Material Matters: Alumina, Nickel, Iron Ore, And Oil & Gas Equities

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-Supply gap widens for aluminium
-No rush to buy nickel
-Steel contraction potential
-Bad news peaking for oil & gas
-But that does not mean a rally
 

By Eva Brocklehurst

Alumina and Aluminium

Can the alumina price recover in the next six months? This is the question Credit Suisse asks. If China’s aluminium smelters ramp up as planned then the shortfall in alumina should peak in the December quarter and push up the price, attracting imports. On the other hand, the broker suspects aluminium smelters need to curtail output by 2.4mtpa this year, bringing forward the peak to the current quarter when prices are falling. If smelter reductions are forthcoming the broker finds little reason for alumina to recover.

The alumina price is at its lowest level since 2009. The fall reflects imbalances in the speed of the ramp-up in aluminium smelters and alumina refineries. In the first half of this year China faced a glut in alumina which drove down prices.

Alumina refineries have ramped up faster than aluminium smelters. Looking forward, aluminium smelter curtailments in China are a major near-term risk. China has a heavy aluminium surplus and will have to curtail smelting as exporting the surplus is no long economic. With smelter output being curtailed and alumina demand dropping a recovery is unlikely. Given prices are still heading lower, Credit Suisse cannot find any support for upside to alumina prices over the next six months.

Nickel

Demand is key to the nickel market as Macquarie continues to witness prices weakening despite a structural deficit looming. Until global growth prospects improve the analysts believe there is no rush to buy nickel. The June quarter was weaker than initially expected, not just in China, but Macquarie has become even more bearish about Chinese demand in the second half and no longer finds compelling evidence for a strong rebound.

A small surplus is now expected, rather than the emergence of deficits from 2016 onwards. The overhang of inventory in the market appears higher than previously projected. A more bullish pricing outcome is predicated on widespread closure of supply capacity and any rebound in stainless steel orders. However, growth in global industrial production has stalled in recent months, leading to a slowing in underlying consumption.

On a positive note, there has been a big fall in average operating costs, reflecting lower ore prices, power costs and transport costs, as well as currency weakness against the US dollar. The other positive is that the price of nickel in stainless steel scrap has risen sharply in Europe in recent months, reflecting higher production following anti-dumping duties on EU imports of stainless steel from China and Taiwan, as well as the sharp rise in Chinese imports of ferronickel.

Longer term, Macquarie retains a bullish stance on nickel. When short covering begins prices could move up very quickly although the broker believe time is running out for a significant rally in 2015.

Iron Ore

The surprise devaluation of the Chinese currency provides more proof the company’s growth engines are cooling. The question for Goldman Sachs is how this will play out for the inputs to China’s copious steel production. While significantly impacting coal, the effect on the iron ore market is likely to be more muted, in the broker’s view. Imported coal must be priced competitively against China’s domestic coal. In the case of iron ore, imports are expected to displace Chinese concentrate.

The potential increase in Chinese steel exports as a result of the devaluation could displace steel production elsewhere, while the introduction of tariffs and quotas should moderate the amount of cheap steel the rest of the world is willing to buy.

Goldman Sachs observes iron ore supply and demand could diverge even further. Iron ore exports from Brazil and Australia have been affected by bad weather and port maintenance issues and low inventory levels in China have left buyers exposed to further disruptions. The broker expects the upcoming weaker seasonal period for steel production will mean supply diverges further from demand as seaborne producers put operational issues behind them.

Goldman expects peak steel production will be followed by a contraction. The greater the delay before demand is allowed to fall to a more sustainable level, and the longer marginal iron ore producers benefit from capital inflows and prices above marginal costs, the more abrupt the transition is likely to be.

Up until recently, excess supply would have been taken up as inventory. In the current climate, optimism about future demand growth appears to be lacking, the broker observes.

Oil and Gas Equities

Another down-leg for the energy sector is unlikely, Morgan Stanley maintains. The upcoming reporting season for stocks will probably be about balance sheets and preserving capital. Bearish sentiment is seen near its peak and some equities are now deeply discounting long-term assets. The broker does not expect a rally, if the lacklustre performance of global energy equities is a guide. Just that there are few bull points on the horizon and bad news may be peaking.

Those equities which are deeply indebted need to sell assets and make additional reductions in expenditure, the broker maintains. Dividends are at risk. If coming from debt rather than free cash flow they will need to be cut, eliminated or underwritten. Morgan Stanley acknowledges the area for positive surprises lies in the depth and extent of expenditure cuts. The only company which has its dividend profile covered by cash flow at US$60/barrel is Oil Search ((OSH)) but the broker observes the yield is low.

Woodside ((WPL)) may respond with downward adjustments to its pay-out ratio, the broker contends. Both Santos ((STO)) and Origin Energy ((ORG)) have taken on large amounts of debt to complete LNG developments and their share prices reflect expectations of a funding gap. Morgan Stanley believes both have unsustainable dividends which, at the very least, are likely to be underwritten.

There are mounting pressures on the oil price, which may delay any meaningful recovery in the price until 2017, the broker maintains. These pressures are coming from resilient US supply, de-stocking in China, easing of Iranian sanctions and no effective OPEC response. Australian companies are not considered well positioned to withstand US$50/barrel oil prices, should they prevail. Still, the industry has survived an oil slump before. The response, the broker notes, was to cut spending.
 

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