Material Matters: Investors Over-Reaction, Not All Metals Are Equal

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– Cost curves to support some commodity prices
– Sell-off in iron ore looks overdone
– ANZ adjusts iron ore and coking coal forecasts
– Support for thermal coal
– Standard Bank looking for long positions in PGMs

By Chris Shaw

To account for recent price movements across the commodities complex, RBS has compared 90th percentile cash costs to spot prices based on recent cost curves. The analysis shows aluminium prices are the deepest into the cost curve, while copper and met coal prices remain well above marginal costs.

RBS's analysis suggests aluminium, alumina, nickel and iron ore enjoy the most cost curve support, ranging from 8% of iron ore producers with cash costs above spot prices to 39% in the aluminium market.

As RBS points out, in most cases this scenario is not sustainable if medium-term demand growth is to be satisfied. Short-term some inventory de-stocking and potentially some capacity closures may be needed to stabilise markets, but from a longer-term scenario RBS notes demand fundamentals remain intact. This is supportive for prices.

Specifically, RBS suggests in copper the market could endure price falls of more than 30% without triggering any meaningful closures of capacity. The reason spot copper prices remain high is the market is forward looking in nature, RBS noting there is a lack of expected new supply, mine grades continue to fall and strikes continue to disrupt production.

Slowing demand has pushed aluminium prices deep into the cost curve, and with demand growth linked to global economic growth there is risk of reduced demand going forward in the view of RBS. With aluminium inventories also near record levels, a return of some pricing tension in the market may require some capacity closures.

Reduced Chinese imports have impacted on alumina prices, with RBS suggesting prices are now offering no incentive to build new Western world capacity. This implies significant upside risk to prices over the medium-term in RBS's view.

A return to pricing tension in the nickel market may be some way off, as RBS suggests stainless steel demand growth appears unlikely to support nickel production growth near-term. 

With material supply additions some way off in the met coal market producers should continue to enjoy high margins. This leads RBS to suggest prices should remain above 90th percentile cash costs for some time. This should encourage higher cost supply to the market.

In thermal coal RBS expects strong Asian demand growth will support prices, especially as low cost capacity is likely to fall short of demand requirements. This implies prices will remain above 90th percentile cash costs for the foreseeable future and so provide an incentive for new, higher cost supply.

While around 8% of iron ore supply is underwater based on an assessment of global cost curves, RBS notes large, low cost capacity is expanding aggressively. This is expected to push high cost capacity off the end of the cost curve over the longer-term. 

Assuming commodity prices remain at current 90th percentile cash costs into perpetuity from 1Q12, RBS suggests the better value to play the sector would be via Rio Tinto ((RIO)) in preference to BHP Billiton ((BHP)). The analysis also suggests Fortescue Metals ((FMG)) offers solid valuation support under such a scenario.

In general, RBS continues to target higher prices across the commodities board over the rest of the year. This suggests using any bouts of price weakness as opportunities to accumulate positions.

With copper expected to remain in supply shortfall through 2013 prices should continue to improve, RBS forecasting a 2012 average price of US$9,925 per tonne. A strong aluminium demand outlook is a positive but the metal needs production cutbacks to curb the current surplus. Regardless, RBS expects cost curve support to be a bullish feature for aluminium prices.

For gold, RBS expects ongoing uncertainty in global markets will support the price as investors continue to chase safe havens. Also supportive should be volatility in currency markets, as the likes of the yen and the Swiss franc have seen official intervention and the US dollar struggles to rally. RBS suggests the gold price is now building a bridgehead, with an average of US$1,900 per ounce possible during the key gifting period of the Chinese Lunar New Year. 

Historically, Macquarie notes ferrous scrap and iron ore prices have tended to remain fairly well intertwined in the movements. This is a function of their natural substitutability as marginal iron units in steel production.

But in recent weeks Macquarie notes while scrap prices have traded to their lowest levels this year, iron ore prices have collapsed far more significantly. For Macquarie, the scrap price is a better reflection of general market conditions, which suggests the sell-off in iron ore has been very much overdone.

