Material Matters: Oil To Japan, Steel And Iron Ore

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-Japanese oil demand growth unlikely
-Improved Chinese steel sentiment
-Iron ore purity to feature
-Australian producers currently profitable

By Eva Brocklehurst

Japan's oil demand development is normally low profile as the market focuses squarely on China and India. JP Morgan has looked at what might change in Japan, given the country achieved relatively strong economic growth in the first quarter of 2013, at 4.1% quarter-on-quarter. The upshot of the analysis is that demand will not boom. Japan's economy remains dominated by services, totalling 71% of GDP according to 2010 data. Thus, the commodity intensity of the economic growth is substantially lower than in more manufacturing oriented economies.

JP Morgan's analysis of Japan's income elasticity in demand for oil products leads to lower values for naphtha and gasoline, despite a rising intensity of diesel use. Transient factors that supported oil demand in 2011 and 2012, particularly in power generation, are now reversing. The nuclear outages that followed the 2011 earthquake increased the oil dependency of the power generators but this has been temporary, as the operators shift to cheaper coal and gas-fired capacity. The prospects for a nuclear re-start in 2014 will likely curtail demand for oil, along with increased competition from alternative sources. The short answer to whether Japan will consume more oil as the economy improves is …no.

Macquarie has results from the July survey of the Chinese steel sector and this points to a marked improvement in sentiment across the 40 steel mills, 30 steel traders and 30 iron ore traders that were interviewed. Orders have improved and profitability is rising, although most are still losing money. Moreover, the de-stocking of raw materials appears to have finally ended. Traders are only modestly optimistic about August volumes. Mills did report an increase in orders in July, the first sequential increase since February. Sales were broadly flat in the month. Mills plan to lift output in August but there is little change seen across end usage. Construction and infrastructure remain the strongest and manufacturing looks weaker.

Nevertheless, traders appear to be acting on more optimistic views with there being an increase in sales to traders and downstream processors after several months of decline. In terms of profitability, mills are gradually recovering from the low point in May. Margins for steel, based on measuring the spread between raw material and rolling costs and steel prices, are also recovering, but back to relatively low levels. Macquarie suspects coking coal's underperformance has allowed steel margins to recover, even as iron ore prices have pushed higher over the last month.

In an oversupplied iron ore market, Goldman Sachs expects steel mills to be less concerned by security of supply and more focused on margins and cash flow management, leading to even tighter inventories and more trading in smaller parcels from traders. Early signs of this behaviour are being seen with inventory levels down to around three to four weeks of use, mill gross margins rising and increased reports of mills trading in small parcels from local traders and producers. This suggests future de-stocking/re-stocking cycles will likely be short term in nature, and a four-month de-stocking cycle that occurred in late 2012 is unlikely to be repeated.

As oversupply looms in iron ore, Goldman expects a major shift to occur in pricing power. The purity and grade discounts and exogenous costs will start to feature more strongly in received prices and producer margins. Goldman estimates that Australian producers will remain profitable at the long-term iron ore forecast of US$88/dmt. Nevertheless, the profitability level is highly dependent on the Australian dollar depreciating and there being no change in the discount for impurities. Some producers are unlikely to have any capacity to absorb additional costs if the Australian currency remains at current levels. Goldman retains a preference those producers with the best quality resources. Those that are the best positioned – BHP Billiton ((BHP)) and Rio Tinto ((RIO)).

Across the Australian producers under Goldman's coverage, each delivers product of a different grade/impurity under different contractual pricing methods and with different freight costs relating to distance and vessel size. In summary, as the iron ore index price (62% iron fines, CFR China) falls, the impact of impurity/grade discounts and exogenous cost on the free-on-board price received by the producer rises. Assuming the Australian dollar is unchanged from current levels around US95c all Australian producers under Goldman's coverage remain cash flow positive at the asset level under the long term iron ore forecasts.

Over the past 12-18 months, in order to reduce finished steel production and maintain high smelter efficiency, mills have turned to greater use of lower cost, lower iron grade ores. This has added a greater level of price support for lower grade ores and seen the discount for lower grade ores virtually disappear. Goldman expects this discount for lower grade ores will remain relatively tight in the near term as steel mill utilisation rates remain low. Demand for higher quality steels will rise eventually as the Chinese economy matures and as environmental regulations tighten such that higher grade ore demand increases.
 

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