Commodities | May 19 2015
-Fewer copper stocks to invest in
-Battle for iron ore share looms
-Manganese supply up, demand soft
–Steel outlook a concern for BlueScope
By Eva Brocklehurst
UBS observes recent strength in the copper price supported by weakness in the US dollar, the cut in China’s one-year lending rate and deposit rate and an easing in global exchange inventories. The market is considered reasonably balanced. A change in view would necessitate evidence of China’s planned lift to spending on its electricity grid, more economic momentum in the OECD, as well as more supply disruptions globally. Beyond the short term the metal remains a favoured exposure for UBS, with deficits forming in trade from 2017, envisaged on the back of steady demand growth and challenges to mining, particularly in Chile from grade, water and power issues.
With the equity market factoring in a price around US$2.33/lb it is implying a significant discount to the spot price. Playing the sector, the broker is drawn to Sandfire Resources ((SFR)) for its operational consistency and balance sheet strength. UBS also believes there is potential for the stock to trade higher as money recycles from PanAust ((PNA)) after the GRAM takeover. There is less potential, in the broker’s view, for OZ Minerals ((OZL)) to benefit, given its recent run, while its acquisition-based strategy presents risks. On the subject of Tiger Resources ((TGS)) there are refinancing risks which pose an overhang to the stock.
Upside for copper was tempered by bearish growth forecasts by the World Bank, in Morgans’ view, given the position of copper as a bellwether commodity for economic health. The broker believes this impact is starting to wane. Interest rate cuts in China and the easing of property ownership rules amid hopes of further stimulus are expected to underpin copper demand.
Moreover, the decline in mined copper grades is containing industry production and supporting a medium-term recovery in prices. Coupled with recent M&A activity, which has meant there are fewer copper stocks to invest in, the broker now believes the next cycle is near enough to encourage a closer look. Now PanAust is off the agenda, copper exposure on the ASX is a choice between Sandfire Resources, OZ Minerals, Tiger Resources and BHP Billiton ((BHP)) or Rio Tinto ((RIO)). Morgans prefers OZ Minerals for its attractive fundamentals, with lower operational risk and a strong balance sheet.
The pool of developing copper projects has become even smaller, Morgans notes. One near-term ASX play exists, Finders Resources ((FND)), which has the high grade Wetar project currently under construction. This should reach 28,000tpa by 2016. The other project is Frieda River, where Highlands Pacific ((HIG)) is in joint venture with PanAust. The broker expects a focus will return to the JV once the GRAM takeover of PanAust is completed.
Iron ore is sustaining a typical re-stocking rally and may be supported above US$50/t through the June quarter, on the back of a modest deficit. This is Credit Suisse’s view of the current market. In China, the price was beaten down earlier in the year and then steel mills rushed to re-stock. Present views suggest there is only 29mt of port stocks in the hands of traders, and therefore available. The rest is in the steel mills.
Chinese domestic supply has fallen and smaller producer regions have pulled out. Nevertheless, the broker considers the second half looks ominous. New supply will have to be accommodated. While there is sufficient room in the market for the major producers, this will only be the case if all seaborne supply from small producers gives way, Credit Suisse believes. Hence, a battle for market share is underway. Under the broker’s base case assumptions, new supply will not be absorbed by Chinese steel demand. Growth in steel demand globally is forecast to be 1.2% in 2016, far too slow to absorb the iron ore supply deluge.
Given Vale has around US$40/t as a cost base and has a willingness to flex 30mtpa of production, the company is likely to set the iron ore floor price. Credit Suisse notes a cluster of companies with break-even prices around US$40/t. Iran, Peru and China have some resilient iron ore suppliers and, if they prove sticky, or iron ore demand falls further, then the broker expects the iron ore price might start to aggravate the major producers.
Those with the highest break even position in this camp are Kumba (South Africa) and the Brazilian exporters. What may surprise some is that, as Credit Suisse observes, Fortescue Metals ((FMG)) is not a marginal producer in this scenario with a US$35/t break even price, ex finance.
Manganese ore prices could remain depressed for the next three years, with the market in surplus because of increasing supply, mainly from South Africa, and slowing demand growth. The market is expected to re-balance by 2018. UBS hosted a recent conference call on the topic which revealed over 90% of manganese goes into steel and is used to remove sulphur, and there is no viable substitute. Non-steel consumption includes uses in dry cell batteries.
South32 ((S32)), BHP Billiton’s spin-off, owns 60% of Samancor, the largest producer of manganese ore in the world with a 23% market share. Samancor operates one mine in Australia and two in South Africa. Samancor has one smelter in Australia and one in South Africa.
Manganese used to be sold on an annual contract basis similar to iron ore but buying is now mainly on a spot basis, UBS observes. Two price series are regularly published, called the “BHP benchmark” for high grade and the “Kalahari semi-carbonate” for low grade. The broker also notes the market lacks transparency, and the index pricing for manganese has not taken off as it has for iron ore.
BHP Billiton remains a price setter by virtue of its market status. Meanwhile, manganese alloy prices are spot based in China and priced quarterly outside of China. UBS notes the alloys are fragmented markets with low barriers to entry. South32 has less than 5.0% market share in alloys so is not a price setter. Manganese demand is expected to grow 2.0% per annum, assuming global steel demand grows 1.0%. The content in steel has been increasing over the last 15 years because of rising standards for buildings and a higher share of urbanisation – as manganese adds strength to steel.
The steel market looks as though it should be in a better position than 2-3 years ago. Macquarie asserts supply growth additions have slowed and steel markets have embraced a new price risk management which reflects more closely their new reality as conversion businesses. Also, raw material prices should be more stable amid sustained oversupply. The problem is that steel makers have no pricing power as the market is exporting a structural oversupply. The broker observes elevated Chinese exports are likely to feature in the medium term, albeit perhaps not at the cyclical highs seen over the past six months.
Thus, with lower raw materials prices, steel prices must follow. Macquarie has reduced average hot rolled coil price forecasts by 10-16% for the next few years. This means margins are at a relatively low level. The broker suspects that supply-side reforms in China will result in rising levels of capacity utilisation, despite muted demand.
This is a major aggravation for BlueScope Steel ((BSL)). Macquarie expects lower steel prices to extend well into FY16 and has revised down earnings forecasts by 76%. The company is challenged by being a price taker on high-cost, ex Australia exports. As a consequence Macquarie has downgraded its rating to Neutral from Outperform.
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