Iron Ore Outlook Updated

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 – Goldman Sachs and UBS update iron ore price forecasts
 – Changes impact on earnings and valuations for Australian producers
 – Preferred exposures in the sector updated

By Chris Shaw

Over the past two months iron ore prices have experienced significant volatility, falling to US$85 per tonne in September before quickly rebounding to US$110 per tonne. 

Citi suggests the Chinese stocking cycle has been the main driver of short-term price moves, with the latest rebound the end of a de-stocking phase. Prices are expected to remain volatile, this reflecting structural issues in the market.

These issues include miners adopting a greater urgency in looking for cost cutting opportunities along with junior projects facing more difficult funding conditions. This has the potential to reduce supply going forward.

An example is Brazil, where Citi suggests only Vale and Minas Rio will add capacity in the next 3-4 years, as expansions elsewhere will be limited. This suggests weaker Brazilian exports into what is an over-supplied market. 

For Citi, cost support for iron ore remains in the range of US$100-$120 per tonne, but this level is at risk if Chinese steel production again stagnates. 

Macquarie suggests the collapse in iron ore prices in recent months achieved a clean-out of both inventory and marginal suppliers while supporting longer-run cost curve assumptions. In Macquarie's view, once restocking activity and steel production increases do impact on the market the large number of potential buyers on the sidelines should see prices hit US$120-$130 per tonne relatively easily. 

In terms of market specifics, Macquarie notes steel mills in China continue to hold too much inventory given the limited demand recovery underway. Excess capacity remains an issue in the steel sector, which has kept many mills bearish on steel prices given the potential for this capacity to swamp any improvement in demand.

Tighter credit conditions in recent months caused steel traders to sell inventory into a falling market, with de-stocking occurring at a rate of 8-10 million tonnes per month for August and September. This has pushed the mills out of the market, which to Macquarie implies end user demand for steel has not really fallen that much.

An end to trader de-stocking would allow steel mills to then de-stock their inventory and so start to increase production, but as Macquarie notes it is still unclear whether or not traders have finished the de-stocking process.

From an end-user perspective Macquarie suggests demand in general remains stable, while order books growing faster than revenue are a positive for future momentum in the sector. Macquarie continues to expect an improvement in steel and raw material prices from current levels.

For Goldman Sachs in contrast there remains enough reason to stay bullish on iron ore, particularly for the short-term, as a further recovery in the market is expected in 2013 given cost support appears to be at levels of around US$140 per tonne. 

To reflect this, Goldman Sachs has lowered its 2013 iron ore price forecast to US$140 per tonne from US$155 per tonne previously. In 2014 prices are expected to average US$126 per tonne, before falling more sharply to an average of US$90 per tonne in 2015.

UBS has similarly trimmed its iron ore price forecasts, with cuts averaging 4% through 2016. The broker's average price forecasts now stand at US$122 per tonne in 2012, US$119 per tonne in 2013, US$104 per tonne in 2014 and US$93 per tonne in 2015.

The revised price forecasts of Goldman Sachs suggest miners should continue to generate super-normal profits until 2014. Beyond this time earnings should fall as growing seaborne supply growth will gradually replace higher cost mines in China, sending the industry cost curve lower. The high costs in China reflect average ore grades falling below 20% Fe content.

Seaborne supply is forecast to increase at an annual growth rate of around 9%, this at the same time as the demand outlook for steel is expected to be more subdued given structural changes in the Chinese economy and a transition to less commodity intensive GDP growth in that country. For UBS this implies seaborne supply will be in modest surplus in 2013, rising to a surplus of more than 100 million tonnes by 2016.

As prices fall, investment in growth projects will become less attractive, meaning those companies with low cost asset bases and the ability to continue to pay attractive dividends appear best placed for longer-term outperformance. 

Among the Australian-listed plays that appear well placed under these criteria, Goldman Sachs includes Rio Tinto ((RIO)), BHP Billiton ((BHP)) and Fortescue Metals ((FMG)). While Rio Tinto is rated as Neutral by Goldman Sachs, both BHP and Fortescue are rated as Buy. Sentiment Indicator readings for the three stocks according to the FNArena database stand at 1.0 for Rio Tinto and 0.6 for BHP and Fortescue.

As part of its iron ore sector review, Goldman Sachs has resumed coverage of both Atlas Iron ((AGO)) and Mt Gibson Iron ((MGX)), the fourth and fifth largest iron ore producers in Australia. Atlas is rated as Neutral with a price target of $1.50, while Mt Gibson is also rated Neutral with a $1.00 per share price target.

The outlook for Atlas is one of production growth, as output is expected to double over the next two years. This offers a shorter-term opportunity, as iron ore prices are expected to increase during that period. This growth appears priced into the stock at current levels in the view of Goldman Sachs.

Longer-term the outlook remains less positive, as on a 3-plus year basis Goldman Sachs expects the seaborne iron ore market will move into oversupply. This is expected to push prices lower, to the point Atlas becomes a marginal producer.

For Mt Gibson the expectation is also for a recovery in earnings in 2013 as iron ore prices recover, but the issue for Goldman Sachs is the unsustainability of volume growth for the company. This is expected to limit any re-rating coming from higher prices.

Mt Gibson's strategy is under review, which also concerns GS and implies increased potential for company transforming transactions over the next 12-18 months. This adds to the investment risk. With new management in place and elevated transaction risk, the stock is fair value around current levels in the broker's view, especially given the longer-term view the seaborne market moves into oversupply in coming years.

As with Goldman Sachs, the changes to iron ore price forecasts implemented by UBS impact on earnings and valuations across the sector, though UBS makes no adjustments to price targets. In terms of preferred stocks, UBS rates Fortescue and Gindalbie ((GBG)) as Buy, while Atlas, BC Iron ((BCI)), Grange Resources ((GRR) and Mt Gibson are rated as Neutral. 

Sentiment indicators for these stocks in the FNArena database stand at 0.7 for BC Iron, 0.5 for Atlas, 0.4 for Mt Gibson, 0.2 for Gindalbie and 0.0 for Grange. 

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