buy, with a price target of $2.95, while BlueScope is rated as Hold with a target of $2.00. 

According to BA-ML, OneSteel is the lowest priced on an earnings multiple basis. The broker sees this as a reflection of iron ore sales, rather than the group's steelmaking operations. The FNArena database shows Sentiment Indicator readings and consensus price targets for OneSteel of 0.7 and $2.62 and for BlueScope Steel of 0.4 and $2.09.

Turning to oil and following a review of the market, Deutsche Bank continues to see solid fundamentals that should support the medium-term oil price outlook. Asia should also continue to generate strong demand for transport fuels, which should push global oil demand above 100mmb/d by 2020. 

According to Deutsche, increased OECD production will fall short of demand growth, so reducing OPEC's spare capacity to 3.5% by 2015. This level is similar to that experienced in 2008, when the oil price traded close to US$150 per barrel. In terms of actual numbers Deutsche estimates current global oil inventories stand at around 59 days of supply, with a fall to 55 days by the end of 2012 expected.

Having made minor adjustments to its model, Deutsche Bank is forecasting average crude oil prices this year of around US$100 per barrel. By 2015 Brent crude prices should be trading around US$125 per barrel on the broker's numbers.

In terms of the outlook for Australian plays in the energy sector, the fact there are wage and cost headwinds still in play sees Deutsche Bank favour oil leveraged names with lower project execution risk. This means limited exposure to major project capex blowouts and time-line delays becomes a key investment attribute.

In such an environment Deutsche prefers Oil Search ((OSH)) as its top pick, as the PNG LNG project has high oil linked revenues, while the project has less exposure to Australian inflationary pressures. Oil Search is rated as a Buy, as are Santos ((STO)) and Woodside Petroleum ((WPL)). 

Elsewhere in the sector Deutsche rates Australian Worldwide Exploration ((AWE)), Eastern Star Gas ((ESG)) and Dart Energy ((DTE)) as Buys, while Origin Energy ((ORG)), Caltex ((CTX)), Nexus Energy ((NXS)) and AED Oil ((AED)) are rated as Holds. 

Having lifted coal price forecasts earlier this week by 13-45% for thermal coal (implying average prices of US$122 per tonne this year, US$139 per tonne in 2012 and US$148 per tonne in 2013) and by an average of 15% for coking coal over the next 10 years, Citi has also factored in the impact of the proposed carbon tax in Australia.

The tax equates to between $1.50-$2.50 per tonne in additional cost above and beyond what Citi suggests are already rising cost pressures. Citi's model has incorporated an increase in cost inflation to 5-10% over the next 10 years across the sector.

In terms of preferences, Citi's top picks in the Australian coal sector are Whitehaven Coal ((WHC)), Resource Generation ((RES)) and New Hope Corporation ((NHC)). All three stocks the broker rates as Buys, having upgraded New Hope post its sector review.

The attraction of Whitehaven is a growing thermal coal profile and continued potential for M&A activity, Resource Generation appears to offer value relative to peers given exposure to a large, long-life asset and New Hope management has shown the ability to control costs and markets.

Citi also rates Coal and Allied ((CNA)), Cockatoo Coal ((COK)) and White Energy Company ((WEC)) as Buys, Coal and Allied being upgraded post the sector review, while Macarthur Coal ((MCC)) is rated as a Sell.

Finally on iron ore, the latest port data from Brazil confirms iron ore supply from that country was restricted in the first half of this year. Macquarie attributes this to a combination of weather-related, operational and loading issues during the period.

June exports in annualised terms came in at 309M tonnes but Macquarie continues to expect a strong bounce-back in second half, enough to bring full year exports to 320M tonnes. This would be an increase of 14M tonnes in year-on-year terms.

Click to view our Glossary of Financial Terms