Commodities | Jun 02 2014
-Potential sharp drop in iron ore purchases
-Iron ore price risk still to the downside
-Discounts on lower grade iron ore widen
-El Nino potential to affect Oz east coast
-Chinese zircon imports rise in April
By Eva Brocklehurst
A rapid increase in lower-cost iron ore supply has brought down prices. High cost producers have responded and imports into China from non-traditional suppliers have been falling steadily this year. The displacement of high cost tonnage has been fairly orderly, Macquarie observes, but the fact that China's inventories have not fallen this year reveals an overhang in the market, with the next step being the clearing of the excess. This process will mean purchasing activity needs to drop below real demand, resulting in further downside risks to prices.
Macquarie asks how easy it will be to displace the incumbent producers at the top of the cost curve and notes, in this regard, the coal market sets a very negative precedent. High cost suppliers have proved to be some of the stickiest. As prices of iron ore have softened, imports into China from outside the big four – Australia, Brazil, India and South Africa – have declined steadily, with the biggest declines coming from regions that sell overland such as Russia, Kazakhstan and Mongolia, as well as South East Asian suppliers such as Indonesia, Vietnam and the Philippines. Chinese domestic iron ore mines also seem to be under pressure and, while output has not declined since January, there has been no rebound after the usual winter shut down.
The fact that inventories appear to have been high all year is not particularly reassuring and Macquarie thinks this has worked in favour of the steel mills, as they have been able to pass the cost and risk of holding inventory onto the traders and allow their own profitability to decouple from the iron ore price cycle. Traders, as a result of Macquarie's steel survey, appear ready to liquidate.
There are two scenarios for rationalising inventory – what Macquarie calls the flash crash or the slow bleed. In the former the assumption is that five days of inventory is de-stocked over June and another two days over July. This would knock out 177mtpa of apparent demand and push down the cost curve to a point where support is slightly below US$80/t. This would be likely to be followed by a recovery. In the second scenario, where it takes five or six months to bring inventory down, this would mean prices hover in the US$90-100/t range and then move back above US$100/t in the fourth quarter. The risk in the latter scenario is that, what might start as a slow bleed, could turn more aggressive as traders cut losses and mills await better buying opportunities. All up, Macquarie advises investors to be positioned for a period of weakness in coming months but also be aware of the buying opportunity that should be presented once inventories are back at healthier levels.
Bell Potter observes discounts on lower grade iron ore have widened. The spread between 58% iron and 62% iron has widened to 22% from 12%. This comes on top of weak iron ore prices. Most Australian producers price off the 62% iron index, adjusted for grade and impurities, despite shipping mostly 57-59% iron ore. The recent discounting poses significant risk to their realised and break-even prices, the extent of which the broker suggests will not be clear until the miners' quarterly reports are published in July. Bell Potter has downgraded iron ore price estimates and assumes that prices average US$100/t in the December half.
UBS has observed that Chinese steel production and iron ore supply are running at record rates. Compounding high inventories is the fact that much of the increase in China's steel production ends up in the export market and thus signals domestic consumption may not be as strong as production data would suggest. The broker examines what is required for iron ore equities to break even. Rio Tinto ((RIO)) appears to be the stock requiring the lowest price to break even – at US$43/t. BHP Billiton ((BHP)) requires US$50/t while Fortescue Metals (((FMG)) requires US$72/t. This compares with Mt Gibson Iron ((MGX)), Gindalbie Metals ((GBG)) and Grange Resources ((GRR)), which require US$79/t, US$91/t and US$97/t respectively.
Taking this one step further, UBS analyses what long-term iron ore price is implied in these companies' current share prices. The calculation suggests Gindalbie, Mount Gibson and Grange are fully valued if the iron ore price does not recover from current levels. BHP and Fortescue look attractive in this analysis, while Rio Tinto stands out sharply as implying an iron ore price of US$72/dmt CFR. The broker does acknowledge that the market may be applying zero value to Rio Tinto's aluminium assets, in which case this would require a higher iron ore price to allow valuations to equal the share price.
Another negative is looming for agriculture. The Bureau of Meteorology has issued an El Nino alert, indicating at least a 70% chance of such an event developing this year. The El Nino results in below-average rainfall and above-average temperatures on Australia's east coast. Bell Potter has looked at the potential impact on Australian producers under coverage.
Australian Vintage ((AVG)) has the potential for lower grape yields to impact earnings and lift the cost of goods sold in 12-18 months time when the vintage is sold. Bega Cheese ((BGA)) has the potential for lower milk volumes while a lower east coast wheat harvest would affect GrainCorp's ((GNC)) receivals, exports and marketing volumes in the following year. Ruralco ((RHL)) would experience reduced fertiliser and crop protection sales, as well as lower earnings in livestock and wool agencies. This may be partially mitigated by stronger earnings in the water business. Select Harvests ((SHV)) has the potential for lower yields and higher water costs, and lower almond prices in the event California has an above-average year.
On a more positive note, China has increased imports of zircon. Imports were up 10% in April compared with March and up 12% from last year. The majority of imports came from Australia and South Africa. The data can be highly variable and imports do not necessarily mean sales to end customers but JP Morgan is encouraged by the uptick and believes it could be an early indicator of a recovery in demand. Moreover, imports from Australia were up 50% to 36,000t out of the total of 55,000t, as South Africa dropped away.
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