Material Matters: Iron Ore & Oil, China Factors, Lead And Manganese

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-Value in resilient iron ore & oil majors
-Will Goa exacerbate iron ore oversupply?
-China base metals outlook better than bulks
-China thermal coal prices likely to be flat
-Sudden short squeeze in lead
-Manganese to the fore with South32
 

By Eva Brocklehurst

Commodities Environment

The last six months have delivered a reality check among resource sector companies, particularly with regard iron ore and oil, with prices severely testing capital management and growth strategies. Accordingly, Morgans recognises a unique opportunity for investors to gain exposure to those stocks with resilient profits, strong management and the ability to adapt. This reveals a small pocket of value among established businesses that can weather the storm. To this end, the broker prefers BHP Billiton ((BHP)) and Oil Search ((OSH)). Both have strong and defendable earnings margins with no need to seek external capital and are already changing key aspects of their respective strategies to capitalise on current conditions.

Indian Iron Ore

Reports suggest the Indian government has lifted the suspension of environmental clearances on Goa's iron ore mines. Citi observes that the restart of mining and exports out of Goa could exacerbate the global oversupply in iron ore. There is a lack of clarity on the timing and quantum of ore likely to be mined and export may not be lucrative at current prices, the broker contends. Nevertheless, Sesa has indicated the Goa mining leases have been renewed and mining is expected to start after the monsoon. Citi analysts expect iron ore prices to be US$53-58/t over 2015, driven by renewed supply growth and further demand weakness.

China Factor

Demand from China remains the swing factor in Morgan Stanley's commodity outlook. The broker has taken a cautious stance across bulks and base metals, particularly given the lacklustre return to the market after Chinese New Year holidays. Encouraging signs out of China over the past six months are yet to materialise in terms of actual demand. With more favourable supply dynamics, Morgan Stanley maintains a relative preference for base metals than for the iron ore and coal markets. The commodities team has reduced its price outlook for copper and nickel over 2015-16 by 10-23%. The broker also notes that a significant part of the better performance for small/mid cap miners at the start of 2015 was gold, but most of the gains were given back over early March.

Morgan Stanley also notes China's metal processing industry remains dormant, despite a growing list of government-approved property and infrastructure projects and easy access to low-cost raw materials. With only months left until the mid-year peak in sales of commodity-intensive goods, Morgan Stanley believes time is running out for Chinese support for commodity prices in 2015. The broker remains convinced that China's maturing economy and stable growth should allow base metals to outperform bulks. Moreover, with a loss of confidence in China's industrial sector this is undermining seaborne-linked prices for bulks. In terms of thermal coal, the broker also notes China continues to invest in domestic production capability, curbing its large and crucial import demand.

Macquarie has also updated its views on China's thermal coal market. Weak power demand, a lower cost curve and a build-up of mine inventory is suppressing prices. Historical patterns suggest to the broker that thermal coal prices will stay flat at best in the second quarter. Inventories at key power plants stand at the highest level for this time of year. The lowering of the cost curve means it becomes more difficult to force capacity closures at current prices than it was six months ago. Macquarie also observes the disappointing situation for thermal coal is partly from strong growth in hydro power generation, which benefited from weather conditions and a large amount of newly installed capacity. The bright spot for thermal coal demand is that this growth is now seen slowing.

Lead

Lead has been rallying recently, taking the price back over US$1,800/t. Macquarie observes this seems to be a result of short positions being squeezed out of the market. London Metal Exchange warrant data shows a dominant position had built which was abruptly cancelled. The broker observes lead, in the data available up until last week, was the only metal positioned net short amongst the money managers' category of the LME. The cancellation of a large position last Friday meant the flat price rallied 4.0% and the cash to 3-month spread in lead moved into a backwardation – where the spot price is higher than the forward price.

Manganese

While a central component to steel making, the impact of manganese on the balance sheets of the major mining companies has been negligible, Macquarie observes, with the price declining in line with peer steelmaking raw materials. Existing mines have mostly ramped up capacity and are looking at a period of stagnation. Macquarie also expects further cuts to Chinese and Australian output in the medium term.

With the imminent spinning off of BHP Billiton's South32 entity, manganese will now represent a more significant driver of earnings for the diversified mining company. BHP is the largest manganese ore producer globally, accounting for around 20% of output, and intends to incorporate the GEMCO operation in Australia and the Hotazel operations in South Africa into the new company. On Macquarie's estimates, 21% of the new company's earnings will be manganese. South32 will be a significant manganese exposure which is likely to boost investor interest in what is a relatively opaque commodity.

The broker observes the first thing needed in the manganese market is paring back of the oversupply since the output surge in 2013. There is little pressure to cut supply ex China and the process looks set to be prolonged. The probability of raw material constraint in manganese, absent a major supply shock from South Africa, is considered low. The broker's price forecasts over the next three years are based on estimates of the marginal cost of South African production. Beyond 2017 Macquarie envisages further steady price appreciation as ore stocks finally start to draw down.
 

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