Material Matters: China, Aluminium, Steel, Commodity Signals And Australian Energy Stocks

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-China's emphasis turns to living standards
-Aluminium supply reductions are happening
-Steel set for long period of oversupply
-US rates, dollar key signal for recovery
-MS stacks up Oz energy stocks
 

By Eva Brocklehurst

China

After touring major cities in China, UBS suspects a normalisation in commodity demand is even further away. Expectations for a sequential acceleration in infrastructure build up do not align with the insights the broker gained on the ground. Emphasis has shifted to quality of growth and living standards.

This presents a challenging outlook for commodity demand, the broker maintains. UBS prefers copper for its exposure to electrification, uranium longer term as nuclear building accelerates and aluminium as the light metal continues to capture market share. The outlook for Chinese coal demand appears grim.

Aluminium

Quiet may have settled on China's aluminium industry, with no news of any joint reductions to production at smelters but Macquarie believes otherwise. The broker suspects cuts are continuing but this is being done in an asset-by-asset manner and remains low profile.

Macquarie identifies 1.48m in production cuts from the smelters since mid October. The fast drop in aluminium prices from mid October has hurt those smelters at the higher end of the cost curve. The broker notes the divergence in smelter profitability could make the industry more difficult to assess in terms of co-ordinated production reductions compared with other metals.

The broker believes the decline in visible inventory has helped improve the market balance. Aluminium outperformed other base metals in November after the fall in October. Still, much of this related to a shift in fund selling into other funds, Macquarie suspects. The broker still expects a further cut to power tariffs in China. Power industry reform has the potential to lower costs for aluminium smelters and lead  to lower domestic prices in China.

Steel

Painful adjustments continue in the steel industry and Macquarie doubts a quick cure is nigh. Utilisation rates are set to remain below 80% in the foreseeable future. The broker suspects sustained price upside will require a number of events taking place, all of which appear improbable.

As a result, the broker downgrades steel price forecasts by 10-15% through to 2020. Despite prices being at a level which not only discourages new supply but also causes substantial capacity to exit the market, the unique factors in the steel equation mean the broker does not envisage demand will grow enough at any point. This means the volume of supply adjustment needs to be significantly larger.

Commodity Signals

Morgans believes the implications of the substantial re-structure announcement from the world's fourth largest miner, Anglo American, are dire, noting the intention to suspend dividends and close, mothball and sell any cash-negative asset.

The market remains fearful, the broker notes, regarding measures other miners may take to shore up their balance sheets. The signals required to build back confidence in commodity prices include specific near-term lifting in US interest rates and a topping out of US dollar strength in 2016 as well as an abatement in volatility and a relief rally in oil.

Positive signals already under way include reductions in capex and capacity. Key supply remains uneconomic for seaborne coal and large segments of global nickel and aluminium, the broker believes. The strain on marginal producers in LNG and iron ore is also increasing. The broker observes further production cuts are needed to bring these markets back to balance.

Australian Energy

Morgan Stanley expects an oil price recovery will occur towards the end of 2016. While not necessarily forecasting such, the broker highlights a sensitive point in the oil price at US$40/bbl and reviews what this would mean for Australian energy stocks if it held out for the next two years.

Obviously, it would significantly reduce earnings and dividends for the companies involved. Woodside Petroleum ((WPL)) would be loss making under this oil price and no dividends would be paid, in the broker's calculation, but the company would be cash-flow positive in FY17 once current spending on Wheatstone is completed.

Oil Search ((OSH)) would be slightly negative in cash flow, assuming such an oil price, amid due debt repayments but the broker observes it does have US$1.6bn in liquidity which could be used to manage a prolonged downturn. Dividends would be negligible.

Santos ((STO)) has a small number of debt maturities in 2016, with its major one being in 2017. At US$40/bbl there would be no earnings or dividends, in Morgan Stanley's estimates.

Origin Energy ((ORG)) which has a defensive income stream from power and energy retailing, but believes it can service its 20c dividend from these activities without cash flow from APLNG. After paying APLNG debt and interest, Morgan Stanley calculates the break-even on cash flow for Origin is US$38-42/bbl.
 

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