Commodities | Jun 17 2020
Guinea’s Simandou project will impact on iron ore dynamics, long-term, while oil prices are on the way up, with most metals impacted by supply constraints.
-Simandou project will impact on iron ore dynamics
-Oil prices on the road to recovery but a long way from previous highs
-Improving base metal prices with copper and nickel stealing the show
By Angelique Thakur
Iron ore: The Simandou deal
The Republic of Guinea has signed an agreement for the development of its Simandou iron ore reserves by the SMB-Winning consortium for US$14bn.
The deal will include a railway line and deep-sea water port. Incidentally, the consortium, which represents Chinese, Singaporean and French interests, is also the largest bauxite exporter in Guinea.
The Simandou mine has one of the largest untapped high-grade iron-ore deposits in the world. Blocks 1 and 2, which are to be developed by the consortium, are estimated to hold more than 3.6bn tonnes of high-grade ore.
The consortium aims at producing 60-80mtpa of high quality 65-66% Fe iron ore every year which translates to a capital intensity of about US$175/t, calculate analysts at UBS.
The analysts estimate the iron ore market to be at around 1.5btpa with circa 150mtpa of that estimated to be high-cost iron ore with a break even cost of more than US$70/t. Contestable high cost ore from China also adds about 200mtpa.
Thus, the analysts do not expect the introduction of low-cost iron ore from Simandou to materially impact their long-term price estimate of US$55/t. However, they do admit this project will provide China with an alternate supply source and that too at a time of heightened trade tensions between Australia and China.
On a more positive note, UBS analysts expect demand for low-grade iron ore to increase to match the increased high-grade ore supply from Simandou. This is likely to benefit Fortescue Metals Group ((FMG)) while being not so good for BHP Group ((BHP)) and Rio Tinto ((RIO)).
Iron ore prices are expected to remain elevated in 2020, helped by covid-19 related supply constraints. The analysts recommend BHP and Fortescue while Rio Tinto is rated Neutral.
Oil: A long way from home
Oil demand reached an inflection point in April with prices looking up from there. UBS experts have lifted their 2020 Brent oil price forecast to US$42.25/bbl, similar to Citi analysts’ US$42/bbl.
The trend is expected to continue with both teams of analysts predicting oil prices to improve in 2021 – although UBS analysts take a conservative stance with price estimated at US$50/bbl against Citi’s US$57/bbl.
The increase is driven by faster market recovery through May/June. However UBS analysts point towards continued supply overhang that will take time to decrease, and Citi analysts caution investors about continuing price volatility.
Since exploration and production companies have high operating leverage, any improvement in oil prices directly impacts their revenues and earnings. UBS analysts estimate improving oil prices impact earnings in the range of 13-100%.
Here, the analysts highlight Oil Search ((OSH)), which has the highest leverage to any rise in oil price, with a US$5/bbl increase leading to about 65% increase in earnings. This is followed by Woodside Petroleum ((WPL)) and Santos ((STO)). These two are also preferred by Citi analysts owing to Woodside’s low-cost operations and strong balance sheet.
In fact, the analysts estimate that if Woodside chose not to protect its balance sheet in order to maintain its credit rating, a drop by one notch in rating could provide access to US$7.5bn of capital, helping it to acquire assets. This, they feel, is a much better option than to wait for oil to touch $60/bbl, a condition that is required to take the final investment decision on Woodside’s proposed Burrup Hub.
This hub contains the Scarborough gas project and Pluto Train 2, both of which have been deferred given the pandemic-led uncertainty.
Citi analysts also prefer Santos. They expect its credit rating to improve and note its funding plan carries less risk. The company is expected to deliver a five-year operating income compound annual growth rate of 9%.
UBS analysts are positive about Origin Energy ((ORG)) in the utilities sector due to its exposure to oil along with an improving outlook on energy markets beyond FY21.
Senex Energy ((SXY)) is liked by Citi due to its strong balance sheet, with the analysts expecting high cash flow yield in FY23.
While Citi analysts think there is value in the energy sector, they admit the risk-reward trade-off is not as pronounced as it was in March. Share prices have rallied since.
The analysts highlight that while oil and gas stocks have appreciated by 54-110% (as of June 12) off the March lows, they are still trading -39-57% below their one-year highs.
In the long term, UBS experts predict oil prices to settle around or more than US$60/bbl while Citi analysts are more cautious and target US$55/bbl.
Recovery seen in base metals prices
Base metals prices have seen a broad rally and Macquarie analysts expect this to continue as the pandemic-induced weakness subsides.
Dr. Copper is up 7% in June alone, bringing gains since the lows seen in March to 21%.