Commodities | May 15 2019
Trade tensions; LNG; bulks; and steel.
-US tariff hike a fresh bear risk for commodity markets
-Divergence in oil and LNG prices putting pressure on buyers to exit LNG contracts
-Iron ore stocks at Chinese ports likely to be exhausted by September quarter
-Outlook for coking and thermal coal diverging further
By Eva Brocklehurst
Morgan Stanley asserts an increase in US tariffs on US$200bn of Chinese goods, to 25% from 10%, provides a fresh bear risk for commodity markets. Commodities are exposed to weaker GDP growth, as doubts are raised about China's recovery.
Globally, the broker's economists expect GDP growth to be -30-40 basis points weaker, with an -80 basis points impact already seen since initial tariffs were imposed. This translates to a mild negative for base metals demand. China's response to trade tensions has been via domestic stimulus but, if this persists for a further 3-4 months, economists expect further fiscal easing up to an additional 0.5% of GDP.
All commodities should gain from this, but particularly steel and its raw materials, those most exposed to China's domestic construction/infrastructure sector. Morgan Stanley suggests tariffs should drive a redistribution of demand but it will take time. Existing tariffs are already affecting US raw material imports from China and the incremental impact is largely on metal in products. As much as 3% of China's total copper demand is re-exported to the US in this way.
Hence, Morgan Stanley believes the impact will be a delayed recovery rather than a further downturn. Any safe-haven demand for US dollars could also be negative for commodities, although the analysts observe the adjustment is occurring via bond/equity markets rather than the US dollar.
The broker's base case remains for a US dollar sell-off. However, upside is likely for gold as equity markets fall. Buying opportunities could emerge, most likely in copper, but the near-term risk in the broker's view is firmly to the downside.
The divergence between oil and LNG spot prices is increasingly expected to put pressure on buyers to exit LNG contractual commitments. Buyers will also be pursuing contract price reviews more aggressively and Credit Suisse notes Woodside Petroleum's ((WPL)) Pluto and Oil Search's ((OSH)) PNG LNG contracts are both under discussion.
The broker's valuation for Woodside could drop by -2% and Oil Search by around -5%. Credit Suisse suspects buyers have more leverage and are under more pressure than ever before in the history of the industry. Negotiations could be protracted, with any outcome in 2019 unlikely. Hence, there could be at nasty surprise for the two companies later in 2020.
Buyers could evade contractual commitments via exercising what is known as Downward Quantity Tolerance (DQT). This is the amount by which a buyer can fall short of its annual contract quantity in a take-or-pay gas sales contract without incurring sanctions.
Credit Suisse envisages long-term LNG contracts will retain the 11.5-12% linkage to Brent range, although does not rule out volume producers such as Shell being willing to offer sub-11.5% volumes for the more fiercely competed tenders to buyers such as KOGAS.
The broker notes the glut of LNG globally is likely to persist to 2021 and Europe will be the "sink" for excess LNG, where it will compete with Russian gas.
Credit Suisse lifts iron ore price forecasts, expecting a peak in the price of US$110/t in the September quarter when Chinese trade stocks at ports are expected to be exhausted. The broker estimates a -57mt iron ore deficit in 2019. This is driven by stronger forecasts for Chinese steel output and Vale's expectation it will lose -65-75mt of iron ore production because of suspensions.
Australian miners, meanwhile, have cut guidance by -32mt following Cyclone Veronica. When supply is no longer available from ports, steel mills are likely to bid aggressively for spot cargoes rather than willingly curtail blast furnaces, in the broker's view.
Chinese steel output is critical for iron ore and coking (metallurgical) coal forecasts. China produces half the world's steel and imports 70% of the world seaborne iron ore. Self-sufficiency for metallurgical coal is greater, as China imports only 18% of the world exported supply. However, domestic coking coal prices appear to support the seaborne price.
The broker lifts metallurgical coal price forecasts, now expecting prime hard coking coal to remain at US$200/t for an extended period. Credit Suisse gained confidence in the durability of the Chinese coking coal price from a visit to Shanxi, noting quality shortages. The long-term hard coking coal price forecast increases to US$160/t, modelled as an incentive price.
Credit Suisse reduces its Newcastle thermal coal price forecasts, undermined by discounted coal displaced from Europe. European coal prices have slumped as a mild winter meant ports were overstocked. And LNG surplus is also driving gas prices down to levels where coal-to-gas switching appears viable. This is expected to persist to 2021.
Cheap gas may accelerate the closure of coal-fired power plants in Europe, Credit Suisse suggests. And Atlantic coal suppliers will look to Asia for new markets.
High-energy coal is experiencing the brunt of the price erosion, as this is the main grade displaced from Europe. Indonesian coal has remained unaffected so far as its major markets of India, China and ASEAN (Alliance of South East Asian Nations) are not facing the threat of large coal-to-gas switching.
Between the extremes, Credit Suisse forecasts a flat price outlook for Australian high-ash 5500 calorie coal, which is largely driven by the Chinese price. The thermal market is expected to head into modest surplus, although there are large uncertainties surrounding Indonesian production.
JPMorgan estimates that lagged US steel spreads need to hold at US$510/t for the remainder of the second half of FY19 to achieve the guidance that BlueScope Steel ((BSL)) has provided. US steel in scrap prices have fallen and the lagged steel spreads are down -12.5% from a month ago.
The lagged Australian hot rolled coil spread is presently at $331/t. Based on this, and raw material price movements, the broker calculates BlueScope Steel's second half earnings (EBIT) could decline by -$390m on the first half. This implies FY19 earnings of $1.31bn versus guidance of $1.4bn.
With spreads continuing to decline in the US, offsetting a recovery in Australia, JPMorgan believes investors may need to revise expectations ahead of BlueScope's results in August. The broker maintains a Overweight rating based on a discounted cash flow valuation to FY25.
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