Material Matters: Strategy & China, Coking Coal, Iron Ore And Copper

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China's policy and support for commodity prices; steel demand underpins iron ore and coking coal; stability in copper prices.

-Oz commodity producers provide a hint of elusive growth
-Leading indicators suggest risks skewed to the upside for mining equities
-China's 276-day policy unlikely to be relaxed in the short term
-Iron ore supported by tighter balance of supply and demand
-Most copper producers generating cash at current spot price

By Eva Brocklehurst

Strategy

Further fiscal expansion in China is likely to support commodity prices, in Credit Suisse's view. The broker was about to lower its Overweight position in Australian commodity stocks as it believed a less expansionary policy from China would weigh. Recent news provides the impetus to reverse course. The broker expects this should mean the consensus Australian earnings-per-share growth outlook for commodity companies for FY17 is more achievable.

This sort of analysis has long history of over-estimating one-year forward growth prospects for companies by a large margin, the broker contends, yet this time it could be different. Australian commodity producers provide a hint of growth in a market where it remains generally elusive.

Credit Suisse places BHP Billiton ((BHP)) back in its long portfolio at the expense of ResMed ((RMD)). Petroleum is considered to be the key differentiator for BHP and the broker is constructive on Brent prices in the coming 12 months.

Deutsche Bank contends that industrial commodities and mining equities have returned to a more normal cyclical pattern. The main indicators for the mining sector remain the Chinese credit and property cycles, global fund flows and risk appetite as indicated by the US dollar. Inflation, as indicated by the oil price, and producer behaviour in managing supply are also leading indicators.

The broker believes, all up, the risks are skewed to the upside for the mining equities. Four of the leading indicators are positive – Chinese property prices, sales volumes, glass price momentum and money supply growth. Only Chinese steel prices, inherently volatile, suggest any near-term weakness. Oil prices have been range-trading but Deutsche Bank expects the trajectory to be positive over the medium term in contrast to the US dollar, which is weak relative to expectations.

Chinese Policy On Coal

UBS observes the 276-day policy that stipulates Chinese coal mines move to producing over 276 days a year suggests a theoretical cut to production of around 16%. The objective is to re-balance chronic oversupply and reduce industry losses. The policy has been successful at lifting prices and profitability but has also lifted imports, unlikely to be the desired outcome. The broker does not believe the policy will be relaxed in the short term.

For the next few months the broker expects coal inventory levels will be important signals, as policy makers may be sensitive to outright coal shortages should they occur. The broker suspects the re-stocking ahead of the winter heating period in China could start earlier this year because of low inventories and this is a potential trigger for higher coal prices.

Iron Ore And Metallurgical (Coking) Coal

China's macro economic data remains supportive of steel demand, with property prices continuing to rise. In line with the usual seasonality, Chinese steel production has started to soften into the year end and 2016 is shaping up as being broadly flat. On this basis Ord Minnett increases output estimates for 2017.

Ord Minnett upgrades its iron ore price forecasts for 2017 and 2018 to $US54/t and US$50/t respectively. Coking coal forecasts are raised 20% and 23% to US$114/t and US$117/t respectively. Hence the broker raises its estimates for BHP Billiton, Rio Tinto ((RIO)), Fortescue Metals ((FMG)) and Whitehaven Coal ((WHC)) over the same forecast period.

A tighter balance of supply and demand, driven by improved Chinese steel demand and slower ramp-up of new supply from majors such as Vale has driven the upgrade to the iron ore price. While it remains difficult to forecast coking coal at this point, given the aggressive rally in the product, the broker also factors in upgrades to hard coking coal estimates. Partly offsetting the positive impact are higher Australian dollar estimates.

Fortescue Metals remains the broker's top sector pick in iron ore and Rio Tinto is upgraded to Accumulate from Hold. Ord Minnett believes, with many other sectors looking expensive, Rio Tinto will be a beneficiary of investors looking to rotate into mining.

Whitehaven Coal is a significant beneficiary of the recent rally in the coal price but the broker suspects prices could react strongly to any potential news regarding a relaxation of Chines capacity reductions. The broker maintains a Hold rating on South32 ((S32)), with oversupply in its key markets needing to be addressed before becoming more constructive.

Copper

UBS observes the copper price has been very stable over the past three weeks, at around US$2.10/lb, and the price has not sold off despite a big move by speculators to short the metal, perhaps instigating selling on the recent spate of weak economic data, particularly in the US. The broker wonders whether short term physical markets have absorbed this speculator swing because the price, usually highly correlated to these movements, has failed to budge.

UBS does note that supply from Chile has been weaker these past three months but, overall, the market looks well supplied. The broker's free cash flow analysis suggest most copper producers are making cash at the current spot price.
 

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