Experts See Continued Price Support For Commodities

This story features BHP GROUP LIMITED. For more info SHARE ANALYSIS: BHP

By Chris Shaw

Speculative positions in many commodities corrected sharply at the start of February, but as Standard Bank notes this is now reversing and speculative activity is again building throughout the sector.

This swing in activity levels is likely to continue in the bank's view, with commodity prices expected to experience sharp corrections as futures markets become over-extended relative to underlying physical market conditions in certain commodities. The bank expects any dips will be bought, meaning recoveries post such corrections will be fast.

What should support commodity prices generally in Standard Bank's view is a widely held expectation the global economy will continue to recover, even given recent concerns about sovereign debt in the Eurozone region. Importantly the bank notes growth is particularly strong in the commodity-consuming economies, especially those in Asia.

The other likely positive for commodity prices in the bank's view is indications suggest accommodative monetary policy will remain in place in both the US and Europe, which will add to global liquidity. Given this, the bank suggests while speculative positions in the commodities complex are building, they don't yet look overextended.

The sovereign debt issue in Europe has been a weight on the euro recently and as a weak euro implies a stronger US dollar, this has meant precious metal prices have come under pressure. But with the possibility of an agreement for Greece to receive some emergency lending, precious metal prices have recovered a little as the euro has bounced.

Barclays Capital sees the news as easing the short-term pressures on the euro but doesn't expect it will be a turning point for the currency, largely because of the conditions attached to the political agreement. These include the potential for any deal to be vetoed, the emergency nature of the funding and the likelihood of IMF involvement in any deal.

A short-term relief rally for the euro should be a positive for gold in the view of Barclays, especially as investment demand for the metal continues to hold firm and there remains potential for labour disputes to impact on the supply side.

Standard Bank agrees the deal may ease downward pressure on the euro short-term, but points out there are still questions to be answered before the longer-term downward trend in the currency will stop. This leads the bank to suggest while gold is finding support, selling into rallies remains the preferred strategy.

According to Standard Bank, resistance in the gold market currently sits at US$1,100 per ounce and US$1,109 per ounce, while support is at US$1,085 and US$1,000 per ounce.

Among the base metals, zinc has been the worst performer in 2010, having lost around 15% since the start of the year. This compares to fairly flat copper and aluminium prices, while nickel has gained about 17% over the same period.

According to UBS, zinc's relatively poor performance this year is partly in response to its better performance in 2009, which meant it began 2010 at an unfavourably higher base. As well, a lift in zinc inventories has undermined confidence in the metal's price.

UBS does expect inventories to come down as economic and trade activity in Europe and the US recovers, while it also sees prices as getting a boost from an underperforming supply side. Over the next 3-5 years major mines such as Brunswick and Century will shut down as a total of 1,035,000 tonnes of metal in concentrate is forecast to be exhausted by 2014. In UBS's view there are not enough projects in place to replace this capacity in coming years.

UBS is forecasting an average zinc price of US115c per pound this year and US117c per pound in 2011, while it notes market consensus forecasts are at 104c per pound for 2010 and US114c per pound for 2011.

To play zinc via listed Australian equities UBS rates Perilya ((PEM)) as a Buy given the stock offers significant leverage to the metal price and has a number of options given a broad asset base. In contrast UBS rates Kagara ((KZL)) as a Sell.

In the metallurgical coal market UBS notes there are reports a major Australian supplier has settled contract prices for the first quarter of Japanese financial year (JFY) for semi-soft coking coal with Posco of Korea at a price of US$167 per tonne. The broker suggests the likely supplier is Xstrata.

The price compares to UBS's forecast for a price of US$125 per tonne and represents an increase of 109% from JFY09. A tight market is helping push prices, as UBS points out when prices for higher grade PCI coal are high and rising, there is a corresponding lift in demand for lower grade coking coals.

At current price levels, export coal earmarked for trade in thermal markets is likely to be washed and sold into the metallurgical coal market in the broker's view, to the extent as much as 3% of thermal coal trade is likely to be switched this year. This is expected to prove supportive for prices.

The most recent point of significance in the iron ore market according to UBS, are comments from China's Baosteel suggesting it is a reasonable expectation for some adjustments to pricing in the market to be made.

This implies a move to more shorter-term contracts, a change from the annual contract price negotiations seen in recent years. As an example UBS expects Brazilian producer Vale's push to move to quarterly contracts is likely to succeed given the comany exports the trade's largest quantity and given supply remains very tight in the global market.

Based on annual contracts UBS had been forecasting a price increase of around 40% for JFY10, which is below market expectations for an increase of something between 70-90% in year-on-year terms. Any shift to quarterly contracts could mean an even bigger increase as Vale is asking for a rise of 110% for the first quarter of JFY10, so UBS suggests a likely outcome for a quarterly price rise is something in the range of a 70-110% increase.

Such a result would fit with what Macquarie notes is an optimistic mood in the industry, one it suggests was reinforced at a global iron ore and steel forecast conference Macquarie analysts attended in Perth by expectations of many more years of Chinese steel and iron ore demand growth.

As Macquarie points out, major industry players such as BHP Billiton ((BHP)) estimate it could be as much as 20 years before China reaches its peak steel intensity. Other major producers also presented bullish steel demand outlook expectations for well beyond 2010 at the conference.

One point of interest to emerge at the conference according to Macquarie, is market related pricing appears here to stay, with contract pricing to shift from an annual benchmark rate to more frequent price resettings.

As UBS also noted, the comments from Baosteel appear to indicate there is the potential for the structure of iron ore contracts to be reviewed, so Chinese steel mills may not be the stumbling block to any transition to market-based pricing that some in the market had thought.

The size of the spot market also supports a shirt in the nature of price settlements, as Macquarie notes spot now has a legitimate place in determining market fundamentals. At the conference, BHP Billiton talked about a 20% increase in volumes sold using a floating iron ore price.

Aside from a new contract pricing structure, the most supportive point for iron ore prices going forward is the constrained supply outlook, Macquarie pointing out this is being partly driven by a lack of labour in WA. The stockbroker expects this will continue to support prices at is implies upward pressure on project costs.

For junior players in the sector a major hurdle remains accessing export infrastructure, which Macquarie sees as potentially causing some projects to be delayed. At the same time, freight rates could actually come down thanks to an expected increase in supply in what is already an oversupplied freight market.

Overall, Macquarie suggests the combination of strong demand and potentially significant supply delays simply reinforce its view of a stronger medium-term price outlook for iron ore.

Click to view our Glossary of Financial Terms