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Material Matters: China, Miners, Coal & Oil

Commodities | Jul 10 2017

A glance through the latest expert views and predictions about commodities. China and the miners; gold miners; coal; and oil.

-China's material needs remain skewed to bulks
-Resource stocks with healthy cash flows preferred by brokers
-UBS singles out company-specific catalysts for gold miners
-China clamping down on low-quality thermal coal imports
-US rig count seen key to a more balanced oil market


By Eva Brocklehurst

China & Miners

Morgan Stanley is constructive on China, although acknowledges the outlook depends on the government's infrastructure promise delivering as other parts of the economy moderate. In steel, capacity will probably move to long products from flat and close the margin gap. Demand for iron ore appears stable, while below-average coal inventories at port and seasonal demand should support seaborne prices.

Copper imports were up in May but are down -20% year-on-year. Meanwhile, supply rationalisation is occurring in aluminium and the broker is waiting to see if relative Chinese beneficiaries affect regional trade. China's material needs remain skewed to the bulks and prices are down -17-34% in the year-to-date and the broker observes this has been priced in by most bulk miners.

Morgan Stanley likes stocks that have healthy cash flow margins, financially robust enough to weather weakness. The list is topped by South32 ((S32)), as it has strong free cash flow and cash to re-invest or return. BHP Billiton ((BHP)) and Rio Tinto ((RIO)) are also at the top of the list because of their strong margins.

Lithium leverage underpins Mineral Resources ((MIN)), while the broker likes Iluka Resources ((ILU)), Evolution Mining ((EVN)) and Independence Group ((IGO)) as they have strong exposure in mineral sands, gold and base metals respectively.

UBS observes the underperformance of the mining sector has been driven by pulling back of commodity prices, off somewhat elevated and unsustainable levels in the case of bulk miners, along with a macro environment that is more challenging. The broker maintains an overweight position towards the mining sector but believes the 12-month view is somewhat less favourable as Chinese property is expected to slow and offset steady/robust infrastructure expenditure.

The broker believes recently constrained steel production and robust demand have led to low inventories and this supports iron ore prices. While UBS does not expect a meaningful change in China's policy after the change of leadership in October, visibility is notably limited and thus equities with strong balance sheets and the propensity for increased cash returns are preferred.

The broker is slightly less bullish on copper and has marked down iron ore, metallurgical (coking) coal and zinc forecasts for 2017 because of a slightly weaker than expected June quarter. The broker favours those miners with improving fundamentals, such as mineral sands, copper, zinc and bulks, through the September quarter.

Rio Tinto and South32 are preferred stocks among the Australian large miners, as they have already stepped up returns to shareholders and have strong balance sheets. The broker recently upgraded BHP to Buy, believing it to be unloved and its high-quality assets and improving balance sheet should mean return step-up.

UBS is cautious on Fortescue Metals ((FMG )) and Mount Gibson Iron ((MGX)), given the large discounts in the market for low quality iron ore. Alumina Ltd ((AWC)) is considered fully valued, while Whitehaven Coal ((WHC)) needs some reassurance from China's policies.

Gold Miners

UBS observes sentiment towards gold has lifted slightly. The market is currently pricing in falling gold prices, reflected in the lift in short interest in Evolution Mining and Northern Star Resources ((NST)). Nevertheless, inflation is not rising as expected and this could eventually curb forecasts for higher interest rates, which in turn would be supportive for gold equities. As the outlook is mixed UBS focuses on company-specific catalysts.

Evolution Mining is preferred, because of its rapid de-gearing. UBS still believes risks are skewed to the downside for Newcrest Mining ((NCM)). At the smaller end, UBS upgrades Beadell Resources ((BDR)) and Silver Lake Resources ((SLR)) to Neutral, noting these stocks have underperformed in the year-to-date, and if gold rallies those that are leveraged will benefit.


Macquarie's suspicions that China would clamp down on coal imports at some stage this year are being confirmed, with news that the government has banned smaller provincial approved ports from accepting coal imports from July 1. The implementation details remain unclear but the main goal is believed to be restricting low-quality coal imports. Most of the ports likely to be affected are power plant-captive ports and this shows the target of restrictions is clearly thermal rather than coking coal.

As Chinese thermal coal prices were in a down trend in the June quarter, the government asked major power plans to reduced imports in order to stabilise the domestic market. Media reports also suggest that the government was planning to lift quality requirements for imported coal.

Macquarie notes the government has been intent on making life harder for coal importers for a number years, after initially introducing and raising coal import taxes in 2013 and 2014 when domestic coal prices kept falling. However, as ASEAN countries and Australia have free trade agreements with China the import tax had no impact on two thirds of China's coal imports.

China's coal imports last year came mainly from Indonesia, Australia, Inner Mongolia, North Korea and Russia, and imports from North Korea have already stopped because of sanctions. The target of restrictions is low-thermal coal, which means Indonesia may be the main country to suffer from the tightening measures. The restrictions supports the broker's structural expectation that seaborne coal prices will experience widening quality discounts going forward.


Oil prices have bounced from their lows of the year, Citi observes, noting the market was aggressively shorted and this has been the platform for a reversal in the oil price. Is this a dead cat bounce or a more sustainable rally? The broker tends towards the latter and expects that stock draw down in the order of around -1m b/d over the rest of 2017 is likely, although Libyan output sustained at around this level would counter this.

The issue is whether this will be reversed in 2018 because of rampant US growth. Citi expects US shale production could grow by around 1m b/d this year, assuming West Texas Intermediate prices are realised in the range of US$50-60/bbl over the rest of 2017. The main factor driving higher forecasts for US production this year is stronger-than-expected Permian production on the back of soaring rig counts.

The broker notes this year either lower or higher prices appear to have had a minimal impact on growth. This is because of several factors, including hedges covering production and the lagged impact of prices on drilling activity. In 2018, nonetheless, Citi suspects the impact of lower prices may be meaningful. The broker expects a decline of around -170,000 b/d in 2018 if prices were to fall to US$40/bbl.

Morgan Stanley believes, if OPEC does not balance the market, stabilisation will have to come from somewhere and most likely this will be US shale. For a chance of a balanced market in 2018, the broker suggests the US rig count can no longer grow and may need to contract by around 150 rigs.

Given current levels of breaking even, this requires WTI to be between US$46-50/bbl. The broker notes OPEC's production cuts to date have not made a dent in inventory levels. Morgan Stanley estimates at least 600,000 b/d of OPEC growth next year, which means US shale growth is constrained to 900,000 b/d at best.

While it may be tempting to interpret a recent decline in US oil-directed rig count as a sign of a falling back of investment, Deutsche Bank suspects further growth in oil-directed rigs is likely over the next six months. The broker takes note of the rolling four weeks average for evidence of a sustained slowing in growth and, on this measure, observes rigs are still running at 5.75 in terms of growth per week.

This may be down from the 13-plus per week rate in March and April but remains faster than what was assumed for the balance of the year. Meanwhile, upside from exempt OPEC countries has now just reached the level of Deutsche Bank's production assumptions, meaning that the assessment of a modest global deficit in the oil market in the second half the year remains intact.

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