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Material Matters: Iron Ore, Zinc And Energy

Commodities | Oct 02 2018

A glance through the latest expert views and predictions about commodities. Australian miners; iron ore; zinc; and energy.

-Controlled supply of bulks and an uplift in metals should underpin commodity markets
-Falling demand expected to mitigate drop in China's iron ore supply
-Zinc rally not expected to last through 2019
-Citi urges caution regarding LNG growth forecasts

By Eva Brocklehurst

Miners

Despite a poor quarter for Australian miners, UBS still advises an Overweight position because commodity prices should remain buoyant and the sector is focused on capital discipline. The broker does not expect cost pressures to abate and volatility should continue, given varying views on supply/demand dynamics as well as an ongoing frustration in the market with over-promising and under-delivering by producers.

Commodity markets should remain strong because of a controlled market supply in bulks and an uplift in metals from China's stimulus. Meanwhile, balance sheets are healthy and returns are solid.

China's infrastructure construction is expected to accelerate and lift demand for commodities. China's capacity reforms on coal, steel and aluminium continue. There are also supply-side factors which are supporting the market, such as capacity closures and China's environmental curtailments, along with producer discipline.

The broker notes capital expenditure in new capacity is increasingly needed in trades such as metallurgical coal and nickel, which in turn will need higher prices. Meanwhile, seaborne coal remains tight as trading volumes hit all-time highs and China maintains tight domestic supply.

The broker expects the iron ore price to hold up at around US$65/t as the cost curve lifts and steepens because of quality discounts.While copper and nickel, particularly, felt the brunt of concerns regarding a trade war the fundamentals remain strong, with low inventory and higher premiums.

Nickel remains the broker's preferred base metal on a longer-term view because of strong prospects for battery demand. Alumina price forecasts have been upgraded but are expected to fall when Alunorte eventually returns to production.

Iron Ore

Production of iron ore in China has declined. China's iron ore is typically low-grade and small in scale, requiring expensive processing. This year production has slowed by -3% because of environmental restrictions while imports of iron ore are holding up. If too much domestic supply from China drops out of the market, lower-cost seaborne producers will move in and reduce the marginal cost of production.

Furthermore, the broker notes supply from China is typically slow to respond to a falling price and the market can be oversupplied in times of rapid seaborne growth, putting downward pressure on the price.

Morgan Stanley does not envisage China's domestic supply will disappear completely. The broker forecasts China's demand for iron ore to peak at 1.28bn tonnes in 2018 and then gradually decline to 1.1bn by 2023 because of falling crude steel production and increasing use of scrap.

Domestic supply from China is expected to decline to 40mt by 2023 but remain at around 16% of China's total iron ore demand. Hence, seaborne iron ore will need to find another home or be reduced. Morgan Stanley retains a bearish view on the price, estimating US$61/t CFR China in 2019.

Zinc

The zinc price is now running hard and Citi has raised its short-term target price to US$2800/t. A major sell-off in zinc in February at US$3575/t had reduced the price to US$2300/t by mid September.

Chinese zinc producers restricted output and consumers are now starting to rebuild refined stocks. Chinese output declined -6% over the two months to August, with domestic and bonded stocks being drawn down sharply.

Citi suggests the tightness in China is likely to spread and envisages some upside in the near term, yet does not expect the rally will last through 2019. The broker's base case envisages prices falling to US$2400/t by the December quarter of 2019.

A low-probability bull case is a delay in ex-China supply while China's infrastructure stimulus comes through stronger than expected. This would maintain a zinc deficit during 2019 in which case zinc can trade sustainability around US$2800/t.

Energy

A long-term contract between QatarGas and PetroChina has been signed and firming LNG markets have benefited both Woodside Petroleum ((WPL)) and Oil Search ((OSH)), Citi observes. Nevertheless, there are risks to LNG markets and the broker cautions investors not to pay full value for LNG growth at present.

Growing liquidity and transparency in the LNG spot market may lead to price discovery in the contract market because the risk of exposure reduces. The broker suggests this would then be deflationary for contract prices. Around 30% of Citi's forecasts for LNG demand growth are based on an orderly increase in demand from emerging markets China.

The broker also urges caution regarding emerging markets calculating that, if all uncommitted LNG import infrastructure does not progress, new LNG supply requirements would reduce to around 40mtpa in 2025 from around 80mtpa, crowding out prospective projects.

In other words, investing in the above two stocks is just dependent on countries such as Bangladesh and Pakistan materially increasing gas imports as it is on China doing the same. Citi downgrades Woodside to Sell given the recent rally in the share price along with long-term commodity forecasts. The broker still prefers Woodside over Oil Search among LNG stocks.

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