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Material Matters: China, Met Coal & Gold

Commodities | Jan 20 2021

This story features SILVER LAKE RESOURCES LIMITED, and other companies. For more info SHARE ANALYSIS: SLR

Australian miners could piggyback on China’s rising growth prospects; A look at what could happen if China were to continue its ban on Australian coal; Stronger AUD playing spoilsport to rising gold prices

-Rising Chinese growth bodes well for Australian miners
-Coking coal and the Chinese ban: A scenario analysis
-Gold: Robust demand backed by a different narrative

By Angelique Thakur

China: The Dragon rises

China’s economy gathered speed in the December quarter, finishing the year on a high note with GDP growing 6.5% versus last year. This takes the GDP for the entire 2020 calendar year to 2.3%, a remarkable feat amidst a covid-ravaged world.

But that's not all. The economy is poised for further growth as it enters 2021, with UBS analysts pegging the growth forecast for 2021 at 8.2%.

This bodes well for Australian miners as well as a robust China implies higher demand for key commodity sector raw materials.

Backing this assertion is a report by UBS that sees upside risk to its iron ore forecast for 2021 on the back of continued growth in China’s crude steel output.

Crude steel production in China reached new heights in 2020, growing by 5.2% to 1.053bt. The trend has continued into the first few weeks of January, with output between January 1-10 amounting to 2.9mtpd.

UBS expects crude steel output to grow 2% in 2021 with demand for iron ore expected to tag along.

Propping up demand for coal is the rise in electricity generation in China, up 11% year on year in December 2020. A major chunk of this rise is attributed to the exceptionally cold winter season.

Insufficient Chinese domestic output and freezing temperatures will support the import of seaborne coal, suggests UBS, noting upward risk to its 2021 coal price forecast.

The broker isn’t so optimistic on aluminium, its bullish stance changing with the more than -10% correction in Shanghai Futures Exchange aluminium prices coupled with an increase in inventory levels in China over the last four weeks.

Coal: What if China does not change its Australian coal ban policy?

Continuing in the same vein, Macquarie is bullish on met coal prospects and forecasts a deficit in 2021 for the market, with prices expected to average north of US$150/t this year.

China’s coking coal demand, expected to be around 36mt in 2021, is expected to be responsible for a huge chunk of this deficit.

However, before investors get too excited, Macquarie reminds all of one very important if unfortunate fact – a bullish stance on met coal is contingent on the relaxation of China’s ban on Australian coal.

While there are signs we are moving in the right direction with the partial easing of cargoes at Chinese ports, it is not unthinkable for China to stick to its ban.

What would then happen to seaborne coal and how will this affect the market?

For starters, the market would slip into a surplus as the last few months have shown. The fact remains no other market comes close to filling the demand void left by China.

Since China mainly imports hard coking coal from Australia, this segment will be the most impacted. The impact on price then depends on what China replaces the coking coal with.

Macquarie has come up with a number of alternate scenarios.

In the first and most gloomy scenario, China will choose to replace Australia’s coking coal with domestic production. This will spell disaster for the seaborne coal market and even cause some mines to shut down in Australia.

Unsurprisingly, seaborne coal prices will remain subdued for longer.

The fact that this scenario has not played out makes Macquarie analysts think it is not as easy as it appears to be.

Following the “if they could have, they would have” dictum, the analysts conclude Chinese production may be fraught with issues like higher production costs or lower quality produce.

The second scenario involves China increasing imports from non-Australian producers.

Some obvious choices are the US and Canada, owing to their abundance of coking coal resources. Russia and Mozambique also make plausible contenders.

Recall in the aftermath of the Queensland floods in 2013, coal exports from the US and Canada to China reached a peak of 17mt to fill the gap left by Australian suppliers.

If we assume a return to 2013-peak levels, about half of China’s imports from Australia could be replaced with imports from North America. But is this really possible?

Not likely, states Macquarie, since a return to such high levels would first require restarting some very costly assets which in turn require coking coal prices to be north of US$250/t.

Of course, US miners always have the option of diverting the existing supply to China. Australian coke stands to benefit in such a scenario with countries like Brazil and Europe vying for Aussie coal.

The last, and most plausible scenario according to Macquarie, is the destruction of demand for coal. Macquarie analysts believe this is only possible via steel production cuts.

But this too is easier said than done with the tactics commonly used for reducing coke consumption (like increasing the pellet charge in the furnace or using higher quality iron ore) not very effective in practice.

Another way to reduce demand for coking coal is to increase steel scrap consumption. With a 1% rise in blast furnace scrap reducing coke consumption by -1%, it is here that the potential for saving on coke consumption appears to be the maximum.

The main constraint? Scrap prices are already notoriously high.

Summing it all up, Macquarie thinks while a sustained ban would unquestionably lead to a lower price outlook, the only case where this would lead to sustainably low prices would be if China decides to increase its domestic coking coal production, of which there is little evidence (so far) and/or decides to cut its steel production.

Also, as shown above, China does not possess enough scrap to reduce its coke consumption in iron making.

Lastly, with almost nil supply growth expected, import substitution towards non-Australian brands will only take China so far, instead only serving to shift the trade flows for the displaced Australian coking coal.

Gold: A hedge against impending inflation

The Fed is moving to “average” inflation targeting regime from inflation targeting. What this essentially means is, rather than treating the inflation target (which is 2%) as a ceiling, the Fed will have more flexibility in allowing inflation to run higher than 2%.

What do we get when we add to this a US monetary and fiscal policy that is expected to remain accommodative in 2021?

A scenario that is ripe for higher inflation levels in the not-so-distant future, at least such is the prediction made by Canaccord Genuity.

Demand for gold, propelled so far by a pandemic-driven, safe-haven demand narrative is expected to shift to being a hedge against inflation, which is why Canaccord Genuity analysts remain bullish on gold and have increased their gold price forecast.

On the flip side, the bullish gold narrative is somewhat tarnished by a stronger AUD/USD forecast.

The analysts have updated their forward curve pricing assumptions for gold, silver and AUD/USD, with the USD gold forward curve rising 1.5% to US$2,014/oz.

Offsetting this is the long term AUD/USD forward curve that has increased by 7.3%, leading to a fall in long term AUD gold price assumption by -5.4% to $2,623/oz.

In terms of local share market exposure, Canaccord Genuity shifts to a Buy from Hold on Silver Lake Resources ((SLR)) and Regis Resources ((RRL)).

Northern Star Resources ((NST)) is a key pick among senior producers while in junior/intermediate producers Canaccord Genuity prefers Perseus Mining ((PRU)) and Gold Road Resources ((GOR)).

Bellevue Gold ((BGL)) is preferred among gold explorers.

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