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Iron Ore Won't Soar Forever

Those miners appear overpriced, but we see value emerging in base metals and coal.

Iron ore and gold prices are flying high, but we don’t think this will last. Iron ore is benefiting from unusually strong demand and supply disruptions while gold is rising with negative interest rates. The global miners remain overvalued, in our view. The sector trades at an average 10% premium to our fair value estimates versus a 20% premium three months ago. The iron ore miners-- BHP BHP/BBL, Rio Tinto RIO, Vale VALE, and Fortescue--on average are at a 30% premium, while the rest of our coverage is only at a 4% premium. The coal miners have been soft, and New Hope and Whitehaven now stand out as being relatively undervalued.

We’ve raised our near-term iron ore forecasts meaningfully given higher spot prices, stronger near-term demand from China, and potential for Vale’s supply issues to persist, but our long-term price is unchanged. We now forecast $41 per tonne iron ore from 2023 with our long-term price kicking in from 2023 versus 2022 previously. The Feijao dam failure has yet to play out, and a slower return to normal production from Vale means that elevated iron ore prices can persist for longer. Our metallurgical coal price forecasts also benefit from higher near-term steel production. On the negative side, spot prices for nickel and zinc have fallen with lower industrial production.

Softening global economic growth has seen base metals generally sell off. Thermal coal also softened with additional supply from China and a relatively mild Northern Hemisphere winter. Price rises for iron ore and gold have been the exceptions, both rallying of late. Iron ore has risen further, principally from Vale’s misfortune, but also because of strong demand from China. Here, softening economic growth and the U.S. trade war have led to a second-order benefit for iron ore. China is again pushing infrastructure investment to stabilize soft economic growth, to the benefit of steel and iron ore demand. Steel production in China grew 10% for the year to date ended May, but the rest of the world was flat.

Iron ore continues to be an outlier in terms of commodity performance. Against a backdrop of weakening global industrial production and generally softer coal and base metal prices, the iron ore price rose more than 30% in the June quarter and now sits above $120 per tonne, at five-year highs. With production costs less than $20 per tonne for BHP, Rio Tinto, and Fortescue, iron ore miners are printing money at current prices. We see potential for special dividends and buybacks for the three Australia-based iron ore majors.

On the supply side, we estimate more than 100 million tonnes of iron ore production, or 6% of the 1.8 billion-tonne market, has been lost in 2019. For demand, China has continued to defy headwinds in property, demographics, and debt to increase steel output 10% in the first five months of 2019. There may be some seasonality to production, though, with the Chinese government implementing cuts to steel production during peak periods for pollution.

Iron ore now trades well ahead of the cost curve, with about 80% of global supply from Rio Tinto, BHP, Vale, and Fortescue, which are all low-cost miners. The tail of the cost curve is steep, however, with supply coming from high-cost sources such as domestic China and nontraditional suppliers such as India and Iran. It’s highly likely that lost supply from Vale will return to the market. The company expects to produce at 400 million tonnes annually in two to three years, from an estimated 320 million tonnes in 2019.

However, it’s increasingly likely there will be delays to the return of full production at Vale. Samarco provides an example: The tailings dam failed in 2015, and production has still not returned despite the strong price incentive. It’s unlikely Samarco will restart in 2019, and if a return comes in 2020, it will have been five years since the accident. And it’s likely to take a couple of years for production to return to the 30 million-tonne annual rate before the tailings dam failure. The likely delay to production restarts at Vale, coupled with stronger steel production in China and higher spot price, sees our average price forecasts rise by $17 per tonne to average $76 per tonne for the four years ending 2022. This is broadly in line with the average for consensus and the futures curve to 2022. Our long-term forecast is $41 per tonne from 2023 onward. Our forecast for 2023 is unchanged, but our long-term assumption now kicks in from 2023 versus 2022 previously.

Higher near-term iron ore price forecasts are the main change to our commodity price assumptions. Elsewhere, we’ve raised our medium-term metallurgical coal price forecasts by $14 on average to $149 per tonne to 2022 due to the stronger steel production in China. Our gold price forecast is also 4% higher for 2019 at $1,320 per ounce but unchanged thereafter. Gold is benefiting from investor risk aversion, heightened geopolitical risk, and fears of a global economic slowdown. Demand from central banks and investors has been strong in 2019. We’re still positive on the long-term outlook for gold demand from China and India, but we think the current price is somewhat inflated by broader near-term investor concerns.

Elsewhere, nickel and zinc prices have softened with slowing global industrial production growth. Our price assumptions fall in line with the lower spot prices of $5.70 and $1.15 per pound, respectively. We’ve also lowered our forecasts for alumina and thermal coal to $370 and $85 per tonne, respectively, for 2019. Our forecasts for 2020 onward are unchanged. We expect alumina prices of $326 per tonne in 2020, $317 per tonne in 2021, and $302 per tonne from 2022 onward. We forecast thermal coal prices of $80 per tonne in 2020 and $73 per tonne from 2021 onward.

Aluminum consumption growth has slowed with lower global economic growth and trade tensions. Auto sales globally have taken a hit this year, slowing demand for aluminum. The alumina price has fallen on the addition of 3.0 million tonnes of supply from Alunorte. The refinery had been operating at just 50% capacity after owner Norsk Hydro made unlicensed water emissions. However, the issue has resolved and the government restrictions preventing a return to full production have lifted. Thermal coal was affected by a relatively mild Northern Hemisphere winter and some additional supply from China. But with prices starting to eat into the cost curve and additional supply from China being relatively high cost, we think there is longer-term support for the thermal coal price and emerging value among the coal miners we cover.

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