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Material Matters: Iron Ore, Aluminium & Coal

Commodities | Jul 18 2017

A glance through the latest expert views and predictions about commodities. Iron ore; aluminium; nickel; and thermal coal.

-Iron ore prices expected to go higher to incentivise more mine re-starts
-Capacity reductions in aluminium in China an unknown quantity
-Earnings upgrade potential for major aluminium players could be significant
-Macquarie expects modest price recovery for nickel beyond the September quarter
-China seen limiting imports of thermal coal


By Eva Brocklehurst

Iron Ore

Citi observes most of China's small domestic iron ore mines have not executed proper mine planning during the boom years, while development expenditure has declined significantly for iron ore over the last couple of years. As a result, the broker suspects it will take some time for iron ore mine operating rates to go back to the levels of previous years.

The current mine operating rate of 66% was last sustained when iron ore prices were close to US$70/t. Hence, Citi believes, even after a rebound to US$65/t, iron ore should go higher to incentivise more re-starts from current levels.

The broker also notes that while China is one of the top three iron ore producing countries in the world, its production is fragmented and there is no visibility on the cost structure of the mines as few of them are publicly-listed entities.

As a result, the broker uses mine operating levels at different price points to get a sense of the supply elasticity. Overlaying China's domestic mine operating rates on the seaborne iron ore price, it is evident to Citi that Chinese domestic production has followed seaborne iron ore prices with 1-2 month lag.


Capacity reductions for aluminium in China are starting to increase. So far, Macquarie notes 340,000tpa of capacity reductions among smelters located in Shandong and Xinjiang, with another 2.58mtpa under the risk of closure. The broker suspects more than 65% of identified illegal capacity in the two provinces may be closed over the next couple of months.

For the fourth quarter, after assessing the overlap with the winter curtailment policy, Macquarie believes production rates may come down further, to 33-34mtpa, leaving full year Chinese production at around 35mt.

In Morgan Stanley's opinion, a large part of the confusion for aluminium-focused investors regarding smelter capacity reforms is that the story keeps changing. Much of the targeted capacity has only been recently identified and the Chinese government is still negotiating with industry on a reform strategy.

The broker is reluctant to simply include capacity reductions that were unidentified in the first place. If all illegal capacity is closed it has no impact on the broker's forecasts since it is not included in the outlook. For now, Morgan Stanley adopts government estimates that suggest 9.7% of China's 44mtpa capacity is "illegal". The Ministry of Industry and Information Technology estimates total permitted smelting capacity in China is 39.5mtpa.

Separately, Morgan Stanley still expects China to enforce at least a 1mtpa reduction to output in the northern winter. In 2017-18 the broker does not expect Chinese output will decline significantly. The bull case for aluminium is not based on whether China can substantially cut output, in the broker's opinion, but rather whether medium-term production growth can be eased back at the same time as demand growth of over 4% is maintained.

A potential upgrade to consensus aluminium prices remains a key driver behind Macquarie's positive view on Rio Tinto ((RIO)), South32 ((S32)) and Alumina Ltd ((AWC)). The broker believes the earnings upgrade potential for the three businesses is significant, should the market start to turn more positive and based on the speed of the capacity reductions.

Under a US$1/lb scenario Macquarie's 2018 earnings forecasts for both Rio Tinto and Alumina Ltd would rise 25% and 28% respectively. South32 earnings forecasts would rise 31%. Spot aluminium prices have traded in a range of US85-90c/lb over the past five months but Macquarie is more bearish. The broker forecasts 2017 and 2018 prices at US87c/lb and US82c/lb respectively.


Macquarie observes, for most of the past 18 months, the nickel market has been in deficit, initially supported by booming demand in the stainless steel industry and for nickel in batteries. More recently, the deficit has been based on weakening supply. The main drivers of price since early 2016 have centred on speculation regarding government policy decisions on exports in both the Philippines and Indonesia.

The broker notes second quarter de-stocking appears to have run its course and a massive surge in Chinese stainless steel exports has also cleared inventory. Moreover, rising chrome and stainless prices in July are signalling a strong rebound in Chinese production of stainless steel.

Macquarie expects, because of seasonal weakness and the lagged de-stocking effect, that US and European markets will remain weak until at least September. The resumption of Indonesian exports and fewer mine closures in the Philippines are likely to mean increased supply enters China this year versus last year.

Macquarie's supply/demand outlook signals a 50,000 tonnes deficit in 2017 and a smaller one in 2018, assuming no more mine closures. Non-nickel pig iron production has been very weak so far this year and the broker does not rule out further closures, noting at current prices around 40% of global output is still loss-making.

A number of operations could close in the second half if prices stay at current levels and the broker expects a modest price recovery is likely. Probably beyond the September quarter when ore supply growth could re-accelerate.

Thermal Coal

Credit Suisse observes thermal coal inventory is soft, as China did not stockpile in the spring and instead focused on ensuring mines did not exceed production quotas. Major miners have ceased selling on spot in order to meet contracts, and spot prices have climbed because of the tightness of supply. China remains the driver of seaborne coal prices as it is further price maker and the marginal buyer.

The broker notes traders only buy imports when they are cheap relative to domestic prices. Given the tightness in China's coal supply the broker now expects the Newcastle price will remain above US$80/t for the second half of the year and above US$75/t in the first half of 2018.

Rising spot prices have triggered several reactions from Chinese authorities, Credit Suisse observes. Contracts have been forbidden to be written above RMB570/t and large suppliers are been called on to speed up the release of coal. China's customs authorities have also restricted terminals that can accept coal imports.

Slowing imports is an unusual way to unwind tightness, Credit Suisse asserts, and this suggests authorities may be intent on keeping spot prices out of the power stations, as well as hoping that domestic output will ramp up. Credit Suisse believes hindering imports is likely to extend the duration of higher prices across the second half of this year.

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