Material Matters: Bulks, Copper, Ammonium Nitrate

This story features INCITEC PIVOT LIMITED, and other companies. For more info SHARE ANALYSIS: IPL

 – CBA revises commodity forecasts lower
 – Bank updates its commodity orders of preference
 – Are the bulks near price floors?
 – Copper under pressure until Chinese buyers return
 – Copper futures now net short
 – Goldman Sachs updates on Oz ammonium nitrate market

By Chris Shaw

As the first half of 2012 draws to a close Commonwealth Bank has marked to market its commodity price forecasts, the result being downward revisions to almost all US dollar commodity prices. This largely reflects revisions to currency forecasts, with the bank now expecting a lower AUD/USD rate over the next few years.

The primary risk to CBA's view is a disorderly European banking crisis stemming from a potential Greek exit from the euro-zone. Even a relatively short banking crisis cold undermine global trade, activity and commodity prices, with CBA suggesting potential worst case falls from 6-12 month highs of as much as 50% or more.

But given any crisis usually results in substantial policy intervention a worst case fall is seen as unlikely, leading CBA to suggest both prices and activity levels should respond within 1-2 years.

A key for the sector according to CBA is the ability of investors to differentiate between price momentum and margin resilience. As an example, the bank expects iron ore price momentum will be negative in the medium-term, yet cash operating margins for leading Australian producers should remain strong. This is consistent with resilient earnings.

In terms of price momentum over the next 12-24 months, CBA's order of preference is iron ore, aluminium, alumina, zinc, nickel, US natural gas and uranium. This reflects guidance from commodities where spot prices are trading below marginal cost, as cost support should ultimately support pricing.

From a margin resilience viewpoint CBA's order of preference is copper, iron ore, hard coking coal, gold and crude oil. From such a perspective CBA's preference is for tier 1 assets with tier 1 management who can optimise production costs to protect margins. Commodities where fundamentals should remain tight in the medium-term are also favoured.

Looking at the bulk markets more specifically, CBA suggests coking coal may have found a floor in line with China's marginal cost of production. China's scarcity of domestic premium coking coal and strong demand suggest the seaborne to domestic price arbitrage should support pricing over the medium-term. 

This implies coking coal prices will trade around or above US$200 per tonne through this decade, before settling at a long-run price of around US$169 per tonne around 2020. Shorter-term, CBA has revised its FY13 forecast down by 10% to US$213 per tonne, while its FY14 forecast has been trimmed 5% to US$205 per tonne.

In the thermal coal market, CBA notes demand is currently challenged given deteriorating economic growth, industrial production and electricity output in Europe and parts of North Asia. At the same time, cheap and plentiful supply of natural gas from the US and new pollution rules in that market are displacing significant quantities of thermal coal into seaborne markets.

CBA's current thermal coal demand forecasts fall short of conceptual new projects, with demand only intersecting supply at a long-run real price of US$89 per tonne. This implies more expensive new projects in Australia will struggle.

Given weak demand at present CBA expects thermal coal prices will be weaker over the near-term, but costs will offer support to longer-term prices. New forecasts suggest average prices of US$98 per tonne in FY13 and US$100 per tonne in FY14, while the bank has lifted its long-run price forecast to US$89 per tonne from US$81 per tonne previously.

In iron ore, CBA suggests steel output and inventory levels suggest demand remains resilient, especially as infrastructure spending should pick up in China in coming months. At the same time iron ore supply from both Brazil and India remains challenged, meaning levels of Chinese domestic supply and cost support will be critical for the market as China is the global marginal producer.

CBA estimates marginal cost for iron ore at present is US$150-$160 per tonne, while median cost is around the US$110 per tonne mark. This implies strong cost support at prices around US$125-$135 per tonne.

For the iron ore price to fall to US$100 per tonne and remain at such a level, CBA estimates Chinese crude steel output would need to fall by around 140 million tonnes per annum or 20%. Such a fall is unlikely in the bank's view.

While changes to forex assumptions mean slight downward revisions to its iron ore forecasts, CBA expects the price will trade through US$130-$155 per tonne in the next 12 months. June quarter 2013 prices should average US$154 per tonne, a premium of around 15% relative to current spot prices. Medium-term the bank expects the iron ore price will stay above US$120 per tonne until 2017.

With Chinese trade data for May to be released next weekend, Macquarie expects the numbers will show refined copper imports falling by around 25% in month-on-month terms. The decline implies consumers are running down domestic stockpiles at the expense of imports, to the extent Chinese net imports could fall below 200kt for the first time since July last year.

In Macquarie's view this decline in imports should not be a surprise, as LME copper prices have been trading at a significant premium to domestic Chinese prices so far this year. If China continues to run down domestic stocks it will increase the availability of copper ex-China at a time of low demand and buyer confidence.

For Macquarie this suggests LME copper prices will remain under pressure until Chinese buyers return to the market. The market appears to be recognising this, as Commonwealth Bank notes since May 15 copper futures have moved to a net short position. 

A net short position reflects a more bearish bet on the prospects for copper prices. The market has fluctuated between net long and net short positions since last September, highlighting the uncertainty in the market.

With a still fragile global economic environment CBA expects these short-term variations will persist in the futures market. Any worsening of the European financial crisis and/or US and Chinese growth would likely translate to bigger net short positions, which suggests lower copper prices in CBA's view.

Turning to the ammonium nitrate (AN) market in Australia, Goldman Sachs notes both Incitec Pivot ((IPL)) and Orica ((ORI)) are looking to add new capacity in the Hunter Valley, Wesfarmers ((WES)) and the Burrup joint venture are adding to capacity in Western Australia and IPL is soon to commission the Moranbah plant in Queensland.

With this new capacity either coming on line or being planned, Goldman Sachs notes there are now concerns over the potential for the market to move to a position of substantial excess capacity. This is despite expected explosives demand growth from around 1.62 million tonnes in 2011 to 2.5 million tonnes in 2017.

The analysis of Goldman Sachs suggests demand growth should be enough to keep the market closer to balanced than some in the market expect, though there will be some excess capacity in certain regions from time to time.

Factoring this in sees Goldman Sachs make minor increases to earnings estimates for both Orica and Incitec Pivot through FY14. Price targets for both stocks are unchanged at $31.09 for Orica and at $3.50 for IPL. Goldman Sachs rates Orica as a Buy and Incitec Pivot as Neutral.

 

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