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Material Matters: Iron Ore, Steel & Aluminium

Commodities | Jun 09 2017

This story features ORIGIN ENERGY LIMITED, and other companies. For more info SHARE ANALYSIS: ORG

A glance through the latest expert views and predictions about commodities. Iron ore; steel; aluminium; and oil.

-Large iron ore oversupply looms but will prices head to US$40/t?
-Increased use of scrap suspected in Chinese steel production
-China's supply-side restructuring of aluminium likely to prevail
-US likely to be the main driver of oil production growth in the near term
-By 2019 the effect of collapsing conventional oil production could be felt

 

By Eva Brocklehurst

Iron Ore

Rising supply and falling demand: the perfect ingredients for a correction in iron ore prices. Yet Commonwealth Bank analysts observe that what makes the recent fall in prices unusual is that Chinese steel rebar spot prices have rallied. They note that these diverging trends have helped Chinese steel mill margins increase sharply.

The analysts expect steel margins will not remain elevated because the industry in China is so competitive. Consequently, they believe steel prices will fall steeply and margins normalise. Following this, demand for inputs such as iron ore will decline and a large oversupply of iron ore will make itself known.

The surplus is likely to be exacerbated as China's focus moves away from commodity-intensive sectors. The analysts expect iron ore prices to decline to around US$45/t by the June quarter of 2018.

Credit Suisse observes low-grade iron ore prices have also suffered over recent weeks. Usually, high steel margins lift the 62% iron price but also increase lower grade ore discounts but the relationship broke down over the last couple of months. Some steel mills have been on-selling contractual cargoes of iron ore to repay quarterly loans and abundant spot cargoes have weakened the seaborne price.

When steel margins are wide, mills seek higher grade ore to maximise pig iron production yet, while this has occurred, coincidentally, the penalty for higher alumina content in low-grade ore has blown out. This was probably because of high coking coal prices affecting the steel production mix, the broker asserts. Overall, the broker expects the end of the construction season in China should soften rebar demand, prices and margins, allowing low-grade discounts to reduce.

The reason that iron ore prices have been under pressure despite strong demand and steel margins, Macquarie ascertains, is that supply has simply overwhelmed demand. Along with higher imports China's domestic iron ore production is also picking up.

Steel mills remain very profitable, which means they have no need to de-stock iron ore and push prices lower in order to improve cash flow. The broker observes steel mill inventory for iron ore is now quite supportive of iron ore prices.

Macquarie does not expect iron ore prices will head as low as US$40/t, as was experienced in late 2015, because demand is on a firmer footing. Seaborne supply is also likely to start coming under pressure, especially as low-grade discounts mean 58% iron spot prices are already approaching US$40/t and Indian iron ore exports will slow ahead of the monsoon season in May-September.

Steel

Macquarie suspects that much of the input to the Chinese crude steel production numbers comes from increased use of scrap and the growth in pig iron, and the use of iron ore is not involved as much as official data suggests. China still has extra scrap steel that is waiting for processing after the closure of induction furnaces.

The closure of these furnaces has also reduced construction steel supply and led to a jump in NBS crude steel production statistics, the broker deduces, and real supply growth in apparent consumption should be much lower than official data implies.

China has announced that all induction furnaces that make "ground steel" are to close by the end of the June. Macquarie believes this heralds increased use of scrap steel, higher scrap steel exports and tighter supply for construction steel. It appears clear to the broker that the Chinese government wishes to encourage scrap metal recycling for the purposes of environmental protection. The broker also notes that apart from increased usage of scrap, the impact of induction furnace closures can be seen in the price performance differential between rebar and hot rolled coil (HRC).

Aluminium

Morgan Stanley believes scepticism about China's supply-side restructuring of aluminium production is unwarranted and this provides an attractive are opportunity in aluminium equities. The broker argues that the aluminium industry's 10-year slump in return on capital may be over and restructuring in China and capacity restraints in the rest of the world may accelerate the normalisation of profits and a recovery in the aluminium price.

The broker's visit to China has underscored confidence in the proposition that the winter anti-pollution plan will be enforced and, although circumvented to some extent by illegal capacity, could still drive a meaningful change in conditions and utilisation rates. What remains particularly attractive, in the broker's view, is that the equities are not even discounting the base case or spot price conditions, let alone a bullish scenario.

Oil

UBS trims its estimates for near-term Brent oil prices and the new forecast is US$56/bbl in 2017, US$60/bbl in 2018 and US$65/bbl in 2019. The broker's long-term oil price assumption of US$70/bbl is intact, being the estimated incentive price required to re-start significant conventional oil investment.

The broker notes oil prices in the June quarter to date have been weaker, despite declining global inventories and a nine-month extension to OPEC's production cuts. US shale productivity gains, meanwhile, have been significant and shale companies are focused on production growth while capital markets remains supportive of the strategy.

In the near term, the broker expects the US to be the main driver of global production growth. Longer term, the arithmetic of sustaining annual production growth of over one mmbbl/day becomes challenging as more rigs are required to offset base decline and supply chain inflation becomes a feature.

The market has focused on OECD inventories and the apparent absence of a large draw-down, taking this as evidence that OPEC cuts were not achieving desired aims. However, UBS points to the fact that inventories have actually been drawn down meaningfully since the end of January at a time of year when they typically build up because of subdued demand. As most inventory draw has taken place outside the US the broker suspects the impact on market sentiment has been limited.

Conventional production over 2016-18 has been supported by a large backlog of major projects and, while this backlog is being worked through, by 2019 the consequences of collapsing conventional project activity will be more clearly felt, UBS believes, and pave the way for a significant tightening of the market post 2020.

While the emergence of electric vehicles is a clear threat to the oil market UBS believes penetration will not be significant enough to lead to peak oil demand until 2030. While this is earlier than most formal forecasts, the broker argues that, if the transition is real, then adoption is likely to surprise on the upside.

In terms of Australian energy stocks, the broker maintains a preference for Origin Energy ((ORG)) and AWE ((AWE)). The reduction in near-term oil price estimates prompt reductions to forecasts for earnings at Woodside Petroleum ((WPL)), Oil Search ((OSH)) and Santos ((STO)).
 

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