Material Matters: Iron Ore, Coal & Permafrost

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Seaborne iron ore market expected to peak in 2023-24; Climate change is leading to increasing temperatures in Russia’s permafrost region.

-Iron ore market likely to be in surplus by around 2025
-China’s domestic thermal coal has become more expensive than imports
-Most Russian commodities are exposed to climate change

By Angelique Thakur

Joining forces at Simandou may not be such a bad idea

Goldman Sachs believes deposits in Guinea's Simandou mines can push the seaborne iron ore market into surplus by mid-decade.

The northern blocks 1 & 2 are owned by a Chinese led consortium SMB-Winning, where construction of the rail line will start in 2021 while the first production will be around 2025.

The other consortium is led by Rio Tinto ((RIO)) which owns the higher-grade and larger southern blocks 3 & 4. Rio Tinto confirmed having commenced design work on the rail and port infrastructure.

Goldman Sachs suggests forming a joint venture (JV) between the North and South. This could reduce combined capital expenditure by -US$6-7bn and boost individual project returns by over 3%, the analysts estimate.

However, it appears the Chinese consortium’s major aim is to have a long-life asset that would safeguard the supply of iron ore for its steel mills. Returns on capital may not be the first item on the agenda.

The analysts highlight Rio Tinto has three options for the project. The first is to form a joint venture with the Chinese consortium that will lead to the aforementioned benefits.

The second is to build a stand-alone duplicate rail at a cost which is more than 20% higher than that of its Chinese counterpart, while the third is to sit and wait for an opportunity to either sell down to a minority position or exit completely.

Goldman Sachs prefers the first option and believes it would make strategic sense for Rio Tinto to form an infrastructure JV with the Chinese consortium.

The analysts also suggest Rio could replace some Pilbara iron ore with iron ore of a higher grade from its Simandou South operations. This will have the effect of improving the miner’s overall average product grade by about 1% Fe (to 61.7% from 60.8% Fe).

Overall, this could add to US$3/t and generate additional revenue of US$1bn annually to the company coffers. The production from Simandou will also impact the seaborne iron ore market, highlight Goldman Sachs analysts.

Currently, Goldman Sachs forecasts the market to peak in 2023-24 at 1.59bt. It is expected to move to a 100mt surplus from 2025, assuming production from Simandou North is at 80mtpa.

If the production expands to beyond 80mtpa, the market may even move to a 200mt surplus, Goldman predicts, unless other major producers like Rio and Vale decide to reduce production.

China’s thermal coal import arbitrage increasing

China’s economic rebound from its first-quarter lockdown lows has caused its local thermal coal prices to increase compared to imported seaborne coal prices, finds a study by Macquarie. Led by post-lockdown recovery and coal import restrictions, China’s domestic thermal coal price has increased by 25% since mid-May and recently peaked at RMB 590/t or US$80/t.

The same period saw seaborne thermal coal prices decline by -5-15% due to the lockdown of Northeast Asian and Indian economies.

One of the impacts is a record increase in China’s import arbitrage, which is the difference between the price of Chinese and Australian coal delivered to the port of Guangzhou, Macquarie reports. This makes China’s coal more expensive by circa US$30/t as compared to its seaborne equivalent.

Macquarie suggests a couple of options to close this arbitrage. One involves China easing import restrictions, causing more of the cheaper seaborne coal to flow into the country. However, the Chinese authorities have hinted this option is not yet feasible and will be considered when domestic prices go above RMB 600/t.

Another way is to increase the production of domestic coal but Macquarie finds this too looks unlikely at the moment.

A third way lies outside China and depends on the recovery rates of other economies. The broker points out a non-China driven recovery, led by a resumption in economic activity in Northeast Asia, will increase the demand for seaborne thermal coal.

Walking on thin ice

About 60% of Russia’s landmass is made up of permafrost. A report by Morgan Stanley notes temperatures in Russia’s permafrost region are rising 3-4 times faster than the global average. Permafrost is basically ground that remains frozen for two or more years continuously. It can be located on land or under the ocean.

A potential impact of permafrost thawing can be the release of large amounts of gases like carbon dioxide and methane. It can also lead to soil degradation and impact soil stability.

This poses a risk to infrastructure, highlights Morgan Stanley. The most recent example of this is Nornickel’s recent incident involving an ongoing diesel spill, which led to the declaration of a national level state of emergency.

The company claimed the incident was due to the thawing of permafrost, leading to discussions around permafrost risks from climate change. Morgan Stanley notes thawing permafrost also impacts most major commodities like oil, gas, palladium and diamonds.

Companies with the highest exposures include natural gas producers Gazprom and Novatek, miner and smelter Nornickel and diamond manufacturer Alrosa.

90% of Gazprom’s gas production is located in permafrost-covered production provinces while all of Novatek’s hydrocarbon production along with most of its infrastructure is located in areas exposed to permafrost risk. Lukoil is the most exposed oil company with 40% of production exposed.

Miners with considerable exposure to permafrost regions include Nornickel, Alrosa and Polyus. This could also put the entire economy at risk since the oil and gas sector forms 40% of the federal budget revenue and 7.5% of Russia's GDP.

Most of the companies exposed state they are taking steps to manage the risks related to permafrost on an ongoing basis and are confident their equipment/technology are resilient. Gazprom expects its assets can withstand temperatures 3-5 degrees above current levels.

As the permafrost issue is not that well understood, the broker believes markets will take time to price the risks in.

Still, Morgan Stanley analysts lower their bear case price targets by -3-34% as a way of acknowledging the risks and the corresponding need to repair/replace infrastructure. Logistics costs will also likely be higher.

Dividend yield could also be impacted under Morgan Stanley’s bear case scenario, dropping to 7.3% from 9.7%.

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