Material Matters: Steel, Bulks And Mineral Sands

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

 – Chinese steel market outlook reviewed
 – Bulks trading below cost support
 – An end to coal's dual pricing system
 – Mineral sands expectations updated

By Chris Shaw

After October offered some signs of improvement, Macquarie's latest survey of the proprietary steel sector in China showed some levelling off in markets. One concern for the broker is that steel mills appear more positive than steel traders, which may be leading to some over-production of steel.

Based on the survey data, Macquarie suggests prices for steel and raw materials appear range-bound in coming weeks, though with inventories falling there is upside risk to steel production volumes in the broker's view.

Macquarie's view is that any production push could result in stronger iron ore and coking coal inventory, especially as raw material inventory remains low and mills are hesitant to re-stock. Macquarie estimates inventory held at mills, traders and the SHFE currently stands at between 5.5-6 weeks of stock. This is a three year-year low.

With de-stocking expected to continue through the end of the year and scope for a more muted seasonal re-stock early in 2013, Macquarie sees potential for the market to start to feel short of steel in the first quarter of next year. This could generate strong roses in both production and prices.

Goldman Sachs suggests bulk commodity prices are trading below cost support at present, with spot prices for iron ore, premium hard coking coal and thermal coal all trading 7-14% lower than the broker's forecast of cost support levels.

The demand outlook for the bulks is expected to improve in 2013 as steel production and coal-fired generation accelerate. Current weak prices are also likely to see marginal coal mines scale back production, something Goldman Sachs sees as a positive for the market next year.

In thermal coal, Goldman Sachs notes the softness in prices this year has reflected a well supplied market, but ongoing strength in seaborne demand and a recent fall in US exports has meant prices have started to recover. 

For Goldman Sachs, price risk for steel raw materials is skewed to the upside from a 3-6 month perspective. Steel raw material prices are not expensive when compared to steel prices and demand looks set to accelerate next year, while current price levels are simply unsustainable at levels below cost support in the broker's view.

Goldman Sachs estimates cost support at present stands at US$140 per tonne for iron ore, US$180 per tonne for premium hard coking coal and US$90 per tonne for benchmark thermal coal.

UBS has also looked at the coal market given the current dual pricing system, where coal is sold into both annual contracts and the spot market, is likely to end this year. Under a new system UBS suggests contract volumes would be fixed but prices would be determined by negotiations between buyers and suppliers and could be set on a monthly, quarterly or annual basis.

The new system is unlikely to have more than a limited impact on large thermal coal producers in China as they maintain significant market share. More competitive imports suggest some import growth in the mid to long-term. This effect has already been seen for Australian coal producers, UBS noting market share for Australian produced coal in China has risen to more than 23% in 2012 from around 19% in 2008.

On Credit Suisse's forecasts, minerals sands prices are heading into trough-cycle pricing in the first half of 2013 as a consequence of weak demand this year. Zircon prices are leading the way lower, while TiO2 prices are expected to follow after pigment producers stock up under legacy contracts this year.

In the zircon market Rio Tinto ((RIO)) holds quarterly auctions and the broker expects prices will decline from August reserve prices of US$2,000 per tonne to around US$1,500 per tonne this month. Prices are expected to continue to weaken, Credit Suisse suggesting levels around US$1,300 per tonne could act as a price floor in coming months. 

Demand appears to be overshooting on the way down and this leads the broker to suggest prices should enjoy a modest rebound once floor price levels are reached. Again, the broker expects TiO2 prices will follow a similar downward trajectory but offer less scope for a subsequent bounce.

In terms of forecasts, Credit Suisse expects from an expected average of US$2,313 per tonne this year, bulk zircon prices will average US$1,425 per tonne in 2013 and US$1,700 per tonne in 2014. Titanium slag prices are forecast to average US$1,688 per tonne this year, then US$1,163 per tonne in 2013 and US$1,100 per tonne in 2014.

JP Morgan agrees titanium feedstock prices are likely to fall given the lack of a supply response to weaker global economic growth and de-stocking in the sector. The weaker market conditions see JP Morgan forecast soft demand for the next three years. 

At the same time JP Morgan argues there is little incentive for producers such as Rio Tinto to curb supply, as low-priced contracts are due to roll-off. This combination of strong supply and weak demand sees the broker forecast material price falls in the titanium feedstock market in both 2013 and 2014. In contrast, production cuts by Iluka ((ILU)) should keep the zircon market in tighter supply in the broker's view.

While this has kept zircon prices higher it has also increased product substitution, though JP Morgan notes using alternative materials for zircon impacts on product quality and so is unlikely to have a significant long-term impact on demand. 

Given zircon demand has growth consistently with GDP over the past 20 years, JP Morgan suggests the current weak levels of demand will likely prove to be a short-term issue and consumption will move back to long-term trends over time.

In JP Morgan's view, Iluka will be able to keep the zircon market in tight supply as it account for around 30% of production and other producers have limited capacity to lift output. As a result, while price forecasts have been revised lower, it is 2012 and 2013 where the major impact is felt. JP Morgan now expects zircon prices this year of US$2,188 per tonne, down 7% from its previous forecast, and US$1,850 per tonne in 2013, down 11%. The broker's price forecast of US$2,000 per tonne in 2014 is unchanged.

Following their respective reviews of the minerals sands market outlook, both Credit Suisse and JP Morgan have updated their models for Iluka. Factoring in revised price forecasts for minerals sands sees earnings forecasts for the company lowered, JP Morgan suggesting the rest of the market is likely to follow suit in cutting forecasts given continued weakness in demand and pricing.

The changes to earnings estimates have resulted in cuts to price targets, to $12.35 from $13.00 for JP Morgan and to $11.00 from $12.00 for Credit Suisse. In both cases Buy ratings have been retained as both brokers expect some improvement through 2013 as markets recover somewhat.

By way of comparison, the FNArena database shows a Sentiment Indicator Reading for Iluka of 0.5, with a consensus price target of $11.33. Targets range from Macquarie at $6.50 to Citi at $16.80. Macquarie has the only Sell rating in the database, based on the view ongoing weakness in Iluka's markets will continue to weigh on the share price.

 
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms