Material Matters: Silver, Oz Oil Stocks, China’s Reform, Gold And Coking Coal

This story features SANTOS LIMITED. For more info SHARE ANALYSIS: STO

-Silver use in solar peaking
-Growth in oil stocks hard to come by
-Chinese push for efficiency, clean industry
-All-in costs not supporting gold price
-Headwinds to coking coal price
 

By Eva Brocklehurst

There's been an interesting story around silver in recent years. Silver is a key component in photovoltaic cells – or solar panels – and demand has risen sharply. Silver was used extensively in the production of photographic film but the advent of the digital camera meant that end use declined. Solar panels appeared to offer a replacement, as silver has a number of attractive properties. Falling manufacturing costs, rising oil prices and environmental concerns meant silver consumption took off. Now, Macquarie suspects demand has peaked, earlier than expected. Silver usage in the solar sector this year is estimated to be nearly 1,000 tonnes lower than at its peak in 2011. What has happened?  There's been a slowing of growth in solar cell production but also a marked reduction in silver usage per solar cell. The former is likely to be just a pause but the latter seems permanent.

A large expansion of the solar sector will not be enough to make a significant increase in silver offtake. Macquarie thinks that, even by 2016, silver demand will be only 7% higher than the 2013 estimate, and 38% below the 2011 peak. Silver prices rose sharply in the first decade of the century which meant efforts to reduce silver consumption were accelerated. The manufacturers have been remarkably successful and average silver used per solar cell has been reduced by two thirds in the past two years. This appears to coincide with an improvement in output. So what's replaced silver? Macquarie observes a drive to use copper, which is almost as conductive and only 1/90th the cost by weight. Some challenges remain, in terms of contact adhesion and stability. The recent fall in the price of silver has taken some of the pressure off reducing usage but Macquarie thinks the game is over for silver in solar.

Credit Suisse has tried to put a handle on the growth potential for Australia's major energy stocks. Assuming levels of sustaining capex and costs of production, Woodside Petrolem's ((WPL)) price is implying nominal 4.5% growth to perpetuity. For Santos ((STO)) this is 5% and Oil Search ((OSH)) 3.9%. Looking at it another way, assuming they all achieve nominal 2.5% growth to perpetuity, real annual stand-still capex would need to be as low as US$1.94bn for Woodside, US$1.67bn for Santos and US$490m for Oil Search. It's a tough ask.

Credit Suisse thinks the location and nature of Woodside's growth projects (Australia) makes it hard for the company to achieve sub-industry costs. Santos also has large and uncertain costs in developing GLNG. Oil Search has structurally unique economics in PNG and visible low-cost production, so it may be considerably easier for that company to achieve such growth. On the basis of the number crunching, Credit Suisse thinks Oil Search offers the only palatable risk/reward profile among Australia's energy stocks.

China's politicians have laid out the road map for reforms after the third plenary session wound up last week. Macquarie noted expectations were low heading into the session and any positive sentiment that was expressed should have helped iron ore and steel sectors. In contrast, statements regarding bringing local government finance under control were seen having potential downside impacts on growth and hence metals demand in 2014. The push for efficiency could impact markets such as coal and aluminium. In these markets, the Chinese domestic price sets the arbitrage floor for the global market. If Chinese producers become more efficient and competitive this will act as barrier to medium-term price improvement.

One of the key reforms was environmental report, rarely mentioned before. Party leaders will be held accountable for environmental degradation. This will have major impact, near term, on steel capacity, particularly in Beijing. It will also likely add to the cost of steel making, reducing competitiveness. Macquarie does not think it will reduce coal consumption. Alternative sources are not of the appropriate scale. What is more likely is a move to increase coal production and consumption in the west of the country and limit consumption growth on the seaboard. This could present a problem for an oversupplied global thermal coal market, in Macquarie's opinion.

Citi has thought about whether all-in cost analysis provides a floor for the gold price. Gold is likely to show an annual decline in price this year, its first in 13 years. COMEX bullion prices are down 21% since the start of the year. Gold miners have been unable to reduce costs quickly enough to keep up. Citi's analysts calculate that average all-in production costs fell by 6.1% year on year in the first half, to US$1,666/oz, and this compares with average spot prices falling at a rate of 7.4% to US$1,530/oz. Citi suspects the entire gold industry is burning cash at an all-in cost basis. The upper part of the curve is dominated by regions such as Russia and South Africa. Hence, the broker does not think that all-in costs support the gold price.

Gold producers are more likely to analyse cash costs rather than all-in costs when considering mine closure. Citi thinks cash costs provide a better indicator of pressures within the gold industry than all-in costs, as these are more likely to be taken into account by miners contemplating a halt to production. Gold mine supply increased by 10% between 2009 and 2012 to reach a record high of 2,846 tonnes. This indicates that, while the gold price has undercut all-in costs, prices have yet to fall by a sufficient degree against cash costs for gold producers to consider curtailing production. In addition, the significant amount of gold stocks above ground, which rose by 2% in 2012, further suggests that mine production cutbacks, if they do occur, are unlikely to support prices.

Metallurgical, or coking, coal has surprised many this year. Supply has outperformed expectations while Chinese demand has held up well above what was expected. Supply side, Australia has provided the product but, despite Chinese imports rising 37% year on year, the price is stuck around US$150/t. What's the reason? Macquarie thinks it relates to the Chinese domestic production. Apparent output has risen by 8% this year and, with state owned enterprise required to take costs out of their business for the first time, they look to have a lower margin cost input than previously witnessed. Hence, any demand-driven recovery in metallurgical coal prices could have significant headwinds.

Moreover, Australia has grown output after 2010 floods and now major suppliers are pushing more tonnes out of existing operations. The market leverage to Australian supply is as strong as ever heading into the season when peak disruptions are likely to occur. Macquarie expects a further 6mt of Australian export growth in 2014. Exports are also rising strongly form Russia, Mozambique and Canada. Increased buying outside of China has not been enough to take up all the excess supply. Thus, 2014 looks like another year where the metallurgical coal market will trade at a level to keep sufficient Chinese supply in the market to balance the books. Macquarie continues to think any recovery in coking coal pricing will be difficult, and another year of prices around US$150/t FOB for Australian hard coking coal should be expected.
 

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