Commodities | Dec 15 2016
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Oil outlook; copper demand; coking coal contracts; steel pricing.
-Positive news priced into oil sector
-Favourable trends to continue for copper
-Macquarie upgrades BHP, S32 on coking coal contract pricing
-Overall outlook bullish for miners, balance sheets in good shape
-Steel stocks expected to outperform
By Eva Brocklehurst
Oil & Gas
Oil prices are expected to recover in coming years, and signs of accelerating cost deflation in offshore and further productivity gains in US onshore compress Citi's oil cost curve. The broker calculates that the incentive price to meet future demand has reduced to US$55-65/bbl, down from US$70/bbl. Hence, long-term oil price forecasts are reduced to US$65/bbl.
Citi does not believe the sector is cheap any more. While Santos ((STO)), AWE ((AWE)) and Sino Oil & Gas ((SEH)) remain Buy rated, the broker downgrades Woodside Petroleum ((WPL)) and Senex Energy ((SXY)) to Neutral. Beach Energy ((BPT)) and Origin Energy ((ORG)) are downgraded to Sell.
The agreement reached among non-OPEC producers was more favourable than Macquarie expected. Cuts of a total of 582,000 barrels per day have been agreed, spread across 12 countries. After a near 25% increase in the spot West Texas Intermediate price since the recent low of US$43.32/bbl recently, the broker believes the majority of positive news is priced into both spot and forward prices.
Macquarie is not inclined to initiate any net short position until spot prices reach US$60/bbl, although acknowledges the risk/reward proposition of being long falls away above US$55/bbl. Negative news is expected to be limited until both execution and compliance with the new cuts are visible in January 2017 and the second quarter of 2017 respectively.
While the inclusion of several countries with natural declines has rightly brought the non-OPEC deal into question, Macquarie's analysis indicates that even after adjusting for these producers, it is still meaningful
. Nevertheless, the broker's modelling indicates the US shale response will be massive. Macquarie estimates exit-rate production growth of 300,000bpd at the current rig count, 600,000bpd at US$55/bbl and 1.1m bpd at $60/bbl.
The outlook for copper demand has transformed this year and Citi believes a favourable trend will hold up even over the long term. The three channels offering sizeable growth potential for copper are urbanisation, electrification and transport over the next 10-15 years.
Greater disposable income in China and India is likely to spur demand for consumer goods that tend to be copper intensive. Growing awareness and investment in non-fossil fuel power generation is expected to define the pace at which copper demand benefits from increased utility in this sector.
Asia remains at the forefront of copper demand, and the broker estimates consumption is likely to stabilise at around 16m tonnes per annum with further potential to improve over the next 10 years.
Reports indicate the March quarter hard coking coal contract between Glencore and Nippon Steel has settled at US$285/t, which is US$100/t higher than Macquarie forecast. This comes despite spot prices falling to US$270/t from over US$300/t in just over a week.
The broker incorporates the contract price into its estimates for BHP Billiton ((BHP)) and South 32 ((S32)) which results in material upgrades to earnings forecasts for FY17 of 10% and 12% respectively.
The settlement price is the highest since the December quarter of 2011. Macquarie understands that the appetite of Japanese mills to push a hard bargain was lessened because increased more materials prices can be used as leverage with their steel customers.
Macquarie expects spot coking coal prices to fall further as the Chinese government has announced production-loosening measures and disruptions at key seaborne suppliers are being resolved.
Morgan Stanley has turned bullish on the outlook for coking coal, revising its 2017 price forecast up by 58%. Forecasts are also revised up 36% for thermal coal, 16% for iron ore, 13% for copper and 10% for aluminium. BHP and Rio Tinto ((RIO)) are both set to benefit and the broker retains an Overweight rating on the two, preferring BHP.
The positive industry view combines better-than-anticipated prices and ongoing productivity gains, which should deliver better-than-expected cash flow, debt reduction and potential returns.
A general expectation that commodity prices will move lower means most miners are reluctant to add supply capacity, and the broker suspects that this, in turn, may mean prices hold at better-than-expected levels for longer than expected. Ultimately, if there is enough incentive there will be a supply response but until then the likes of BHP and RIO should generate strong margins.
The broker notes large miners typically outperform during a reflationary period and rotation in the industry. The metrics look compelling if even half the spot price upside is captured, the broker asserts.
Ord Minnett also believes the outlook is bullish for the miners. The gap between 2017 spot earnings and consensus forecast remains large, suggesting the consensus upgrade cycle should continue in the near term.
Meanwhile, balance sheets are in good shape across the sector which means reporting season should witness a return of higher dividends and/or capital management.
Also, Chinese economic data remain supportive of commodity demand and buoyant prices. In considering these factors many investors that are underweight the sector are expected to neutralise this position heading into January/February, and this is another re-rating catalyst.
Morgan Stanley believes supply-side reforms in China will create more favourable pricing for steel worldwide. The broker is more confident that China can achieve its permanent capacity reductions of 150mt by 2020. The merger between Baosteel and Wuhan Iron & Steel also shows that the industry continues to consolidate, pointing to improved fundamentals over the next 3-5 years.
Morgan Stanley believes China's steel exports will stay in a range of 100-120mt over the next few years. While this will improve the fundamentals of the global steel industry overall, the broker expects steel stocks in China, Australia, Latin America, India, Japan and North America will outperform as the benefits of supply-side reforms are not fully priced in.
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