Metal Matters: US Dollar, Copper And Iron Ore

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-US dollar rallies, metal prices fall
-Copper production to rise strongly
-Iron ore oversupply could be earlier
-Arrium's fortunes rest heavily on iron ore
 

By Eva Brocklehurst

Improving US economic fundamentals and a rally in the US dollar has provoked Macquarie into looking at how a prolonged dollar bull market would play out for commodities. If, and the analysts emphasise the If, a bull market is in train this would mean weaker US dollar prices for precious and base metals. This does not automatically mean the prices will diminish in terms of other currencies. Macquarie analysts suspect the changed dynamics of the US dollar could make the negative impact less pronounced, at least for metals prices ex gold.

Macquarie analysts have looked at the historical cycles for the US dollar in terms of metal prices and, for anything not produced in the US, there is a negative correlation for metals prices with a rising US dollar. But other factors can outweigh the currency. For example, a bear period for the US dollar occurred in 2002-2008. Then the US dollar price of metals rose as expected, but so did the euro price of those metals (except palladium). Why? Supply and demand were such that weak mine supply and strong Chinese demand reinforced the impact of a weaker dollar and offset the negative impact of a stronger euro.

Recently, with the US dollar rising on resurgent economic optimism, the improved sentiment may also boost metals prices and actually offset the impact of the stronger dollar. Euro metal prices could also perform very strongly. The analysts note the exception remains gold as it is often bought as a safe haven so the price could be hit by the US dollar gains and better economic circumstances.

Putting speculation on the dollar aside, copper prices could come under scrutiny with production in 2013 looking like turning around. Copper and gold production over the last few years has shown the worst downward trend of the metals but Macquarie, having reviewed the top mines across the world, is of a view that copper will reverse. Of the top ten mines producing in 2005, the analysts note that Antamina and Los Pelambres are the only ones that produced more in 2012. More mines are having output re-jigged, with Escondida the stand-out case after output more than halved between 2005 and 2011. Macquarie is more confident that a recovery in output witnessed in late 2012 can be consolidated in 2013. Hence, 2013 should deliver strong gains from the top mines of 2005 and Macquarie expects this will make up a large part of the 5% global copper mine output growth that's forecast.

Will that recent iron ore price weakness continue? Goldman Sachs has shifted to call a more neutral view on iron ore, ratcheting down the forecast to US$139/t from US$144/t for 2013. Longer-term the analysts are bearish because of more robust domestic Chinese production and an expected surge in seaborne supply.

Steel production growth in China has slowed recently and Goldman expects that to remain below GDP growth rates in the future, as the Chinese economy matures. Moreover, steel scrap availability should increase at the expense of primary steel production. On this basis, global iron ore demand is forecast to revert to historical rates of 2% per annum, which compares with the 8.8% in 2002-12. The analysts are not so sure, now, that Chinese iron ore production will decline. Previously, small, high cost mines were expected to be displaced by lower cost seaborne supply. Now, continued investment in large scale mines is seen offsetting the loss of marginal mines and may impinge on import demand.

There are important implications for seaborne iron ore producers, Goldman maintains. The top four – Brazil's Vale, Rio Tinto ((RIO)), BHP Billiton ((BHP)) and Fortescue Mining ((FMG)) deliver around 67% of seaborne supply growth over 2013-15. After threshing the numbers, Goldman has brought forward expectations of an iron ore oversupply to 2014 from 2015. The analysts are not stating outright that supply will exceed demand, rather that the supply side needs to take note of current growth projections. Even so, the magnitude of potential oversupply could force a significant downsizing in the sector.

Furthermore, no other growth market is likely to emerge to take the place of China in seaborne iron ore demand. India's steel sector has not relied on imported ore to date and annual production volumes are only a fraction of China's. Goldman finds the iron ore industry highly concentrated with weak producer discipline. Seaborne demand growth is slowing to average 3%, while seaborne supply is still running at 7.3%. The analysts believe the most likely outcome is prices overshooting on the downside and staying below the marginal cost of production for long enough to balance the market.

Goldman has reviewed iron ore and steel stocks and found Arrium ((ARI)) the most wanting. Earnings estimates are seen peaking earlier than previously assumed, in FY14. The revised iron ore outlook puts prices broadly in line with the broker's estimate of cash costs for Arrium in FY16. This will more than offset any recovery in steel operations in FY15 and FY16. The broker has recently downgraded Arrium to Hold. The implications of the iron ore revisions are less drastic for BlueScope Steel ((BSL)) and Sims Metal ((SGM)), with the former is not involved in iron ore and the latter dealing in scrap, diversifying the risk.

Without a near-term improvement in the domestic steel business, BA-Merrill Lynch, too, finds the fortunes of Arrium rest heavily on the iron ore price. The broker believes the company can deliver a ramped up capacity of 12mtpa of expected sales by July but the additional tonnage is likely to be sold into a lower priced environment. BA-Merrill Lynch weighs iron ore at 80% of earnings forecasts for Arrium in FY13. The broker is not expecting Arrium to make inroads into its debt balance in the near term and expects volatile trading. Risk is weighted to the downside, tied to iron ore price weakness. BA-Merrill Lynch has rated the stock as Sell.
 

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