Material Matters: Mineral Sands, Coal, And Aluminium

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– ANZ revises commodity price forecasts
– Some positive signs for met coal
– Downside risk for thermal coal
– Mineral sand price forecasts lifted
– Bearish view on Chinese aluminium
– Citi likes better yielding resource plays

By Chris Shaw

The combination of stronger than expected headwinds from Europe and disappointing growth numbers from China have seen ANZ Banking Group revise commodity price forecasts for both the near and medium-terms.

On average, ANZ has lowered commodity price forecasts by 4.5% for the remainder of 2012 and by 3.3% for 2013. The largest cuts to forecasts have been in iron ore and oil, the former given its leverage to the Chinese economy and the latter thanks to the influence of swinging investment fund sentiment.

In general ANZ's smallest changes for 2012 have been in the base metals, where cuts to estimates have ranged from 0.2% for zinc to 5.5% for nickel. In contrast, oil prices estimates for 2012 have been reduced by 7-8% and iron ore fines forecasts have fallen by 8.8%.

It is a similar story in 2013, where base metal price forecasts have been trimmed by 0.2-4.6%, while oil price forecasts fall by around 5% and iron ore fines by 3.7%. The largest cut to ANZ's forecasts for 2013 is in thermal coal, where estimates have been reduced by 8.2%. 

In terms of the market outlook, ANZ expects some signs of improvement in the September quarter, though this is most likely to come near the end of the period and into the final quarter. Plans for Europe and signs of a pick-up in the Chinese economy would also revitalise markets, so releasing some pent-up buying.

ANZ expects investment fund activity may be sporadic shorter-term, as most net speculative positions have been wound back to neutral in recent weeks. While this offers scope for some re-entry in the market, ANZ's view is the ongoing uncertainty with respect to market fundamentals means any short-term recovery is likely to come primarily from short covering rather than a rebuilding of long positions. 

In coal, Macquarie suggests better seaborne fundamentals should support Chinese metallurgical coal prices. This reflects the expectation as the import arbitrage narrows, Chinese steel mills will turn back to the domestic market.

This should drive production to new highs, so putting upward pressure on domestic prices. Along with Chinese coking coal producers, these price increases should also be a positive for higher grade iron ores as the higher coke rates required to use lower-grade ores would then become more costly.

Fundamentals for the seaborne met coal market continue to improve and prices have followed suit in rising slightly in the third quarter, with reports Posco has settled hard coking coal contracts at US$225 per tonne, up from US$210 per tonne in the June quarter.

This has brought in the arbitrage in seaborne coking coal prices against Chinese domestic prices to around US$10 per tonne, down from a peak of around US$30 per tonne in February. At the same time Australian shipments to other markets such as Japan and Korea have been rising.

As ex-China buyers increase their draw on seaborne material, Chinese mills will be forced to increase the volumes taken from domestic mines. Macquarie expects this will result in Chinese coking coal production setting new record levels in the second half of the year as additional supply will need to be incentivised by higher prices.

For the Chinese coal market in general Macquarie notes prices remain under pressure shorter-term given high inventory levels and weak demand. This weakness is expected to extend into summer, Macquarie pointing out both seaborne and domestic supply have been higher year-to-date, while growth in power demand has slowed as the economy has weakened. This suggests there remains downside risk to the Chinese thermal coal market.

Still on bulks, Goldman Sachs suggests Chinese preliminary trade data ease fears of a hard landing. Growth in fixed asset investment has risen to 20.1% in year-on-year terms, while bank lending has also increased and inflation has declined. Chinese Iron ore imports have also risen and in Goldman Sachs's view this is consistent with a soft landing for China's economy.

In the mineral sands market, Goldman Sachs suggests while the global supply deficit in both zircon and TiO2 has increased the number of potential new projects, incentive prices for these projects to be developed remain higher than the broker's current long-term price estimates. 

Factoring in what are the most likely new projects to come onto the market, Goldman Sachs has revised its long-term mineral sands prices higher. Zircon forecasts have been increased to US$1,600 per tonne from US$1,223 per tonne previously, while rutile forecasts have increased to US$1,050 per tonne from US$615 per tonne.

For the mineral sands market in general, Goldman Sachs notes there are a number of key projects that will need to be built to provide enough new production to move markets back closer to a balanced position given the demand outlook.

This will see the likes of Iluka ((ILU)), Mineral Deposits ((MDL)) and Base Resources ((BSE)) develop new projects in coming years. Accounting for this and the changes to its mineral sand price forecasts, Goldman Sachs has updated earnings forecasts and price targets for these companies.

For Iluka the broker's price target increases by $1.00 to $24.00, for Mineral Deposits the target increases by a similar amount to $8.00, while for Base Resources the target rises to $1.05 from $0.90. Goldman Sachs retains Buy ratings on all three stocks, with Iluka the most preferred, followed by Mineral Deposits and then Base Resources.

Assessing the Chinese aluminium market, Citi suggests there is little downside to smelting spread in the third quarter as the government attempts to subsidise power to smelters in south-west China and Henan. As well, Citi notes the production ramp-up in Xinjiang is slower than had been expected due to delayed power plant construction, a lack of experienced labour and constrained power supply.

Citi expects the market in Henan will move from loss making to break-even in the September quarter, helped in part by lower costs thanks to subsidized power supply. The news does nothing to change Citi's long-term bearish view on the Chinese aluminium sector, which reflects the expectation an on-going production ramp-up in western China will push the gross spread back into negative territory, possibly in 2013.

Looking at the resource sector in general, Citi expects dividend yield will likely be a key valuation metric for large cap miners going forward. With yields for a number of large cap miners having become attractive recently, Citi suggests this should provide some downside support to share prices.

While value creation in the mining sector over much of the past decade has been the result of increasing commodity prices, this environment now appears to have passed. For Citi this means mining companies will need to balance a growth versus yield outcome.

In Citi's view, with major growth companies in the mining sector expected to deliver volume growth of 3-5% and a dividend yield of around 4%, a long-term combined return of 7-9% becomes more attractive to investors.

So despite a neutral short-term and bearish five-year view on the resources sector, Citi's approach is to own the large cap miners that offer both returns and yield. Under such a scenario favoured plays -on a global scale- are BHP Billiton ((BHP)) and Rio Tinto ((RIO)).

Citi also favours small cap miners offering low yield but significant volume growth. This approach doesn't screen well for Australian-listed plays, as on such a basis Citi favours London Mining, Petropavlovsk, Centamin Egypt and African Minerals. 

Laggards under such an approach in Citi's view include Anglo America, New World Resources, Boliden, Talvivaara, Hochschild Mining, Randgold Resources, ThyssenKrupp and Kloeckner. 

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