Material Matters: Iron Ore, Steel, Coking Coal, Oil And Gold

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-Iron ore rebound less likely
-Chinese steel consumption slows
-Oil earnings outlook plummets
-Lower AUD cushions gold sector
 

By Eva Brocklehurst

Super-high profits once enjoyed by the iron ore sector are over. That is the view of ANZ analysts. The large low-cost producers are now keen to nail down market share. This dynamic is emerging several years earlier than ANZ expected and also means near-term price forecasts are too high. Given weaker-than-expected demand the broker downgrades 2015 price forecasts by 22%. Iron ore prices are not expected to breach US$100/tonne again, even if high-cost supply in China is permanently closed. The analysts suspect this development is occurring now.

A visit to Chinese steel mills underpinned the gloomy outlook. The analysts previously expected a material rebound for iron ore off an oversold base but are now less convinced the mills will restock to previous levels. Prices are not expected to fall below US$70/t, a level that would shut down as much as 20% of global supply and position the market for substantial deficit. Still, prices for 2015 have been downgraded to an average US$78/t with a range of US$70-95/t expected. Only a mild recovery is expected in 2016.

NAB analysts note conditions in China remain the most critical influence on bulk commodities, reflecting the sheer scale of Chinese consumption. Of note, the Chinese economy grew by 7.3% in the September quarter, the slowest rate of growth since March 2009. For bulks, key parts of the economy are weak and the analysts expect China's growth will ease further, to 7.0% in 2015. While data quality is acknowledged as an issue when it comes to China's consumption of steel, it appear growth has slowed considerably across 2014 and the analysts expect that, should demand from construction continue to ease, opportunities to export steel may be limited.

As for the raw materials, iron ore stocks at China's ports are at high levels and, despite falling prices, the supply response from high-cost Chinese mines has been limited. China's metallurgical (coking) coal imports remain weak, while the analysts cite evidence that domestic production has expanded this year, with improved rail capacity boosting supply to key consuming regions.

Oil prices are now enduring a raft of downgrades similar to that which iron ore prices endured in recent months. Citi believes there is a need for oil supply cuts to offset price declines and the Organisation of the Petroleum Exporting Countries – OPEC – is unlikely to come to the party. A response appears to default, therefore, to US shale/tight oil production. The broker's analysis suggests that any pull back in this area of production requires a West Texas Intermediate price below US$75/bbl for an extended period of time.

In sum, Citi expects the oil price outlook will be…lower for longer. Beyond the valuation impact on stocks, the broker believes lower oil prices will make oil-priced LNG projects more competitive and may support cost deflation in the industry. On the other hand, this will further challenge domestic gas assets in a balanced market. Of Australia's major oil stocks, the broker envisages Woodside Petroleum ((WPL)) is the one least exposed to lower prices, given higher margin LNG projects.

JP Morgan also contends the prospect of a cut to OPEC production at the November 27 meeting is fading, amid disagreement over the appropriate response to falling prices. JP Morgan now has oil price forecasts that are materially below consensus, with its 2015-16 price deck now at US$82-88/bbl, down from US$115-120/bbl. The broker retains a positive stance on Australian oil equities based on long-term valuation support but concedes that should the bearish near-term view for prices be borne out, these stocks are unlikely to outperform. The impact on earnings forecasts from the broker's downgrades is significant, with the earnings leverage for mid-caps particularly aggravated by the low earnings base of some of the companies. JP Morgan retains a preference among large caps for Santos ((STO)) while AWE ((AWE)) and Drillsearch ((DLS)) are the top two in the mid caps.

Onto a brighter area – at least in terms of colour, and Credit Suisse observes the depreciation of the Australian dollar against the US dollar has provided some relief for gold companies that report in the local currency, cushioning the decline in realised prices. Credit Suisse notes the stand-out producer under the spot price scenario is OceanaGold ((OGC)), which benefits from low production costs via high by-product credits and the strong performance at its Didipio mine. Alacer Gold ((AQG)) and Regis Resources ((RRL)) also fare better in the current climate compared with other producers.

The broker recognises that its US$1,300/oz gold price forecast for the current quarter looks a little ambitious but then, if that is the case, its cost assumptions are equally too punitive. Where spot valuations are above prevailing share prices it may indicate value is emerging, or that the stock is mis-priced because the equity sell off has been de-linked from underlying value and is likely pricing in a further reduction in the gold price. In this context the aforementioned stocks stand out as the most resilient, in Credit Suisse's view. 
 

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