Commodities | May 23 2013
-Recent mine expansions risk impairments
-Rising US dollar affects metals prices
-China to ban low-grade coal imports?
-Copper fundamentals may be improving
By Eva Brocklehurst
What goes up must come down. Goldman Sachs suggests that, if companies change strategy when prices rise, they need to do the same when prices fall. Miners seek to maximise net present value/discounted cash flow when optimising assets. The treatment of large volumes at lower grades delivers more output and can result in lower unit costs, delivering benefits while commodity prices are high or rising.
Among the benefits of increasing production is additional free cash flow, earnings growth and, with lower grade cut-off, potential extension of the mine life. Along the way there are higher cash costs and additional capital requirements. What this scenario does not necessarily do is deliver better returns on investment capital. When prices of commodities fall, as Goldman forecasts for next year, the higher costs driven by inflation and expansion come into play. In order to remain profitable companies may need to close high cost operations and retain a preference for treating higher grade material. Goldman highlights the potential for mine lives to be materially shortened and the carrying value for many assets to be impaired at a segment level, if the company cannot demonstrate a profitable future.
The broker takes a look at which miners are most at risk. Those that have recently undertaken expansions are now more highly leveraged to volume and price than previously. Kingsgate Consolidated ((KCN)) is one example. The Chatree mine recently underwent expansion, doubling the plant size and lowering the head grade. The expansion was justified as the company assumed higher gold prices and the operation looked significantly more valuable at an expanded rate. As the gold price eases the resulting valuation is less favourable. Alacer Gold ((AQG)), Teranga Gold ((TGZ)) and OZ Minerals ((OZL)) are also at high risk of impairments, in Goldman's view. Newcrest Mining ((NCM)) may not be at risk at a consolidated level but the broker highlights the potential for impairment at the Telfer mine. Telfer profits look to be in decline from FY15 and Goldman believes any impairment on this asset will impact sentiment on the stock.
A rising US dollar may be pressuring marginal producers of metals. Or is it? The US dollar continues to gain ground against most major currencies, particularly the yen and euro, and this should mean lower metal prices. The US has become less important in recent years as both a consumer and producer of metals but this should mean prices become more correlated with the currency's movements. Hence, marginal producers of base metals should be under pressure from lower prices. In Macquarie's view, this expectation ignores China, where the renminbi is not free floating but pegged to the US dollar. Against the renminbi the US dollar has been falling steadily and is down 1.4% so far this year. China is not only the largest consumer of most metals but also a marginal producer of all base metals, with the possible exception of tin.
What this means is that, as the US dollar and renminbi both rise, the cost of buying metals for Chinese consumers becomes cheaper, increasing demand, but revenue for Chinese producers falls, curbing output. More demand and less supply typically means a higher price, offsetting some of the price falls caused by the currencies' rise. As long as this continues the impact of a stronger US dollar will be reduced.
Media reports are suggesting China will ban the import of low-grade coal, leading to expectations the domestic price will bounce. Morgan Stanley has viewed the draft document and thinks it is unlikely to push up the domestic price of coal. Instead, demand is so weak prices are not seen picking up any time soon. The definition of low-grade coal in the document suggests current coal imports exceed the specification. If imposed, it is unlikely to have a significant impact on volumes. Moreover, having just deregulated the coal market by removing pricing caps on contract sales, Morgan Stanley believes the government would be unlikely to intervene in the domestic market. Weak coal prices are considered a result of poor demand. Based on power generation data it seems thermal coal is losing share to hydro. Having said that, the analysts believe coal prices are well supported at current levels heading into the Chinese summer.
Morgan Stanley finds signs of an improvement in the fundamentals for copper. While acknowledging the bearish scenario over the past five months has been compelling, there is some evidence the key components are breaking down. Most importantly is the sharp rise in cancelled warrants in the LME system, which signals improving demand and warehouse bottlenecks. the near tenfold increase in cancelled warrants is not only large in absolute terms but heavily concentrated in the three major warehouse locations that had the bulk of copper inflows over the past eight months. These are Antwerp in Belgium, Johor in Malaysia and New Orleans in the US.
In the analysts view, queues are forming at these locations as the owners of the metal try to secure a timely departure, a signal of increased demand and restricted LME load-out rates. The new rates the LME has implemented have done little to address bottlenecks the analysts are now seeing, as supply interruptions in India and at the Chilean ports tighten up available copper. One consumer, Luvata, has stated it has been forced to obtain material form alternative sources to the LME to satisfy near-term demand. Morgan Stanley also thinks the feedstock market is becoming increasingly tight. Unexpected mine outages and a share fall in scrap availability is narrowing the allowance for supply disruption in the forecasts for supply.
Last but not least there is a modest improvement in demand in China. Morgan Stanley's copper consumption leading index for China has been rising for five months on the back of rising white goods sales, increased power grid investment and strong automotive sales. As a result of the review, Morgan Stanley has decided to leave a relatively optimistic forecast unchanged at US$7,793/tonne or US$3.53/pound for 2013.
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