Material Matters: Copper, Iron Ore, Nickel And Coal

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-Leveraged stock risks in 2014
-Copper downside likely in short term
-Fortescue stands out in pure iron ore play
-Nickel price likely to dislodge inventory
-Coking coal price downgrades
 

By Eva Brocklehurst

It's evident that growth China is slowing but BA-Merrill Lynch is preparing to look past this. Having revised 2014 GDP growth forecasts down to 7.2% from 7.6% the analysts observe markets have responded quite negatively to the weak Chinese activity data in January and February but warn these months are relatively volatile. Based on high frequency data such as daily steel production the analysts note some improvement and expect a turnaround in March. Also, the Chinese government has already taken some action, with significantly lower interbank rates and a cheaper currency. Beijing is expected to ramp up spending on infrastructure and social welfare projects.

The broker is reminded of how resource stocks are substantially leveraged to the underlying commodity, with the recent slump in iron ore and copper prices. Leveraged stocks with poor fundamentals in the underlying commodity – tending to oversupply – are at risk through 2014, in Merrills' view. Gearing amplifies the situation. Miners with operational leverage tend to be high cost, have short mine lives and lower quality reserves. Stocks in this camp are Atlas Iron ((AGO)), Evolution Mining ((EVN)), Kingsgate Consolidated ((KCN)), Alumina ((AWC)), Perseus Mining ((PRU)) and OZ Minerals ((OZL)). Those stocks with high gearing are financially leveraged and this adds Newcrest Mining ((NCM)) to the list.

The stocks Merrills calls "super leveraged" cut both ways and in that sub-set are Atlas, Evolution, Kingsgate, OZ Minerals and Newcrest.  Merrills prefers BHP Billiton's ((BHP)) diversified exposure, Western Areas ((WSA)), because nickel fundamentals are supportive, and Alacer Gold ((AQG)), a low-cost producer with a strong net cash position. For those wanting copper and iron ore exposure the broker recommends PanAust ((PNA)) and Fortescue Metals ((FMG)) respectively.

Macquarie has reviewed the recent selling in copper and finds it mainly driven by fundamentals. A noticeable feature was a spike in the Shanghai exchange's open interest since the default last Friday by a solar panel manufacturer. Still, while copper financing trade has been unwinding from bonded warehouses this is not large scale in Macquarie's view. The trade has been declining since Chinese New Year, partly because banks have imposed stringent credit rationing and partly because of the elevated costs of the trade. Coinciding with this is the softer demand response from downstream users, a contrast to previous times when the price fell. There is little appetite for buying. Macquarie notes major wire rod fabricators have not reported a notable increase in orders. Moreover, larger fabricators and cable producers are suffering from the tight credit conditions.

Macquarie expects copper inventory to increase in bonded warehouses in coming months and there is limited scope for copper stock to move from these warehouses to the London Metal Exchange in the near future. Hence the analysts expect further downside for copper in the short term, but demand should move higher as the economic outlook brightens. Furthermore, bigger changes might come from the supply side. Already some marginal miners have held back sales because of weaker prices and Macquarie would not be surprised to see production cuts if the price of copper stays below US$6,600/t for a longer period. While corporate defaults are likely to continue Macquarie's economists do not think this will de-rail the Chinese economy.

CIMB has run a ruler over the downside for Australia's pure iron ore miners, given the 20% decline in the benchmark price to US$105/t. What stands out is Fortescue's low cash cost buffer and economies of scale. Adjusted to a 62% iron basis Fortescue's cash cost is US$72/dmt at a CFR iron ore price of US$100/t. The broker retains an Add rating for the stock. Juniors Mount Gibson ((MGX)) and Atlas Iron are rated Hold. Mount Gibson's adjusted cash cost on a similar basis is US$84/dmt at a price of US$100/t and, under this scenario, earnings turn negative over the foreseeable future. Atlas Iron's earnings also turn negative at a price of US$100/t CFR, making it a challenge to turn a profit, in the broker's view. Atlas suffers from relatively high depreciation and exploration costs.

In terms of the Chinese producers, CIMB's analysis suggests that at US$100/t approximately 50% of production is cashflow negative while only a fraction of seaborne supply would be cashflow negative at the same price. The reason why Chinese costs are materially higher is simply the geology. CIMB estimates that the average grade of Chinese mined iron ore has fallen to around 18% in recent years compared with the average of seaborne iron ore at around 60%.

For nickel, the outlook might be improving but JP Morgan does not think there are sufficient catalysts for Indonesia to reverse its ore trade policy. What is likely is that China will react by accelerating the build-up of Indonesian processing capacity. Production forecasts from inside China have been cut. Even so, the analysts highlight the fact that less nickel pig iron does not equate to increased demand for refined nickel units. The Chinese stainless steel industry is likely to react by producing more low-nickel stock and using more scrap. JP Morgan forecasts a small deficit in the nickel balance in 2014 and a 4.3% deficit in 2015, which would mark the largest deficit since 2010. Given high refined nickel stock both on and off exchange, and a marked lack of reaction in Chinese nickel plate prices, the analysts think higher prices would simply dislodge stocks into the spot market, thereby curbing further appreciation.

Goldman Sachs has downgraded metallurgical (coking) coal price forecasts to reflect a supply side response and falling cost support levels of a market in oversupply. The broker has incorporated the revisions, with forecasts for BHP, the world's largest metallurgical coal producer, reduced by 0.7% in FY14, 1.3% for FY15 and 1.6% for FY16. The Rio Tinto ((RIO)) impact is not material as coal makes up less than 4% of group earnings. For pure coal producers Whitehaven Coal ((WHC)) and Yancoal ((YAL)), which are already operate on fine margins, it means the price revisions extend the expected losses for FY14 and reduce the scale of profit recovery in FY15.
 

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