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Basic Materials: China Will Keep a Lid on Most Commodities

Looser credit conditions or fiscal stimulus may temporarily boost China's demand for coal, copper, and iron ore, but the bounce would be fleeting.

  • Mined commodity prices are unlikely to recover from recent lows, as China's structural economic transition diminishes the main source of global demand growth.
  • Falling input costs and global overcapacity have reshaped the global steel industry: Prices will be lower for longer.
  • Weak crop prices and low farmer incomes are a significant headwind for fertilizer and seed companies, but we don't expect the breeze will be too strong.

Prices for most industrial commodities (for example, coal, copper, and iron ore) fell considerably last year and have largely continued their descent in 2015. Slowing Chinese demand has been the common denominator, reflecting a deceleration in construction and industrial production. We view this as a structural slowdown catalyzed by overinvestment and rising debt. Although looser credit conditions or fiscal stimulus may succeed in boosting construction and industrial activity, this would likely provide only a temporary respite.

China's structural shift diminishes the main demand growth engine for mined commodities globally. For commodities like copper and iron ore, China accounted for nearly 100% of demand growth over the past decade and now consumes roughly half of global output.

Weak Chinese demand takes a sustained price recovery off the table for most commodities. After updating our outlook to reflect revisions to our oil price forecast and falling producer country currencies, we now expect seaborne thermal coal prices to average $67 per metric ton for the remainder of the decade, down from a $94 trailing five-year average. We see copper prices at $2.46 per pound versus a $3.49 trailing five-year average, and iron ore at $60 per metric ton from an average of $135.

China's economic transition transforms the competitive landscape for the global steel industry. Over the past decade, China's seemingly insatiable appetite for steel had supported global steel prices. Our research suggests China's demand for steel has peaked. The country is likely to increasingly rely on export markets to sop up significant overcapacity at home. Overcapacity in China, combined with lower prices for steelmaking inputs (iron ore, metallurgical coal, and ferrous scrap) suggest persistently low steel prices globally.

Low-cost steelmakers that operate with an economic moat are best-positioned to navigate this low-price environment. Steelmakers are no longer able to establish an economic moat through vertical integration alone, and we now favor companies that compete on the basis of raw material conversion costs rather than input costs.

With crop prices low compared with highs of the past few years, farmers' net incomes have come under pressure in North America. The USDA projects that lower prices will result in flat corn and soybean acreage for the 2015 planting season. Producers of fertilizers and seeds should expect a neutral effect on volumes from planted acreage this year. As farmers look to cut costs, this would seem to paint a rather weak picture for seed and fertilizer companies in 2015.

We think the market overstates the headwinds for seed and fertilizer purchases. Although still well below recent highs, corn, wheat, and soybean prices did rebound nicely during the fourth quarter of 2014, restoring some farmer profitability. Moreover, yield-improving inputs are usually the last items to get cut from a farmer's budget.

On the fertilizer side, potash producers should continue to benefit from a market that has stabilized since the shake-up caused by Uralkali in the summer of 2013. We think potash prices have bottomed for the medium term, and we're expecting a modest price increase when new contracts are signed with China and India in the first half of 2015.

Flat planted acreage and low crop prices make for a more challenging environment for seed companies. Nevertheless, they should be able to push a modest level of annual price increases with the introduction of higher-yielding technologies.

Yamana Gold

AUY

Yamana Gold is a Canadian-based gold miner operating mines in Brazil, Chile, Argentina, Mexico, and Canada. Shares have traded off after Yamana impaired three recently opened noncore mines because of underwhelming performance. However, we believe the market is overlooking consistently solid performance from Yamana's low-cost cornerstone assets, a meaningful growth pipeline, and the benefit of lower expansionary capital expenditures in the coming years. We expect Yamana to continue to be one of the lowest-cost gold miners we cover.

Newcrest Mining

(

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Newcrest Mining is engaged in exploration, mining, and development of gold and gold-copper concentrate in Australia, Indonesia, and Papua New Guinea. Its projects include Cadia Valley, Telfer, and Lihir, among others. Newcrest's long reserve and resource life is a key differentiator and supports future growth. The market is uninterested in the large reserve base, but it provides valuable long-term options.

Cloud Peak Energy

CLD

Cloud Peak Energy mines thermal coal out of the Powder River Basin in the western United States at low production costs. Although rail issues caused by severe winter weather in early 2014 have delayed contracted coal deliveries, we expect PRB coal prices to improve as rail service normalizes, allowing utilities to make spot purchases. Shares have also traded off as oil prices plunged. However, we believe the relationship to oil is largely overblown, as the two energy sources are not direct substitutes. In addition, any cancellation of U.S. shale projects because of low oil prices could benefit coal, as these projects often produce natural gas as a coproduct.

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