Material Matters: China Policies, Coal And Iron Ore

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China's greener policies are leading to increased burning of coal, for now, while the US shale revolution is hampered by infrastructure constraints with RBC Capital worried about short term outlook for iron ore prices.

– China’s environmental plan good news for high-grade exports
– Most vulnerable to new policy are thermal coal and low-grade iron ore and coking coal
– Risk of US oil output contributing to world over-supply is mitigated by pipeline constraints
– Drop in iron ore prices forecast to drag down Rio Tinto stock

By Nicki Bourlioufas

China’s anti-pollution plan drives preference for higher-grade raw materials

China has announced its new anti-pollution plan, “2018-2010 3-Year Action Plan for Winning the Blue Sky War”, building on the Air Pollution Prevention and Control Action Plan (APPCAP) that expired at the end of 2017. The new plan expands the geographical scope of environmental protection measures that are already in place, but doesn’t make them any tougher. Commonwealth Bank analysts believe the sectors that appear to be most vulnerable to the new environmental protection policy are steel, iron ore and coking coal.

CBA identifies four trends from the 3-year action plan: i) coal to gas switching will likely be gradual, ii) metal production costs are set to rise in the areas under focus iii) the preference towards higher quality raw materials is expected to continue and iv) profitability in China’s industrial sectors will likely remain resilient.

While it is too early to tell how Australian mining exports will respond, the winners will likely be high-grade iron ore, coking coal and LNG exporters. Australian LNG exports may be constrained by the Domestic Gas Security Mechanism, which broadly looks to address shortages in east-coast Australia before exports. Low-grade iron ore, coking coal and thermal coal exporters are likely to be the losers from the plan.

Iron ore and coking coal exporters also face increasing risks from China’s environmental push towards using more scrap steel in steel production. While that substitution risk is unlikely to be meaningful until next decade, it is a risk that is emerging more quickly than expected, according to the analysts.

China’s increasing call for electricity takes coal full circle

Analysts at Macquarie note that in trying to clean up air quality, China has boosted demand for electricity and this, ironically, has had a knock-on effect on demand for coal.

Demand for electricity is being driven by many of Beijing’s key policies on the environment, including emission controls in steel, the shift from trucks to rail transport, and support for electric vehicles. China’s power consumption rate in the first half of 2018 jumped 9.2% year on year, much faster than the corresponding rise in GDP.

Curiously, despite the country’s spectacular growth in alternative power options such as nuclear and renewables, China is burning more coal to meet this demand kick. Macquarie says this is a tricky outcome for Beijing, since China’s government is trying to be a champion of global pollution reform.

Pipeline infrastructure likely to constrain rise in US oil output

Commonwealth Bank analysts suggest constraints on pipeline infrastructure mitigate the rise of oversupply in the oil market posed by rising US output.

The major question mark hangs over the pipeline infrastructure in the Permian basin, which is the largest shale oil basin in the US. Infrastructure constraints could start weighing on Permian supply growth from August and continue until the end of 2019, predict the analysts.

The US Energy Information Administration (EIA) expects output to rise in all the major US shale oil basins by August. The EIA is forecasting US oil production will rise 15.4% to 10.79 md/d this year and another 9.3% to 11.8mb/d in next year.

As well as the Permian, rises are expected in the Bakken, Eagle Ford, Niobrara, Anadarko and Appalachia basins. In the Haynesville basin, which is predominantly a gas producer, oil output is expected to remain stable. These seven basins have accounted for nearly all of the growth in US oil output in recent years.

The increase in output has been helped by the rapid expansion in US oil rigs, which are now close to levels last seen in March 2015. However, CBA says the backlog of oil wells to be completed also continues to rise.

The EIA reported that drilled but uncompleted (DUC) wells have increased to a multi-year high of 7,943 at the end of June. These DUC wells just require fracking to bring oil to the market. And since these wells require less labour to bring online, they are a source of low cost production, CBA points out.

Falling iron ore prices weigh on Rio Tinto

The local research team of RBC Capital cut its price target for Rio Tinto ((RIO)) to $65 from $76 while downgrading its rating to Underperform from Sector Perform, in the light of forecasts of falling iron ore prices.

Rio Tinto remains significantly more exposed to iron ore than BHP ((BHP)), given the reduction in volume contribution from coal and a lack of exposure to oil. As a result, Rio's fortunes remain linked to both the rise and fall of the iron ore benchmark and market sentiment, highlight the analysts.

RBC’s analysis suggests that a drop in Chinese steel demand will cause steel margins to fall from their current highs and this is likely to see both de-stocking and an unwind of iron ore premiums and discounts as China margins fall.

“We reduce our iron ore price forecasts from US$65/t to US$49/t for the second half of 2018, and from US$70/t to US$63/t for 2019. Regression analysis suggests that a price below US$50/t is a real concern before stabilising,” so the RBC forecast goes.

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