Commodities | Nov 01 2011
– Magnetite iron ore deposits: winners and losers
– Quarterly pricing for iron ore under threat
– Met Coal unlikely to fall by as much as iron ore
– Chinese production important for balancing metal markets
By Chris Shaw
The development of magnetite deposits is a growing element of the iron ore market, RBS taking the view first mover advantage is critical with respect to beating escalating construction costs and enjoying the current window provided by historically high iron ore prices.
With this in mind, RBS has analysed 33 major magnetite projects in Australia, with a view to highlighting those projects seen as most likely to succeed. In general, the broker's preference is for projects already in or close to commencing production.
The only Australian plays that fit this bill are those of Grange Resources ((GRR) and Gindalbie ((GBG)), with RBS seeing both as well placed to take advantage of current prices and correspondingly strong margins over the next several years.
In contrast, RBS suggests few of the other magnetite projects will actually be developed, this due to high capital intensity, tightening funding availability and a lack of infrastructure access. Other issues include project resource size, as well as the need to secure financing and production offtake agreements with Asian steel mills that can assist in funding development costs.
As well, with estimated development time of more than six years from initial feasibility studies to first production, projects not currently at an advanced stage may miss out on the near-term window of currently strong prices.
Among the 28 projects not yet close to production, RBS sees seven as fulfilling one or more of the criteria seen as necessary to get such a project off the ground. These include Jack Hills for Murchison Metals ((MMX)), Balmoral South for Australasian Resources ((ARH)), Southdown for Grange Resources, Mount Forest for Mindax ((MDX)), Fusion for Centrex Metals ((CXM)), Centrye Erye for Iron Road ((IRD)) and Ridley for Atlas Iron ((AGO)).
In terms of how best to play investment exposure to magnetite developments, RBS rates Grange Resources as a Buy and its top pick in the sector. Gindalbie is also rated as a Buy, while Iron Road is rated as a Hold.
RBS is the only broker to cover Iron Road, while the FNArena database shows Sentiment Indicator readings of 1.0 for both Gindalbie and Grange Resources.
Further on iron ore, Deutsche Bank notes the spot iron ore price's discount to the contract price now exceeds US$40 per tonne, the largest such discount since the market's move to quarterly pricing. The discount is likely to be enough to break the system, Deutsche expecting a move to even shorter-term contracts.
In the view of Deutsche Bank, the large price discrepancy is not healthy for the industry as it leads to clear and potentially destructive tensions between producers and consumers. One issue is the quarterly pricing system has been of most benefit to the mills, so they are likely going to think hard carefully about moving from the current system.
On a cumulative basis Deutsche notes since the start of 2010, a consumer buying a tonne of iron ore every day would be US$7,000 better off on the quarterly contract system than on spot. As this bias is likely to remain in a tight market, and Deutsche expects a tight market in coming years, the mills are likely to be worse off from a move to spot pricing.
This decline in iron ore prices of 30% over the past month has been enough for the market to also turn its attention to metallurgical coal given it is the other key ingredient in steelmaking. To date the relationship has been far from equal, as compared to iron ore prices premium hard coking coal spot prices are down just 6% since the start of October.
The magnitude of the fall in the iron ore price is unlikely to leave met coal totally unscathed in Citi's view, but the broker doesn't expect a price fall of the same magnitude for several reasons. The first is met coal is less exposed to the marginal Chinese buyer, as China accounts for only 17% of the seaborne met coal market. This compares to 62% of the seaborne iron ore market.
As well, Citi notes Chinese and Indian buyers have been far more agreeable towards spot or monthly prices in the met coal market, meaning less risk of any reneging on cargoes priced at a massive premium over spot prices.
Finally, Citi suggests the combination of strong Japanese steel production and high prices in the Chinese domestic market should keep import demand high. Given Japan, which accounts for 32% of all met coal imports, prefers premium hard coking coal and most other met coals are priced off this material, prices are unlikely to move violently in Citi's view.
When the risk of another wet Australian summer is also factored in, Citi takes the view buyers are less likely to pull back from the market given concerns over the potential for losing current security of supply.
Citi does accept the current macro environment will likely weigh on spot prices short-term. With spot prices now about US$40 per tonne below the current quarterly contract price, it appears unlikely prices in 1Q12 will be higher or even unchanged without some sort of disruption on the supply side.
One difference between the met coal and iron ore markets is the cost structure, as in iron ore at present the marginal cost has a number of producers under water and so is likely to generate some supply response.
In contrast, Citi notes the cost structure in the met coal market is relatively flat, so a supply side response is unlikely unless prices were to fall another 20% from current levels.
For Macquarie, one interesting result of the commodity demand boom of China has been the need for solid volumes of high cost Chinese mine and smelter supply to balance a number of metal markets. This has had the effect of changing market dynamics, as the flexibility of this production has meant price moves rather than just changes in stock levels have had an impact on market balances.
As an example, Macquarie notes the lack of seaborne iron ore supply growth in 2010 and 2011 has seen prices trade at a level high enough to attract suitable Chinese material into the market to satiate steel production.
At present Macquarie points out the market is in a disincentivisation phase, as prices are trading at levels where a proportion of Chinese supply is not economic. This suggests any evidence such supply was actually being cut would be a positive, helping clear the decks for the next leg of incentivisation as apparent demand normalises.
Macquarie suggests the October sell-off has seen nickel, zinc, aluminium, steel and iron ore trade into the cost curve. Nickel pig iron produced in small blast furnaces is now extremely marginal, more than 25% of Chinese aluminium smelters will be losing money and around 10% of zinc supply is also losing money at current levels.
Macquarie's view is in most of these markets the price falls have overshot any drop in real demand, as the Chinese economy is still growing. Macquarie analysts have noted some signs Chinese supply is already adjusting, as zinc smelters are reacting at certain price levels and some smaller ironmaking blast furnaces in China are being kept idle.
Rather than taking the view any lowering of Chinese production would be a negative, Macquarie argues such moves are a positive as it will assist in bringing metals markets back into balance more quickly.
Macquarie's view is as market conditions normalise, it will become apparent too much material as been cut back by the price falls. This means as certainty returns to the Chinese market, prices will need to rise to provide the incentive for a response from currently idle capacity.
Macquarie sees such incentive-disincentive cycles as likely to become more the norm as China's share of global metals demand increases.
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