Material Matters: Miners, Copper And Iron Ore

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Conditions favouring bulk miners; copper's price surge; iron ore outlook.

-Chinese steel consumption expected to hold up, US infrastructure agenda supportive
-Copper makes sharp gains on improved fundamentals and likely US infrastructure spending
-Macquarie suspects iron ore prices have overshot and risk is to the downside
 

By Eva Brocklehurst

Miners

Morgan Stanley analysts have come away from their trip to China with the belief steel consumption could hold up, allowing higher metallurgical (coking) coal prices and necessitating the use of higher quality iron ore.

China's domestic iron ore supply is likely to be slow to respond to demand and, while there is a coal supply response under way after the relaxation of mining restrictions, it is not affecting the price yet because of re-stocking.

Hence, Morgan Stanley believes conditions are constructive and favours the bulk miners. While uncertainty remains high, the broker acknowledges, the agenda of infrastructure spending and tax reform in the US also underpins expectations and presents potential upside risk to demand growth.

The US share of major commodity demand is about half what it was back in 2000, so even conservative estimates for a stimulus plan may result in material upside to growth forecasts, Morgan Stanley asserts.

As the broker favours bulk miners, BHP Billiton ((BHP)), South32 ((S32)), and Iluka Resources ((ILU)) are in the top five. BHP is considered a nod to quality and longevity, while South32 has cash flow drivers and the broker envisages Iluka is leveraged to the US and Chinese property market.

The broker also includes gold names such as Evolution Mining ((EVN)) and Perseus Mining ((PRU)), as inflation and debt issuance associated with an infrastructure program should support gold, the risk being a US dollar bull scenario.

Copper

Macquarie upgrades copper price forecasts by 11-15% for the next four years. Spot copper prices have surged from a tight trading range and improving supply/demand fundamentals are expected to provide some support. This broker also suspects, given increased infrastructure demand in the US, there is little reason for prices to retreat back to the previous range.

Copper was the one big commodity to gain nothing in the year to date then rally sharply ahead of the US election, peaking at US$6025/t on November 11. The rally was unprecedented in recent copper history, Macquarie observes and, despite the later sell-off, the broker cannot envisage the price retracing to pre-November levels easily.

The election victory of Donald Trump was the major trigger, the broker believes, given US dollar weakness and expectations of increased stimulus in China and infrastructure spending in the US.

Copper was probably supported by a bearish skew among speculators, which provided a short stop-loss means for prices to climb. Also, China has cleared a lot of physical stock in the last few months, leaving it vulnerable to metal shortages, and this in turn, the broker notes, influences its huge futures trading sector.

While the impact of Donald Trump's election may have helped tighten the copper balance further Macquarie stresses that the major upgrade to its price forecasts is more heavily motivated by the realities of the price pushing to new levels. The broker envisages some oversupply in 2018/2019 which will moderate prices to below US$5000/t, before a deficit takes hold and puts prices back in the low US$6000/t region.

Incorporating the improved outlook, Macquarie upgrades earnings estimates for both Sandfire Resources ((SFR)) and OZ Minerals ((OZL )). Both are upgraded to Outperform from Neutral. Newcrest Mining's ((NCM)) outlook is enhanced by the upgrades to copper price forecasts but Macquarie retains a Neutral rating ahead of the company's investor seminar.

Improved copper prices have also translated to a material improvement for the short to medium term outlook for both BHP and Rio Tinto ((RIO)). Macquarie notes copper leverage is higher for Rio Tinto in the near term from an earnings perspective.

The upgrades to copper price forecasts have taken care of some of the upside risk to the broker's base case, but there is still material upside risk envisaged to its iron ore, coking coal, thermal coal, aluminium and alumina price forecasts.

Iron Ore

Iron ore prices have breached US$74/t for the first time since January 2015. Macquarie observes this move comes despite an apparent lack of fundamental support, and most market players are pointing to short covering. Meanwhile, in the physical market there is a widely disparity between grades. The demand for high grade fines and pellets is very strong as mills look to minimise the use of coking coal.

Earlier this year the Chinese government raised trading fees on the Dalian exchange and on the Shanghai futures exchange, which resulted in a sharp drop in trading volumes and prices. Recently the government took similar measures regarding speculators.

Macquarie is unsure whether these measures will lead to a reassessment of the recent bullish trading activity in bulk commodities in China, which has been driven by inflation expectations and concerns about depreciation of the renminbi.

Market fundamentals are unchanged and the broker continues to believe that prices have overshot and should ease back to trade in a fundamentally supported US$45-55/t range.

While Chinese steel demand has exceeded expectations, the broker still expects that seasonal and sequential steel output in China will fall in the months ahead. The broker observes iron ore supply is plentiful already and will continue to rise in the months ahead.

Citi suggests changes being called to the Western Australian iron ore royalty are a risk for both BHP Billiton and Rio Tinto. The changes being proposed are part of the long-standing tension over GST raised in WA being used to subsidise other Australian states.

The issue has been heightened by the pressure on WA's budget from infrastructure projects committed to during the mining boom, which have to be paid for when commodity prices are significantly lower.

There are two forms of royalty payments in WA, a royalty for ore and a 25c/t rental that applies after 15 years of production on a mining lease. The rental is what the WA National Party is looking to increase to $5/t and is currently only being paid by the former two miners and Cliffs' Koolyanobbing mine, although other producers are likely to be captured over time if they have production over 15 years.

In 2015 the tax collected $120m, affecting 470mt of BHP/RIO production and suggesting, in Citi's calculations, a cost of $2.2bn, with a net impact after minority interests/tax of US$500m for each company. This would lower net present value (NPV) and net profit by 4% at spot prices, increasing the risk that BHP and Rio Tinto would expand production by 20mt and 30mt respectively.

Fortescue Metals ((FMG)) is not liable to pay the tax for a number of years but such a scenario would also re-shape the cost curve, in the broker's view, making Vale the lowest cost producer.
 

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