Commodities | Jun 19 2014
This story features AURIZON HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: AZJ
-Nickel dip a buying opportunity
-China's aluminium squeeze
-China's port capacity limits on iron ore
-Risks to coal haulage margins
-Goldman wary of Iluka's leverage
By Eva Brocklehurst
Indonesia's nickel export ban is likely to remain in place and the nickel market turn to deficit at the end of the year. Citi believes this to be the case, despite reports of a review being undertaken by Indonesia's interim minister. The minister has pledged to settle protracted negotiations with several copper miners, not nickel miners. Buoyant stainless steel markets, unaffected by substitution, should support a 2014 growth rate of 5.8% for nickel demand. Moreover, Citi does not believe substitution will be material in affecting nickel prices. Both of Indonesia's presidential candidates support the nickel export ban and Norilsk and Rusal, as well as Chinese companies, have shown interest in Indonesia producing more value-added products in the future.
London Metal Exchange nickel prices have corrected since their peak in mid May, suggesting to Macquarie there has been some liquidating of long positions. This is a buying opportunity, as nothing has changed in regard to the fundamental supply shortage resulting from Indonesia's ban. As LME prices have fallen, physical prices for refined nickel and nickel alloys have also pulled back in China. With inventory looking high and cash flow tightening, spot buying has slowed, leading to a correction in prices. The analysts note that nickel pig iron prices have not fallen as much as nickel or nickel ore prices. This reflects the fact that these producers are at a point in the chain where there is some genuine cost pressure, given how quickly nickel ore prices have risen relative to other products in the value chain.
Nickel pig iron producers are now withdrawing from the market for ore. Prices may take some weeks to settle, as participants adjust purchasing activity to account for higher levels of inventory downstream, but Macquarie believes the fundamental drivers behind a bullish nickel call are unchanged. China's imports of nickel ore have fallen 20% over the first four months of 2014. Yet Chinese stainless steel production remains robust, despite a relatively high inventory of finished product. This means demand is still out there and Macquarie expects the mills will come back to the spot market for nickel by late July. Then the physical market for nickel will tighten again. Thus, this short term weakness presents a good buying opportunity.
Although there is no immediate shortage of raw material for the aluminium market following the Indonesian ban, Macquarie suspects Chinese domestic producers maybe be squeezed in the next few years as production costs for bauxite and alumina rise. Local bauxite may not be readily available. The world's reserves of bauxite are extensive but Chinese extractable reserves are just 3% of world reserves. Given China's continued strong demand from the aluminium industry, current domestic reserves are likely to serve the country for no more than 10 years. The bulk of imported bauxite is converted in Shandong into aluminium but there are some real concerns over the additional capacity that is being created outside of Shandong. Macquarie believes these refineries will be under cost pressure as they are adding capacity that relies on local feed.
Lower seaborne prices for iron ore are driving Chinese domestic prices down and the pressure on marginal Chinese production is gradually increasing. Goldman Sachs believes the smaller, more labour-intensive mines are most vulnerable to the low prices. They are responding via reduced production volumes. Goldman notes stock yards in Chinese terminals have provided a useful buffer to absorb excess seaborne iron ore in the early stages of structural oversupply. Chinese port stocks are now nearing a physical constraint on storage and this means ports will no longer act as a safety valve in an oversupplied market. Inventory build will be limited and marginal producers are now fully exposed to the structural oversupply in the market.
Coal prices are now below the cost of production for some mines and Goldman estimates that cash costs relating to 30-40% of Australian coal production could exceed spot prices. Despite the fall in prices, coal production in Australia is growing and miners are hurting on take-or-pay contracts. Asciano ((AIO)) and Aurizon ((AZJ)) service 55% and 45% respectively of this coal volume and these long-term haulage contracts provide some protection against volume downside. Miners are increasingly seeking relief from their obligations and in some cases this is being granted. Goldman thinks a renewed focus on productivity by coal miners means risks are related more to margins than volumes. On this basis the broker reviews near-term assumptions for the two carriers and prefers Asciano (Buy) over Aurizon (Neutral).
Goldman notes many investors look for Iluka Resources ((ILU)) to provide pure exposure to the recovery in the mineral sands market. In Goldman's view, Iluka is a price taker and its fortunes are ultimately dictated by market leader Rio Tinto ((RIO)). Investors expecting strong leverage to a market recovery are likely to be disappointed. The two companies are the world's top mineral sands producers. Goldman considers Rio Tinto is the price maker in the titanium dioxide industry and derives very healthy margins at current prices. The company will be concentrating on volume expansion and production efficiency to drive earnings growth. Iluka is restricted by its higher unit cost base and will be forced to defend unit margins by managing sales to achieve prevailing prices.
Goldman believes Iluka has limited opportunity to increase sales without undercutting current prices and affecting its unit margins. Hence, any earnings recovery for Iluka is reliant on gains in zircon, a rational market where the company has a more favourable position. Still, against peers that believe zircon is a by-product, the market dynamic could destabilise very quickly. Iluka's strategy of lower costs by maximising production may work in the near term but this is cash intensive and unsustainable in the absence of a strong recovery in demand, in Goldman's opinion.
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