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Material Matters: Iron Ore, Costs, Small Caps, Mineral Sands, Base Metals

Commodities | Jul 22 2014

-Measuring iron ore discounts
-Miner costs to diverge
-Opportunity in small resources
-Muted outlook for mineral sands
-Aluminium tightness may ease

-Nickel deficit still likely
 

By Eva Brocklehurst

UBS has set out to demystify iron ore discounts. Discounts have become a discussion point this year as the headline iron ore price – which is the Platts 62% iron index – fell 30%, while the 58% iron index fell even more. UBS does not think the market is looking at this the right way. The broker suggests the focus should be on the dollar discount received for impurities, such as aluminium and silicon, on a dollar per dry metric tonne basis. Steel mills and producers agree. The broker has changed models to incorporate a dollar value discount rather than a percentage discount. In deriving the appropriate discount for impurities the broker looks at the average discount received by each company since the March quarter 2012. UBS acknowledges that June quarter discounts will be materially higher than average but expects the discount will narrow over the next six months.

Analysts at Citi suspect the past 10 years have been a lost decade for the mining industry. Unit operating costs have risen since 2005. The question going forward is how successful the miners will be in achieving planned cost savings. There is a strong correlation in the broker's analysis between operational efficiency and share price performance. Lower operational efficiencies have cost the large miners around US$35bn since 2005 with rise of over 30% in unit costs and a 27% increase in the number of employees, resulting in an 18% loss in output per employee. That is the negative aspect.

In a flat commodity price environment operational efficiency will be a key driver of earnings growth and Citi thinks this should have a positive impact on 2016 earnings for the sector. Nevertheless, divergence within the mining sector will be greater as the cost curve, having flattened for the six years preceding 2013, is now expected to steepen out to 2016.

Morgans believes there are signs of life among Australia's small resource stocks. Companies seem to be increasingly rewarded for exploration success and sentiment is improving slowly. The broker suggests the point in the cycle is nigh where investors are of the belief things cannot get any worse. The is reflected in the fact that the S&P/ASX Small Resources Index bounced 12% of its 2014 lows recently, driven by the return of risk appetite for gold stocks. The broker cites Thundelarra ((THX)) as an example where, upon the release of drilling results at Red Bore, the stock jumped 140% on the news. Stavely Minerals ((SVY)) is another which has risen almost 150% since its IPO.

The broker likes Avalon Minerals ((AVI)), for its potential to develop into a copper miner in a short time frame, and Finders Resources ((FND)), which has achieved critical funding for the transition to production. The broker makes the point that quality projects will progress to the point where they will demand attention and, when that happens, price moves can be short and sharp.

Commonwealth Bank analysts have downgraded titanium dioxide prices for 2014, following commentary from Iluka Resources ((ILU)) regarding rutile markets. The analysts are concerned about the surplus of high grade titanium dioxide as world economic growth, a driver of demand for the pigment, has accelerated but prices are yet to respond. This probably reflects the impact of new volumes coming on line. Hence, the analysts suspect the re-stocking cycle is likely to have a more muted impact on prices. The analysts leave zircon prices unchanged, although downside risks are suspected to be rising, particularly with China's property construction volumes, a key driver of demand, looking like they may be falling.

Signs of curtailment to aluminium production since 2013 have been encouraging in an oversupplied market. Macquarie observes new capacity additions are likely to preface renewed pressure from production in the second half of 2014. This may ease tightness in some regions but the reversal of the curtailment trend looks worrying, as it means supply-side risks persist. The ramp up of Middle Eastern smelters have provided the offset. Annualised output in that region hit a record of 417,000t in May, driven by completions.

In China, the impact of supply cuts and slower-than-expected new capacity additions means the domestic market is not succumbing yet to significant pressure from the supply side. However, Macquarie notes that around 650,000tpa in Chinese aluminium capacity has recently come back on line, on receipt of power subsidies from local government. Macquarie observes Chinese primary aluminium is likely to remain strong. For the ex-China market, fewer ongoing curtailments and increased supply from the Middle East, Malaysia and India means regional tightness may be easing.

Nickel's rally from the start of 2014 has run out of puff. The price has risen to peak of US$21,000/t in May from a low of US$13,365/t in January. What Macquarie thinks is remarkable is that this price rise occurred at a time of surplus in the nickel market. Macquarie observes the market remains in surplus because of an ongoing rise in Chinese nickel pig iron production. Hence, the price rise is viewed as speculative. Macquarie is nevertheless of the view that the market will turn to deficit in 2015 with the impact of the Indonesian ore export ban.

The broker notes some investors are becoming anxious that London Metal Exchange stocks are rising too much and that the political situation in Indonesia is too unstable. Nickel ore exports from the Philippines are also rising sharply and progress on new smelting capacity in Indonesia may be faster than some suspect. Macquarie discounts all these theories as overplaying the case in terms of a significant change in the supply trajectory. The broker also dismisses the rumour that nickel ore is being smuggled out of Indonesia labelled as iron ore. Indonesia's nickel ore is very low in iron and the rumour is fanciful, the analysts contend. They expect to see the deficit materialise from the fourth quarter this year, as a fall in Chinese nickel pig iron production is likely to take effect from mid year.
 

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