As evidence of this, Macquarie points out over the past year the scrap to iron ore unit ratio has traded in a range of 1.5-1.8 times, but the collapse in iron ore prices means this has blown out to 2.2 times into November.

This means in relative terms either scrap is expensive or iron ore is cheap. Macquarie suggests there is something of a case for both, as scrap prices may indeed fall further as steel output continues to adjust. But entering the Northern winter when scrap collections tend to stall, downside here appears limited.

As well, Macquarie notes the scrap to rebar spread has remained relatively robust in recent weeks, whereas if there had been mass over-production this spread would have fallen more sharply. This adds to Macquarie's view scrap prices are currently reflecting actual market conditions reasonably well.

This means iron ore looks oversold, as a buyer's strike, sudden defaults on tonnages and the need to “fire sale” distressed cargoes has pushed prices down too far too fast. With prices now appearing to stabilise, Macquarie suggests a quick recovery of US$20 per tonne is possible thanks to low inventory positions and a more stable steel market.

A return to a more normal 1.7 times iron unit price ratio with scrap would suggest iron ore prices need recovery to US$155 per tonne, a level Macquarie suggests is nearer to fair value in the current market environment.

ANZ Banking Group agrees the correction in bulk commodity prices in recent weeks appears overdone, though the 15% drop in Chinese steel prices has prompted cuts to the bank's forecasts for iron ore and coking coal in 2012. Iron ore estimates have been reduced by 8% to US$156 per tonne for fines and US$188 per tonne for lump, while coal price forecasts have been reduced on average by 11%.

As ANZ points out, the changes to forecasts are a mark-to-market price adjustment rather than any change in strategic view, as the bank remains upbeat on the outlook for bulks prices. Encouraging given this view is both the iron ore and coking coal have shown some price support over the past week or so.

As well, ANZ notes key Chinese steel inventory levels are now turning back down, which suggests steel consumers are returning to the market. Relative price movements between iron ore and steel prices suggest the iron ore market has overreacted, which ANZ suggests may be partly explained by some adjustments on the part of Chinese consumers.

The recent fall in iron ore port stocks is indicating an increase in steel mill de-stocking in ANZ's view, which would have lowered buying activity in seaborne markets. Such a change would have accentuated the decline in iron ore prices.

Another consequence of the fall in bulk prices is Chinese steel mill margins have improved in recent weeks to a 13-month high of around 4.5%. This, plus the potential for Chinese policymakers to respond to weaker than expected domestic demand, should be a positive for demand in coming months according to ANZ.

With the key Chinese urbanisation story having at least 15 years more to run China is expected to increasingly become net short all major commodity inputs, particularly high quality iron ore. To ANZ this suggests the recent correction indicates prices may have reached a peak for Chinese customers. Downside should be short-lived however, the key being policy flexibility in China helping restore investor confidence quickly. 

In the thermal coal market, Commonwealth Bank notes the benchmark price at China's major coal transhipment port of Qinhuangdao is now broadly equivalent to the Newcastle thermal coal price. 

This equality between prices is not common, as the bank points out the previous times Chinese domestic prices and seaborne prices have been in line, China's thermal coal imports have picked up.

Commonwealth Bank sees scope for this effect to again become apparent in the next few months, especially as the Chinese market is entering a re-stocking period for power generators ahead of the peak winter demand period. Such a trend should support volumes and the price of seaborne thermal coal in the view of Commonwealth Bank.

Speculative shorts in the palladium market have continued to decline in recent weeks, but Standard Bank suggests there remains some way to go before it becomes clear the speculative market has turned convincingly more positive.

In Standard Bank's view, the second week of declines in ETF holdings suggests still fragile confidence in the palladium market. But after a sharp decline in platinum group prices the bank is starting to look for opportunities for long positions.

This is despite currently lacklustre demand and sufficient inventory levels at present. Standard Bank's analysis suggests there is value in platinum below US$1,550 per ounce, while palladium appears to provide value at levels below US$600 per ounce.

 

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