Material Matters: Lithium, Coal And Copper

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A glance through the latest expert views and predictions about commodities. Lithium & graphite; iron ore; metallurgical coal; and copper.

-Capitalising on opportunities in battery demand not straightforward, UBS suggests
-Lithium pricing expected to ease back by 2018 on increased supply
-Deutsche Bank suspects iron ore prices will not stay below US$50/t for long
-Metallurgical coal shifting towards index-linked pricing
-Small market deficit expected to emerge in copper
 

By Eva Brocklehurst

Lithium & Graphite

As global attention becomes more and more focused on greenhouse gas emissions and the electric vehicle revolution, UBS takes a deep dive into the lithium and graphite market, initiating coverage on several stocks. The broker has built up a supply/demand model for batteries, lithium and graphite to evaluate the pricing outlook.

Yet UBS believes it is not straightforward to capitalise on the opportunity in battery demand. Lithium and graphite are not scarce and the current projects under development can supply forecast demand but there are challenges that warrant a cautious approach to supply. Projects are hard to develop, finance and commission and delays and under-utilisation have been the norm so far.

Producing high-quality battery products requires skillful execution and involves lengthy safety & performance qualification processes. UBS prefers the lithium volume opportunity, given high leverage to rapid battery demand growth, versus graphite. Yet graphite spot prices are below incentive prices, underpinning a positive profile on the price. Lithium spot prices are well above marginal cost and incentive prices, and are expected to ease in the next few years.

Utilising these price and demand forecasts the broker initiates on Galaxy Resources ((GXY)) with a Neutral rating and $1.80 target and Orocobre ((ORE)) with a Buy rating and $5.00 target.

Galaxy offers direct exposure to the lithium demand story through its Mount Cattlin spodumene concentrate mine in Western Australia. Increasing demand for lithium carbonate and a near-term shortfall in hard-rock lithium supply means the company should benefit from short-term elevated prices for spodumene concentrate.

Citi has upgraded Galaxy Resources to Buy/High Risk from Neutral/High Risk, with a $2.70 target, asserting the recent -30% decline in the share price is not justified, despite concerns about lithium over-supply next year. The broker suspects that the build up in direct shipping ore (DSO) will prove unsustainable and ameliorate current concerns. In addition, the broker flags the potential for Galaxy to miss its own production guidance for the year.

Deutsche Bank recently visited the Wodgina lithium project in Western Australia, owned by Mineral Resources ((MIN)). The scale of the project suggests the company will soon be the world's largest lithium producer once its Mt Marion and Wodgina assets are ramped up. Deutsche Bank estimates the company could process and export 300-500,000t of DSO material per month but this material will need to be concentrated before use in spodumene conversion facilities.

The broker has long held a view that the current lithium price will incentivise new supply to the market until the supply demand equation rebalances, probably in six months time. Deutsche Bank currently forecasts Chinese battery-grade pricing of US$17,000/t for lithium carbonate equivalent (hydroxide) and US$15,000/t for lithium carbonate by year end, -25% below spot pricing.

Meanwhile, Orocobre offers exposure to the brine lithium carbonate market and is expected to experience significant demand on the back of forecast growth in electric vehicles. Despite operating risks in lithium brine processing, Orocobre is one of the few new entrants to the market with a producing asset which could benefit from any interim shortfall in supply more readily than its earlier-stage peers, UBS suggests.

The broker also initiates coverage on Syrah Resources ((SYR)) which offers a pure exposure to demand growth in the graphite market, generated by the emerging battery and electric vehicle thematic. UBS believes the company offers a unique proposition as it has the world's largest advanced flake graphite project in Mozambique. The broker initiates coverage with a Buy rating and $3.80 target.

Iron Ore

Benchmark iron ore prices have fallen by around -40% from the peak in February, Deutsche Bank observes. The broker suspects there is still some further downside to the end of the year and into 2018 and forecasts an average price of US$50/t for the December quarter and below this in 2018. That said, Deutsche Bank does not forecast prices to stay below US$50/t for more than two quarters.

Reasons to be cautious include, as the broker points out, illusory demand growth in China of around 10% or more, as illegal capacity was never tallied in the historical production numbers. Secondly, scrap that was being used by illegal induction furnaces is displacing iron ore units.

The increase in scrap utilisation is being mirrored elsewhere in the world as well. Another reason is that supply is responding to a period of higher prices and shipments have been increasing after a seasonally weak March quarter.

While not painting a bullish picture for steel demand in China, Deutsche Bank does not believe there will be an outright collapse. Profitability of the industry, post the closure of illegal capacity, means raw material affordability is better. Nevertheless, the broker's blast furnace cost model does point to the high discount for low-grade ore as being partly structural.

There is also some support on the cost curve, as large portions of the Indian and Chinese iron ore industry are unprofitable below US$60/t. At prices of US$45/t at least 200m tonnes of the 1500mt market is loss-making and this is considered unsustainable for any extended period.

Metallurgical Coal

Macquarie believes the shift in the metallurgical (coking) coal market pricing has major implications. Business models will need to adapt as hard coking coal contract prices shift to an index-based system. Nippon Steel has agreed to use spot index price averages over March to May for its June quarter tonnage. Macquarie believes this is reflective of a steady shift towards index-based transactions across all commodity markets, as traditional contract systems are now considered less useful.

The broker suspects this will be a catalyst for the financial market in coking coal, given the increased price and counter-party risks that are likely to be involved. Moreover, a lack of widely-quoted spot indices suggests semi-soft and PCI coal will not shift in the same way and this signals potential for a hybrid system.

The broker notes a lack of diversity for coking coal supply (mostly Queensland and China) has meant this particular coal is prone to supply shocks and the nature of benchmark negotiations has meant Japanese steel makers have tended to settle close to the peaks of the cycle.

Macquarie expects financial market growth in this area to accelerate and the issues with commoditising hard coking coal have been alleviated to some extent, which facilitates wider market participation.

As metallurgical coal gets set to depart the contract system the broker observes benchmark contract agreements are now few and far between across both metals and bulk commodities. The broker suspects LNG will be the next major commodity where longer-term contracts become increasingly index-linked.

Copper

Copper prices have unwound much of the gains that followed the US election last November. Some of the world's largest copper mines faced supply disruptions early this year, including Escondida, the world's largest, while a ban on exports in Indonesia meant Freeport's production and shipments fell.

While these disruptions were resolved for the present they are likely to remain an ongoing issue, National Australia Bank analysts suggest. Companies appear to be better at managing worker demands but weather factors remain harder to anticipate. The analysts expect the market to be in a small deficit in 2017 and 2018, with prices moving sideways on uncertainties in both supply and demand and averaging around US$5720/t.

Demand growth in China, copper's biggest consumer, is expected to slow gradually. US demand is expected to improve, given the proposed increase in infrastructure expenditure. Nevertheless, the market has few details to date about the US President's plans for infrastructure and whether the measures will pass Congress.

The analysts believe that given US copper demand is dwarfed by Chinese demand, any increase in US expenditure will be more of a support to sentiment rather than changing the demand picture substantially. Meanwhile, large quantities of copper are in Chinese bonded warehouses and pose a significant upside risk to supply.
 

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