Commodities | Dec 08 2016
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Coking coal uncertainty; few bearish catalysts for oil; iron ore softens; Ord Minnett raises copper forecasts, lowers gold; tight primary supply of lead.
-Seaborne coking coal prices to remain elevated over lack of clarity on China's reform program
-Is OPEC underestimating the cost curve for new US shale?
-Iron ore expected to soften with slight oversupply in 2017
-Ord Minnett upgrades Alumina Ltd and Whitehaven Coal
-Lead prices spike, expected to retrace to low US$2000/t range
By Eva Brocklehurst
Price negotiations for metallurgical (coking) coal in the first quarter of 2017 are soon to begin. Morgan Stanley observes corresponding spot prices are falling from a great height, while the state of China's local mines remains a market mystery. The broker does not believe conditions have normalised. While the quieter northern winter trade has begun, seaborne spot prices are likely to remain elevated into 2017, mainly because of the lack of clarity over the ongoing reform program in China.
Morgan Stanley believes a review of China's altered import flows is now needed to re-set the price outlook, given what is known about the scale/duration of the reform program. A reasonable estimate of the potential upside risk to the market's 12-month price outlook for key coking coal products would be at least 30%, in the broker's calculations.
The broker also notes the return from bankruptcy of US-based coking coal plays, Alpha Natural and Arch Coal, highlights the extraordinarily tight conditions prevalent in global coal trades.
There are few bearish catalysts for oil in the near term, Morgan Stanley contends. Other than a complete collapse of the deal gained at the recent OPEC meeting, the broker does not envisage many catalysts that will reverse the recent rally. Evidence of falling OPEC production in January could add to bullish price action. Scepticism regarding compliance is warranted, in the broker's opinion, but any evidence to support this is unlikely to emerge before March or April next year.
Nevertheless, OPEC appears unconcerned about a US supply response and Morgan Stanley suspects the organisation may be underestimating the cost curve for new shale, and the size of the response if both OPEC and its non-OPEC allies cut production. Morgan Stanley notes positive onshore trends in the US started to emerge even before the OPEC agreement and resultant price surge. Given the amount of hedging and rig activity, US production may surprise both in magnitude and its timing.
Buoyant iron ore prices are currently based on a combination of coking coal strength, resilient Chinese demand and broader risk appetite, Ord Minnett observes. As 2017 progresses the broker expects prices to soften from current levels, as the market digests a slight oversupply and coal prices ease as marginal production responds. The broker's revised forecasts envisage around 58mt of oversupply in 2018, before the market starts to look more balanced.
Ord Minnett upgrades price forecasts to US$60/t and maintains 2017 Chinese steel production growth assumptions. At the same time, the broker expects the major miners to add 77mt to the market. 2018 appears to have the weakest pricing fundamentals, in the broker's opinion and the long-term price forecast of US$50/t is unchanged.
Ord Minnett increases its price forecasts for coking coal and copper, while downgrading near-term forecasts for gold. The broker believes the mining sector can continue to re-rate based on the significant value that exists, with around half the broker's coverage trading at net present value or lower. Significant cash is being generated at base-case prices and balance sheets are also in good shape.
Ord Minnett raises 2017 copper price forecasts by 7%, although still expects copper to decline to US$2.03/lb in 2018 from the spot price of around US$2.60/lb. Coking coal forecasts for 2017 and 2018 are raised 30% to US$175/t and 7% to US$125/t, respectively. Gold price forecasts are reduced by 9% to US$1225/oz for 2017 and to US$1291/oz for 2018.
Ord Minnett upgrades Alumina Ltd ((AWC)) to Accumulate from Hold. Spot alumina continues to look strong at US$325/t and presents upside potential to the broker's earnings estimates. The broker also upgrades Whitehaven Coal ((WHC)) to Accumulate from Hold, recognising it may be late with its call but is factoring in higher coal price forecasts and the company becoming net cash within the year.
Among major miners, the broker continues to prefer Rio Tinto ((RIO)), based on more attractive valuation metrics and a higher chance of capital management. Fortescue Metals ((FMG)) remains a key pick as its strong free cash flow yield will start to migrate to a dividend yield as the company hits its US$3m net debt target in the next year.
Newcrest Mining ((NCM)) is the broker's least preferred gold stock for its stretched valuation and likely gold sector de-rating. For those seeking gold exposure, Ord Minnett recommends Regis Resources ((RRL)).
Lead prices rallied sharply in the past week, hitting an intra-day, five-year peak of US$2576.50/t before a dramatic sell-off the following day. Macquarie believes the usual suspects, Chinese investors, scooped up the relatively unfashionable metal before selling it off again. The reason is probably because lead was looking left behind by the rest of the complex.
The metal was becoming highly discounted to its sister metal zinc and, while zinc was also moving up, the subsequent rally has reduced lead's discount to well below US$400/t.
Speculative momentum aside, Macquarie notes the fundamental lead market does look a little tighter. Primary supply is tight and lead mine output has been hit by the same reductions as in zinc, although has also been experiencing a contraction in Chinese domestic output because of intensifying environmental scrutiny at the country's mines. Traceable mine output data signals a drop of 11% in the first nine months of the year versus the same period over 2015.
In the scrap market, which contributes around 51% to overall supply, battery stocks were drawn down in October, as high lead prices drew out material. The broker observes the market is somewhat lean. Nevertheless, with this side of the market well covered, buyers have felt no pressure to accept the rally in lead prices, and scrap prices have failed to keep pace.
Macquarie observes demand, which is dominated by lead acid batteries, has been supported by much stronger automobile sales and production across several regions over the year. The broker envisages a better outlook for demand. Still, while lead prices deserve to lift somewhat, the recent rally is considered to be well in excess of the fundamentals.
Macquarie expects prices will retrace back to more justifiable levels in the low US$2000/t range, with the potential for further slippage after the peak battery demand in the northern winter period. On the other hand, a sharp fall in winter temperatures would facilitate more battery failures and may create a squeeze in the scrap market, in turn causing buyers to accept some of the higher prices.
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