Commodities | Jan 20 2014
-Copper capacity constraint ahead?
-Upside risk to iron ore prices?
-Citi likes miners, diversified
-Coal pricing looks soft
By Eva Brocklehurst
There's a supply conundrum in copper. Macquarie observes that the current cyclical tightness in refined copper may be turning, while the impact of a growing surplus in concentrate has not been recognised to date. This is expected to have an increasing impact on the first half of 2014. Global demand growth is not the problem. It's the renewed crackdown on financing in China, which is taking away a driver of demand, as well as the easing of tight scrap supply.
Macquarie notes one of the key factors driving copper prices higher in recent months was a cathode deficit, as material was drawn from warehouses and shipped to China because of high premiums over the LME cash market. The analysts are concerned LME prices may trade lower, as this demand is removed through a reluctance for Chinese banks to finance copper. Macquarie also expects the recovery in developed world industrial output will help scrap generation. The analysts expected the copper stock cycle to turn in 2014 and smelters to increase output in coming months, as they have incentives to process concentrate into cathode. In 2-3 years there may be strains on downstream capacity, in the analysts' view. Copper refineries have not added to capacity in recent years with the low margins hindering such expansion. Should this continue there is an increasing chance that capacity will be at a maximum by the end of 2015 – something the analysts will be keeping an eye on.
Hence, for small cap copper stocks this could be a significant year but the implications are mixed across the sector. It's the Year of the Horse but it could well be the year of Tiger Resources ((TGS)), in the broker's opinion. The company is moving from supplying copper concentrate to copper cathode. Cash flow is expected to be supported by a strong performance from the HMS plant as well as copper concentrate production. The broker suspects mine supply overall is slowing and there will be a sustained market deficit from 2016 for the company to supply to. Altona Mining ((AOH)) has improved its balance sheet and offers a solid low-risk production base and a number of options for realising value, in Macquarie's opinion.
The broker has added two new small cap copper stocks to its coverage. One of these, Aditya Birla Minerals ((ABY)), has received an Underperform rating as it suffers from grade problems and challenges at the Nifty mine, while the Mt Gordon project is currently on care and maintenance and requires higher copper price to justify further investment. On the other hand, Macquarie notes Indophil Resources ((IRN)), which receives an Outperform rating, has cash backing and options for consolidating its 37.5% stake in the large Tampakan project. Indophil has built a strong alliance in The Philippines, although there is uncertainty regarding the merger of Glencore with the project manager, Xstrata. The other small copper stock in this outlook is Hot Chili ((HCH)) and Macquarie retains an Outperform rating. The broker expects some major share price catalysts over coming weeks and and agreement on Productora infrastructure will substantially reduce risk in that project as well as offer capex savings.
Iron ore prices had a strong run in 2013, one of the few commodities to do so. Chinese mills replenished inventory and purchasing activity stayed firm, even as steel production fell. Macquarie notes re-stocking is now fading as a supportive factor for prices and demand will also peter out during Chinese New Year celebrations at the end of the month. Macquarie notes steel production volumes and real iron ore demand will be determined by the appetite of domestic traders to build stocks of steel. Last year at this time, the analysts note, Chinese government directed banks to keep credit lines open to traders to avoid an implosion as financing was wound back. This year, Macquarie has not heard of any such arrangements and credit conditions are looking tighter, with sentiment weaker. The analysts expect a much more muted re-stocking of steel inventory this year. As a result, the analysts would not be surprised if output was down in January and February.
Key to iron ore's trajectory this year is output restrictions in some regions of China as environmental issues play their role in stemming low quality iron ore production. Nevertheless, steel demand is in play. Rather than assuming steel output will be restricted Macquarie's analysts expect 30-40mtpa of incremental steel production in 2014, produced by the 75% of steel making capacity that is not subject to output restrictions. This in turn should increase demand for higher grade iron ore and presents upside risk to benchmark iron ore prices. With premiums returning to the higher grades Macquarie expects prices can trade at a level above what would be implied from looking at the cost curve.
Substantial shipments of additional material are expected from Australia, as Fortescue Metals ((FMG)) and Rio Tinto ((RIO)) ramp up capacity. Supply is expected to be in line with the seasonally stronger second half. Supply from Australia may ramp up more quickly in the second quarter, but volumes from Brazil are expected to remain subdued in the first half. On the current modelling Macquarie assumes China will take all the material it can get from the seaborne market and domestic material will be a stop-gap measure.
Citi has turned bullish on the mining sector for the first time in three years. The broker's key picks are BHP Billiton ((BHP)), Rio Tinto and Glencore Xstrata. While Citi is mindful of the long-term structural demand issues in China and a seasonal slowing in the first quarter of this year, the bullish call reflects a better fundamental base, particularly from the major miners. Citi doesn't believe commodity prices will do the trick – expecting flat prices and a reduction in volatility. What's helping is improved European and US growth and weakening commodity currencies. Adding to the better outlook is a reduction in miners' costs, improved balance sheets and alignment with shareholder needs. Dividend yields are now considered supportive for the sector. Nevertheless, it's not all plain sailing. Citi expects the diversified miners to outperform in 2014. Included in the broker's Sell portfolio are those such as Antofagasta, Randgold and Anglo American, as Citi remains underweight in gold and base metal stocks.
The severe winter in the US has kicked off a cold start to 2014 and, in JP Morgan's view, that means US thermal coal prospects have improved. Lower US utility inventories should increase domestic demand and remove some coal from the export market. Also helping thermal coal to start the year is reduced Columbian supply. Despite this, thermal coal prices are not strong. JP Morgan observes there are negatives such as lower Chinese prices, with improved Chinese domestic supply reducing imports. Weakening commodity currencies are also playing a part to keep the coal market well supplied. The analysts do not think thermal coal prices will be inspiring in 2014.
With the Australian dollar now below US90c, those hoping for a rebound in the price of coking coal may also be disappointed. JP Morgan analysts note Australia took back market share in China at the expense of Mongolia last year but a slowing steel sector in China has led to a surplus and this could be a concern as, without a pick up in demand, the price has potential to drift lower as miners compete for access to China's steel mills. Lower prices have reduced the attraction of imports and contributed to an increase in Chinese coke exports.
Also, the analysts note the Reserve Bank of Australia is targeting a further depreciation in the currency to protect exports and, while this protects margins for Australian coal producers, it is not good news for the US producers. This could depress the benchmark price further in US dollar terms to levels which make US exports uneconomic. The key is how much support US miners receive from domestic contracts this year with US steel makers. Another aspect is Australian coking coal supply has not been hindered by rain or cyclone activity so far, with drier-than-normal conditions forecast for the next few months in the eastern seaboard. JP Morgan recently lowered coking coal price forecasts for 2014/15. Falling international coking coal prices have put pressure on US miners, which expanded exports to fill the gap left by the floods in Queensland in 2008/11.
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