Material Matters: Further Volatility In Prices, Iron Ore Expectations Lowered

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– NAB expects further weakness in commodity prices this year
– A modest recovery forecast for 2012
– Danske Bank trims commodity price estimates
– Iron ore price expectations lowered

By Chris Shaw

In aggregate, base metal prices in October were 18% lower than the levels at the end of 2010 according to National Australia Bank. In real terms the outcome was even worse, with prices 21% lower. This reflects a risk-off attitude on the part of investors, which NAB attributes to ongoing turmoil in the global economy.

For October, lead and copper prices fell the most heavily among the industrial metals, while prices for aluminium and nickel softened slightly. Given no convincing solution to the European sovereign debt crisis is likely shorter term, NAB expects volatility in metal markets will continue for several months.

In general, NAB's view is while supply for most metals will pick up over the next few years and demand should slow somewhat, fundamentals for the base metals will remain broadly positive. This generates an expectation prices will stay elevated relative to historical levels.

A number of factors have supported base metal prices in recent weeks in NAB's view, including improved GDP outcomes for the US and Japan in September and solid retail sales for the former in October.

While industrial activity in many developed economies has slowed in recent months, NAB suggests the deceleration of growth appears to have bottomed out for now given the support offered by Japan and the US. 

Growth in developed economies should still soften further but NAB has for some time taken the view continued strong demand from emerging economic will be enough to offset this softer developed economy demand.

But even the developing economies have shown some signs of slowing of late, which NAB notes is causing some central banks to take more of a wait and see approach with respect to normalising interest rates.

China's outlook remains the most important and here NAB notes internal risks to the economy appear to be mounting. This a reflection of the pressure of tight monetary conditions and government sanctions on the property sector. Despite this, NAB expects Chinese demand for base metals will remain generally robust, in part because buyers have taken advantage of lower prices. 

On the supply side, NAB notes industrial actions continue to play a large role, particularly for copper given ongoing issues at the Grasberg mine in Indonesia. In the nickel market in contrast increased production is expected in coming months as new projects come on stream 

NAB notes weekly data indicates stock rebuilding of aluminium and copper has ceased in recent weeks, while stocks of nickel and zinc have fallen and lead stocks have surged. Overall, stock levels are elevated in comparison to levels prior to the GFC.

With the market outlook still full of risks, NAB sees an uncertain near-term outlook for commodity prices. Fundamentals remain relatively favourable however, something the bank expects will help sustain prices close to current levels in coming months. 

NAB's Base Metals Price Index is forecast to fall by around 13.5% over the final quarter of this year, before an expected rise in the index of around 7% in 2012. 

Danske Bank shares the view commodity prices are likely to struggle to find direction in coming quarters, also agreeing with NAB this will be a reflection of uncertainty in relation to the global economic growth outlook and the debt issues in Europe.

But Danske Bank suggests a far too negative scenario with respect to global growth is now expected in financial and commodity markets. As well, there are other supportive factors for commodity prices emerging in the view of Danske.

These include the expectation market balances in the likes of copper, oil, corn and soy beans will tighten in 2012. As well, Danske sees aggressive monetary policy being pursued by the US Federal Reserve, with a further easing still a clear possibility. This could weaken the US dollar, which would be supportive for commodity prices. 

Looking to 2012, Danske Bank expects both the US and Chinese economies will recover in 2012, de-coupling somewhat from an expected recession in the eurozone. The US economy is forecast by Danske to grow by 1.8% this year and 2.5% in 2012, which is above consensus estimates of 1.7% and 2.1% respectively. 

To account for revised global growth expectations of 3.8% this year and 4.0% in 2012, Danske Bank has lowered commodity price forecasts. The revisions for next year are relatively modest as Danske Bank continues to expect a price recovery for most commodities in the second half of 2012.

In regard to oil, Danske suggests Brent Crude could trade in a range of US$105-$115 per barrel for some time, as while Libyan production is easing fears of a shortage there are still geopolitical issues the market is dealing with. By the second half of 2012 fundamentals should tighten, pushing prices to US$120 per barrel by the end of next year. 

Short-term Danske Bank suggests risks are primarily to the downside given the potential for demand growth to be weaker than forecast. But assuming global growth meets the bank's forecasts, Danske sees scope for prices to move higher in the medium-term. Forecasts now stand at US$112 per barrel for Brent crude in 2012, down from US$114 per barrel previously. 

In the base metals Danske Bank notes current prices imply poor to no recovery in 2012, but risks remain to the downside shorter-term given the possibility of a further escalation in the eurozone crisis. These risks sees reductions to estimates, meaning lower 2012 averages overall when compared to previous forecasts.

Danske Bank expects copper will outperform in relative terms thanks to steady demand from China given signs the de-stocking evident for much of this year may be coming to a close as lower prices encourage more buying. 

The aluminium picture is not as clear, as Danske Bank notes while the metal has seen similar risk aversion pressures as copper, market fundamentals for the metal are less supportive given production has tended to exceed world consumption.

In terms of actual price forecasts, Danske Bank expects copper prices will average US$8,844 per tonne this year and US$8,625 per tonne in 2012, while aluminium is forecast to average US$2,422 per tonne this year and US$2,275 per tonne next year. Forecasts for 2012 are down from US$9,313 per tonne for copper and US$2,525 per tonne for aluminium.

In zinc Danske is forecasting annual average prices of US$2,221 per tonne this year and US$2,125 per tonne next year, while nickel is expected to average US$22,941 per tonne in 2011 and US$20,500 per tonne in 2012.

To account for lower forecast demand growth, JP Morgan has lowered its iron ore price forecasts by 10-15% over the next five years. For the market overall, a still tight supply side and the expectation high cost Chinese production will keep its place in the market should support prices above normal levels for some time. But JP Morgan expects weaker global growth to limit demand, so forcing prices down from previous levels.

For 2011 the broker's price forecast has been reduced by 6% to US$167 per tonne, while in 2012 a 16% reduction sees a new annual price forecast of US$147.50 per tonne. In 2013 JP Morgan expects a slight recovery to an average price of US$150 per tonne, while there is no change in the long-term price forecast of US$80 per tonne.

The changes to iron ore forecasts impact on earnings expectations for Australian iron ore stocks, JP Morgan's estimates falling by 20-30% for the pure plays and by 10-20% for the more diversified companies.

Valuations have also fallen by 10-20% for the pure plays and by 9-10% for the diversifieds. JP Morgan retains a preference for Rio Tinto ((RIO)) over BHP Billiton ((BHP)) among the diversifieds, seeing better relative value at current levels. Ratings reflect this, Rio Tinto rated as Overweight and BHP Billiton as Neutral.

Among the pure plays JP Morgan continues to rate both Fortescue ((FMG)) and Mount Gibson ((MGX)) as Overweight, seeing both as the cheapest in the sector based on revised earnings expectations.

The only change in rating is for Gindalbie ((GBG)), where JP Morgan has moved to a Neutral rating from Overweight previously given Gindalbie's position as the most leveraged stock to iron ore prices under the broker's coverage.

No other changes to ratings mean JP Morgan continues to rate both Aquila Resources ((AQA)) and Atlas Iron ((AGO)) as Neutral, while Murchison Metals ((MMX)) is rated as Underweight.

By way of comparison, Sentiment Indicator readings for these stocks according to the FNArena database stand at 1.0 for Rio Tinto and Fortescue, 0.8 for BHP, Gindalbie and Atlas Iron, 0.3 for Mount Gibson, minus 0.3 for Aquila and minus 0.7 for Murchison. 

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