Material Matters: Coking Coal, Iron Ore, Prices, Production And Productivity

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-Coking coal outlook robust
-Iron ore prices find support
-Uranium, gold price forecasts eased
-Copper tops base metals for Merrills
-Goldman: focus on productivity not cost
 

By Eva Brocklehurst

Prices for coking coal produced a wild ride for US equities in recent years. Bumper profits helped, but JP Morgan suggests this connection is now at an end and the impact of falling coking, or metallurgical, coal prices on equities is probably over. Having said that, the broker thinks US producers of the black stuff face significant headwinds. The Australian benchmark price has been reported to have settled at US$152/t, a better look after the spot price fell as low as US$129.5/t in July. What's disappointing for US-based coal producers is that the most recent reports show the (FOB) price for equivalent US coking coal is US$10/t below the Australian level. This difference in the price for the Pacific and Atlantic regions highlights the dichotomy of stabilising Chinese demand and weak European and Brazilian demand.

The biggest driver of the higher benchmark price has been the recovery in the Australian dollar from lows of US89c to the recent level around US94c. Now, the broker is not of the view that the Australian dollar drives the coking coal benchmark but that both the coal price and the Australian dollar reflect changes in Chinese demand for raw materials. The lower local currency also lowers the marginal cost of production. US producers were helped when the Aussie was holding well above parity. With Australian miners now more competitive and planning to expand production, the broker suspects US miners will be deeply pondering the upcoming contract renewals with the US steel makers for 2014.  JP Morgan expects a mild recovery in metallurgical coal prices in 2014, averaging US$161/t for the Australian benchmark.

Production costs among metallurgical coal producers in Australia fell 14% in the first half of 2013 relative to the second half 2012 but Goldman Sachs expects excess capacity and falling costs will limit further improvement. This is because spot prices are already at US$150/t , the broker's upper estimate of cost support, while seaborne prices have overshot relative to Chinese domestic prices, suggesting that Chinese import volumes could ease in coming months. On that basis, Goldman's 2014 forecasts are raised to US$150/t but 2015-17 forecasts are unchanged. Further production cuts are seen as necessary over 2013-15 in order to offset the incremental supply from growth projects that are coming on stream and allow for some pricing tension to emerge.

Australian production costs have benefited from several tailwinds and the local coal sector appears robust to Goldman as well. Recovery from the 2010-11 floods means mines affected by water management problems are now at full production. Production volumes across six BHP Billiton ((BHP)) mines are in line with the same period prior to the floods. More broadly for the Australian coal sector, port throughput at the main coal export terminals in Queensland looks like exceeding previous record levels, set in 2010. Goldman also thinks the depreciation of the Aussie has been beneficial for producers, since approximately 70% of operating costs are denominated in local currency. The recent focus on efficiency and cost control has reduced overhead costs, put greater pressure on commercial terms with suppliers and contractors, and generated higher volumes.

Macquarie observes 2013 as a year where commodity demand has exceeded expectations. This is the first in four years that the analysts have increased demand forecasts mid year. Nevertheless, prices are still reflecting excess supply characteristics. Coal supply is seen starting to react to this pressure and the analysts have reduced expectations for metallurgical coal.

Macquarie has raised near-term iron ore forecasts to US$90/t CFR China (62% iron) from US$80/t previously. Macquarie expects prices to average over US$100/t in the medium term. After analysing steel demand and both the Chinese domestic iron ore industry as well as the seaborne market, the analysts conclude that iron ore prices will remain above US$115/t over the next two years and be above US$100/t out to 2020. Looking at the Chinese domestic ore situation, Macquarie finds that nearly 40% of Chinese capacity will be uneconomic by 2018 under base case forecasts. Also, financial and political incentives to support a loss-making sector are no longer present. In terms of seaborne expansion, half of the proposed projects will require a long-run price of over US$100/t to generate a good return and subsequently, depending on the timing to market, many could be at risk. Hence, Macquarie's base case seaborne supply additions of 380mt through 2020 are well below market expectations, as many prospective additions are not expected to develop.

One aspect of the analysis suggests there'll be less volatility in iron ore prices, with a 200mtpa annualised swing from peak to trough in iron ore demand within any given year. This may be affected by the incentives and displacement of marginal tonnes at various points in the cycle but Macquarie sees the upper end of the curve flattening, resulting in lower levels of volatility over time. The potential for overshooting and undershooting the price estimates will stand, but the lower volatility could be the catalyst for positive re-rating of equities. The broker's view is that US$85-90/t represents a floor in cyclical price swings and this favours the major producer as their top tier assets mean they will not be subject to the competitive behaviour smaller companies will be engaged in.

