Material Matters: Aust Capex, Steel, Price Forecasts And Thermal Coal

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-Aust infrastructure unlikely to prop weak economy
-Support for low grade iron ore
-Developed world steel demand is weak
-Price outlook for commodities diverging
-European thermal coal price edging up

By Eva Brocklehurst

Public infrastructure spending in Australia is unlikely to replace mining investment. Goldman Sachs has analysed the elements of size and scheduling for major public projects that are both underway and flagged. Overall, the analysis shows that there will be just $3 billion or less added to 2014 growth from the Commonwealth's flagship road projects, with modest upside across public infrastructure spending in other sectors. This will not offset the $25 billion contraction that is forecast for mining construction activity.

Goldman suspects that the Reserve Bank board is feeling a degree of frustration, as attempts to talk the Australian dollar down are thwarted by the US Federal Reserve's decision to delay the tapering of quantitative easing. The rally in the Australian dollar may be only short term, with the recent downgrade of Western Australia's rating and only a weak recovery in the non-mining economy. In the broker's view this should be enough to signal to the RBA that, after confirming a benign CPI in the third quarter, a cut to the cash rate is necessary in November. The analysts concede the RBA has not signalled any urgency to cut the cash rate and there are some signs of recovery in some areas of the non-mining economy, such as housing and building, but growth is just not robust enough to put the spectre of a further easing out of the picture.

The World Steel Association has published the August 2013 statistics, indicating global steel production rose 5.4% over the year. For the first time China's production exceeded the rest of the world. While global steel production continues to grow, global steel mill utilisation rates are soft, at only 75.4%. Goldman points to these two statistics as underpinning support for low grade ores. With limited ability to change prices, Chinese steel mills have been defending margins by inventory management and reducing input costs. Iron ore stocks at the mills remain near functional lows, at around three weeks of use in Goldman's estimation, while incremental buying is holding seaborne prices near marginal cost levels. Mills have made greater use of lower iron grade ores to reduce input costs and the discount for lower grade has disappeared. Goldman expects the low grade iron ore producers will benefit while excess capacity exists, the steel market is in surplus and iron ore in deficit. In the near term, this supports producers such as Fortescue Metals ((FMG)) and Atlas Iron ((AGO)).

Macquarie observes the recovery in steel supply, ex China, has suffered a setback. The developed world's call on steel is still very weak. Europe's share of global output has slipped to a new low, at just 13% of overall production. Okay, August is not a strong month in northern hemisphere steel production, because of holidays, but production was below the equivalent in 2010-12 and continues a general downtrend. Europe was not alone in being weaker either. Output from Japan, India, Korea and Taiwan fell month on month. The weakness in these key markets reinforces the risks to emerging market demand, quickly observed in steel given its overall leverage. Macquarie cannot deduce a developed market recovery from what is happening in real steel demand.

One other interesting point from the data was the implied recovery in China's use of scrap. From an average of around 125mtpa last year, recent months have revealed that around 150mtpa was used, even with lower prices. It could be partly because 2012 was a weak year for price-driven scrap collection, following the surge in 2011, but it does suggest to Macquarie that industrial output in China, and thus the generation of scrap, has been improving.

Citi has altered price forecasts for gold, oil, iron ore and coal. The analysts have upgraded gold price forecasts by 4% for 2013 to US$1,405/oz, 9% in 2014 to US$1,250/oz and 8% to US$1,350/oz in 2015. Despite the upgrade, the 2014 forecast remains below current spot. Oil price expectations for 2013, 2014 and 2015 Brent have been upgraded by 4%, 10% and 11%, to US$109/bbl, US$108/bbl and US$103/bbl respectively. Iron ore price forecasts have been upgraded 3% for 2013, due to higher than expected prices in the third quarter, but the forecasts are maintained at US$115/t for 2014 and 2015. Coking coal prices have been downgraded around 5% to US$161/t in 2014 and US$170/t in 2015, with thermal coal downgraded 11% to US$78/t in 2014 and 8% to US$85/t in 2015. Base metal prices remain largely unchanged, but Citi is still bearish relative to consensus.

The analysts expect that the price outlook of various commodities will continue to diverge from the "super cycle" as capital investment differs across commodity classes. Generally, supply should rise as capex falls but is not entirely cut. Projects that are under construction should continue and support supply. Citi's basis for altering the price outlook for various commodities include slightly better US growth. Despite the macro indicators being somewhat lacklustre, Citi observes there is a tendency in the US to revise data higher, which has happened in 11 out of the last 13 years.

The Fed's lack of action on reducing quantitative easing reflects uncertainty, in Citi's view, and appears designed to prop up fragile momentum. European growth, meanwhile, is tepid because of a lack of credit, while performance will continue to be differentiated in the developing world based on individual economics. Slowing demand for commodities, particularly as the Chinese economy transitions, could leave exporting countries such as Brazil, Chile, Indonesia, Mongolia, Peru and South Africa more vulnerable than others, in Citi's view.

European thermal coal prices appear to be pulling out of a slump but Macquarie notes the price has only returned to May 2013 levels, while the recent bottom in July of around US$72/t was the weakest level since March 2010. Nevertheless, the upside risk to Europe's thermal coal prices exceeds the downside, and the analysts forecast that prices in 2014 will average US$83.50/t versus US$80.9/t year to date. The analysts base this view on the fact US exports continue to be cut and new coal-fired units in the Netherlands and Germany will come on line over the next couple of quarters. The conservative upside reflected in the forecast relative to current levels is because the market remains substantially oversupplied. Macquarie suspects that, at between US$85-90/t, US central Appalachian export volumes to Europe become economical again, imposing a ceiling.

On a global basis, supply curtailments in thermal coal have really not materialised. The continued supply glut has meant that prices are currently down more than 10% since the start of the year. Although the economics of power generation in Europe remain positive for coal relative to gas, thermal coal imports have been marginally lower. The demand weakness has been driven by a couple of factors, in Macquarie's view. Firstly, weak macro economic conditions in the Mediterranean has meant that power demand, overall, has fallen, with Spain an obvious example. Secondly, stocking cycles in Europe now involve smaller volumes of material. Buyers are not wanting to keep large stocks when the price is falling and the product is plentiful. 

As many metals markets move to surplus the warehousing situation is receiving a lot of attention. In nickel and aluminium, Macquarie estimates that total stocks amount to almost six months of global metal output in these markets, of which one-third in both cases is estimated to be held in raw materials, mainly in China. This has important implications as Indonesia potentially restricts exports of nickel-bearing ores and bauxite from the start of next year. At this stage, Macquarie thinks there is ample raw material on hand to cushion any disruption to supply chains for a number of months before any real physical shortage might emerge. At the other end of the scale is the lead and tin markets, where there does not appear to be excess stocks, at least for lead in the primary market. Macquarie thinks lead and tin markets are very finely balanced and, in the case of lead, approaching peak seasonal demand.
 

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