Material Matters: China, Nickel, Steel And Iron Ore

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 – Current base metal surpluses should ease
 – Gold well placed for medium-term gains
 – Medium-term outlook mixed for base metals
 – Arguments for and against higher nickel prices
 – Chinese steel market the key for iron ore

By Chris Shaw

The recent softening in base metals prices is, according to Barclays Capital, due to data suggesting a deterioration in Chinese physical market fundamentals. Copper is evidence of this, as rising SHFE stocks to the point the market is indicating it is in a surplus at present.

The issues spread beyond copper in the view of Barclays, as recent months have seen a significant weakening in the premium of Chinese base metal prices over LME prices. The arbitrage window for aluminium, copper, tin and zinc has clearly closed.

While stocks for the base metals have risen in China, Barclays suggests stock builds should not automatically be considered overly bearish, as the market is still recovering from aggressive supply chain de-stocking in the first half of last year.

Barclays expects current surplus conditions will ease in the shorter-term, as imports should adjust lower given a lack of incentive and higher year-to-date LME prices, while any lower prices should also help stimulate demand.

Activity in the base metal markets is expected to accelerate from the second quarter on, something Barclays expects will help re-tighten domestic market balances. This suggests limited downside for base metal prices from current levels.

From a medium-term perspective, Barclays suggests the most significant change expected is for the lead and zinc markets to swing from surplus to deficit. In contrast, fundamentals for nickel are expected to deteriorate, while more bullish outlooks for copper and tin should remain in place given ongoing supply tightness.

In the precious metals, Barclays suggests gold is searching for a new catalyst, so upside now appears to rest with the macroeconomic outlook. In contrast, firmer investment demand and supply disruptions have helped support the platinum group metals.

With respect to price expectations, Barclays is forecasting relatively flat aluminium and zinc prices this year compared to 2011, while copper is expected to deliver a modest increase. Lead prices should fall slightly, while falls in nickel and tin will likely be more pronounced.

For gold Barclays predicts a solid gain to an average price of US$1,875 per ounce this year, while silver prices are forecast to fall modestly. Platinum is also expected to post a slight decline this year, while palladium is forecast to deliver a modest gain.

Looking at nickel specifically, Macquarie notes International Nickel Study Group numbers indicate the market was in surplus of around 17,000 tonnes last year, compared to a decline in reported stocks of 48,000 tonnes. This implies a large build in unreported stocks.

Given expected year-on-year production growth of around 7.4% this year, down from the 10.7% seen in 2011, Macquarie sees the nickel market surplus as growing modestly this year to around 26,000 tonnes.

This meshes with the Deutsche Bank view the physical market for nickel at present is in poor shape. This reflects negative sentiment at European mills, low nickel premiums and solid inventories, as well as structural concerns stemming primarily from the growth of nickel pig iron output in China.

Given such an outlook Deutsche notes the market doesn't believe the recent rally to prices of nearly US$22,000 per tonne are sustainable. But Deutsche's view is the opposite in that not only can these prices be sustained, they could still move higher in coming months.

In support of this view Deutsche argues there is potential for the macro environment to continue to improve through this year, given policy will be focussed on keeping China growing, keeping Europe united and keeping the US spending.

Accommodative monetary policy is most likely to be used to try and achieve these goals and if successful Deutsche suggests the result would be highly supportive for nickel as one of the more cyclical of the base metals.

What also supports a positive outlook in Deutsche's view is the likelihood of Chinese nickel pig iron production being impacted by even higher operating costs and the expectation High Pressure Acid Leach supply will hit the market at a slower pace than currently anticipated.

Following a review, Deutsche has lifted its nickel price forecast for 2012 by 21% to US$22,500 per tonne. The long-term price forecast has also increased by 6% to US$18,000 per tonne. To play such a view Deutsche prefers low cost assets over leveraged plays.

This means preferred exposures among Australian nickel plays for Deutsche Bank are Western Areas ((WSA)) and Independence Group ((IGO)). For Western areas the combination of low cost output, high grades and expected positive news flow is attractive, while for Independence the positives are a diversified production base and likely exploration success.

Elsewhere in the sector Deutsche rates Mirabela Nickel ((MBN)), Panoramic Resources ((PAN)) and Mincor Resources ((MCR)) as Hold. Mirabela is the most leveraged of the Australian plays, Deutsche noting a 10% increase in nickel prices would lift valuation by as much as 50%. Given the positive view on nickel prices, Deutsche has upgraded Mirabela from Underweight.

While Panoramic is one of the largest of the Australian nickel producers, its high costs are expected to limit the potential for outperformance, while for Mincor the main issue preventing Deutsche from taking a more positive view is limited mine life. 

In the view of UBS, new bearish risks are emerging around the Chinese steel market, stemming from bearish 4Q11 production data and a materially weaker commodity housing market. This has implications elsewhere, as with Chinese steel production the key driver for iron ore prices there is earnings risk for the likes of BHP Billiton ((BHP)), Rio Tinto ((RIO)) and the pure iron ore plays in Australia.

If Chinese steel market numbers were to disappoint, UBS estimates there is as much as 20-30% earnings per share (EPS) downside risk to forecasts for both BHP and Rio Tinto. For the pure plays the downside potential is even greater at potentially more than 50%, assuming Chinese steel production falls by 5% in year-on-year terms this year.

The most leveraged of the pure plays are Fortescue ((FMG)) and Gindalbie ((GBG)) on UBS's numbers, though the broker cautions against reading too much into current data as policy moves, seasonal factors and restocking could quickly turn around the Chinese steel market.

UBS currently has Buy ratings on BHP, Rio Tinto, Fortescue and Gindalbie.

Macquarie is less concerned about the numbers out of China, suggesting Chinese steel production in the final quarter of last year was probably under-reported for the third year running. This implies a more moderate slowdown than suggested by the numbers reported.

On Macquarie's numbers, Chinese crude steel production was around 11 million tonnes higher in 2011 than indicated by official figures, with final quarter output probably eight million tonnes better than reported.

This suggests there is a good chance Chinese steel output will surprise to the upside in the early part of 2012. Assuming its numbers are closer to the actual mark, Macquarie also sees under-reporting of steel production as a reason why iron ore prices were so well supported at US135-$140 per tonne at the end of last year and into 2012.

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