BA-Merrill Lynch has also reviewed iron ore price forecasts. Inventory is seen elevated and the modelling suggests some downside to prices. However, while inventories at mills are high they have not reached alarming levels. Downside should be limited and the analysts are comfortable with a Q413 price forecast at US$125/t. For 2014, the analysts' price estimate is unchanged at US$110/t. Preferred iron ore exposures in this scenario are Fortescue Metals ((FMG)) and Atlas Iron ((AGO)).

Citi is more bearish on short-term iron ore prices, with a 3-month price forecast of US$115/t. Moreover, the analysts believe risks are skewed to the downside. Chinese demand is expected to be pressured by credit tightening that began in the June quarter and intensified over the northern summer. Recent data is also less reassuring. Strong Chinese steel production and iron ore imports in recent months have masked weaker fundamentals, in Citi's view. Excess steel production has been pushed onto international markets, while iron ore inventories have been rebuilt at lower prices. Citi expects expect weaker steel production and softer demand for imported ore in Q413. A surge in seaborne iron ore supply is expected over the coming months, driven by increases in Australian exports from Rio Tinto ((RIO)), BHP Billiton ((BHP)) and Fortescue Metals. This has led to expectations that Q413 production will increase by a record 34mt year on year and 12mt quarter on quarter. Large quantities of Brazilian ore are also currently in transit as a result of inventory drawdown after rail problems were resolved.

BA-Merrill Lynch has reduced gold price forecasts as the US Federal Reserve's decision to taper QE creates headwinds. Prices may remain supported in the run-up to the US fiscal debt ceiling. The gradual normalisation of monetary policy in the coming quarters should bring sustained pressure to gold prices and the analysts have lowered 2014 price forecasts by 17% to US$1,294/oz. The broker's preferred gold stock is Alacer Gold ((AQG)).

The broker has also taken the blade to earnings from uranium producers because of large downgrades to forecast spot prices -11%, 24% and 8% in 2013, 2014 and 2015 respectively – and contract uranium prices – 4%, 6% and 7% in 2013, 2014 and 2015 respectively. Prices have been lowered because of soft Japanese demand as nuclear reactor re-starts are delayed. As a result, the previously expected uranium supply-demand balances has turned from a around 14mn lbs deficit at the end of 2014 to a 7mn lbs surplus. Preferred uranium stock is Energy Resources Australia ((ERA)). As a result of the supply headwinds, Macquarie has also made significant downgrades to uranium and molybdenum prices for the coming years.

Copper remains the top base metals pick for Merrills. While prices have stabilised, stronger economic activity in China has had only a limited impact on the physical market, partially because market participants have continued to de-stock. In Merrills' opinion the reduction of stocks will gradually subside and along with higher growth in China, the US and Europe, copper should average US$3.27/lb in Q413. Preferred copper stocks are PanAust ((PNA)) and OZ Minerals ((OZL)).

Finally, productivity – the third 'P'. Over the past decade, Goldman Sach,s observes productivity within the Australian mining sector fell around 30%, as mining companies were focused on volume rather than value. That focus, coupled with rising commodity prices, delivered profit growth but masked falling productivity. Now that growth is more subdued a renewed focus on productivity is required. In fact, the broker thinks shareholders should demand it. Goldman's analysis shows that the combination of commodity currency deflation, a cyclical downswing in consumables and improved productivity has the potential to reduce costs by more than 15%. So, rather than judging companies on cost cutting strategies investors should attend to the productivity measures that the companies are targeting. To Goldman, this is a better reflection of operational quality and provides a more sustainable path to cost reduction.

Improving productivity would ultimately deliver the benefits of greater volume and falling costs. A cost cutting scenario is not the broker's base case, but Goldman thinks it could drive significant reductions in commodity price forecasts, margin compression and value destruction. Assuming long-term marginal cost support falls 10% across all commodities, valuations for mining companies within the broker's coverage would be 11-27% lower than base case. BHP remains the broker's preferred exposure in the sector due to the relative valuation, lower downside risk in a cost-cutting scenario and asset diversification.
 

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