Material Matters: Large Miners, Industrial Demand, Mineral Sands And Coal

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-Iron ore, coal price weakness abounds
-Nickel, aluminium strength
-Mineral sands challenges remain
-Weak iron ore price underpins BSL
-But pressure on ARI, SGM
 

By Eva Brocklehurst

Higher base metal prices versus lower coal and iron ore prices mean Morgan Stanley's opinion on the big miners BHP Billiton ((BHP)) and Rio Tinto ((RIO)) is unchanged. The companies are defensive, fiscally sound and well supported. Multiples remain elevated and the broker suspects the market's expectations of capital returns may be disappointed.

Morgan Stanley has reduced forecasts for iron ore and coal prices by up to 20%. The strong Australian dollar remains a headwind for bulk commodities and provides a downside risk to the broker's estimates in the second half of 2014. For the major miners the resultant earnings impact swings from negative to positive by less than 5% because of competing price impacts. The broker's nickel, alumina and aluminium prices forecasts are strong for the next four years. BHP and Rio Tinto should still be able to pay dividends and deliver on growth projects because of their long-life, low-cost assets.

Citi expects an acceleration in industrial commodity demand despite the difficult start to 2014. This is based on improving global output and more positive sentiment regarding China. That said, the broker expects growth will be modest. Citi thinks the rate of growth in iron ore supply will abate by the end of the year and, with cut-backs in mining capex, will take 1-2 years to have an impact on commodity markets. In the meantime, supply side disruption could boost prices, as has been evident this year in nickel, zinc and palladium. Earnings momentum has become less negative but the miners are already pricing this in, in the broker's view. Yield support has served as a floor for the big players but the broker suspects this alone will be unlikely to drive the sector higher. BHP is likely to deliver the biggest surprise, in the broker's view, because of improved cash flow and working capital, opening up the way for increased dividends and/or buy-backs.

Market fundamentals for mineral sands remain weak. New supply is coming on line at a time of significant excess capacity, although Goldman Sachs observes supply discipline has helped to stabilise prices slightly above marginal production costs. Goldman assumes the largest producers will continue to show restraint in order to stem further price declines. The broker maintains forecasts for zircon but downgrades the outlook for titanium feedstock prices by 5%. The mineral sands sector is challenging and, on the demand side, the broker thinks the US housing sector offers most potential for upside to offset the slowdown in the Chinese property sector. On the supply side, forecasts are highly depending on the willingness of larger producers to operate below capacity for the next six months or more.

Deutsche Bank has reviewed its forecasts for commodity prices and, in line with this review, has increased profit expectations for BlueScope ((BSL)) for FY15 and downgraded expectations for both Arrium ((ARI)) and Sims Metal Management ((SGM)). Iron ore price forecasts decline to US$89.3/t for FY15 fines, reflecting a decline of 20.7% year on year in US dollar terms. Should iron ore prices remain at current levels, which the broker thinks unlikely, this could lead to a 24% increase to Arrium's FY15 profit forecasts, a 3.7% increase for Sims and a 1.5% reduction for BlueScope.

The broker has also reduced FY15 premium hard coking (metallurgical) coal price forecasts by 8.8% to US$130/t. Should coal prices remain at current levels this would have the most favourable impact on Arrium's earnings. BlueScope remains the broker's pick in the sector, given a strong balance sheet, exposure to the Australian housing recovery and potential upside in steel earnings. Key risks for the steel sector include a stronger Australian dollar, softer steel and scrap prices and an increase in imports.

The hard coking coal benchmark price appears to have been settled between Anglo Coal and Japanese mills at US$120/t FOB Australia, unchanged from the second quarter and in line with Macquarie's forecasts. It seems pricing is, at the very least, not deteriorating in US dollar terms. The broker notes the prices are the lowest in the history of the quarterly system that started in 2010. The realisation for Australian producers is down $2.50/t quarter on quarter. The market remains oversupplied and despite a number of mine closures, more are required. Macquarie thinks the price can only grind slowly higher at best. Admittedly, North American supply curtailments largely came too late to be reflected in seaborne exports for the first half of 2014 so this will be an incremental positive for the second half.

Continued strength in Australian and Russian export volumes is expected and Mongolia, although a wild card, continues to outperform. This suggests to Macquarie that further US cuts remain the source of supply rationalisation. The broker notes this is exactly the situation Australian producers were hoping for. The Chinese market now appears less flexible and spot prices at a key break-even point for a number of Shanxi producers, so Macquarie is relatively confident that downside to spot pricing is limited. Spot prices may tick higher and a fourth quarter contract settlement of US$125/t is possible but short term upside is likely to be capped as Chinese import growth is not considered sustainable. Moreover, virtually every tonne of Australian semi-soft coal is being sold into the thermal market and, as the coking coal price recovers, these tonnes will return to that market.
 

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