Trends and market fundamentals
Managing the latest wave of volatility
During 2013–15, increased supply and weakened demand put downward pressure on commodity prices. In 2016, there are signs of a return to growth and some reduction in supply, and commodity prices have trended higher. However, market uncertainty is having as much impact on commodity prices as supply-and-demand fundamentals.
Political events, such as increasing Chinese regulation of coal production and the election of Donald Trump to the US presidency, have caused significant uncertainty, which is increasing commodity price volatility.
Chinese coal regulation fuels price volatility
China is seeking to bring its coal sector under control, leading to increased regulation, production cuts and market deficit, particularly in coking coal. This has significantly increased volatility of coal prices. Metallurgical coal is up by over US$300/t, and thermal coal has doubled to over US$70/t.
As coal prices have increased, Chinese steel producers want to get maximum value and reduce coal consumption, and as such have sought to secure higher-quality imported iron ore. China cut its domestic (mostly low-grade) ore supply by about 6% this year, contributing to increased demand and thus a rise in price for imported ore.
Speculative activity boosted by proposed US infrastructure spend
The expectation of new policies in the US proposed during the election campaign, particularly around infrastructure spend of US$500b in the next 12 months and US$1t over the next decade, has fueled speculative activities in a number of commodities, including iron ore, steel, aluminium and copper.
Iron ore prices, in particular, surged to a two-year high in mid-November. The sustainability of higher prices, however, is questionable, until it is clear how Trump’s foreign trade policies, particularly with China, eventuate.
Several of Trump’s proposals made during his campaign, such as trade protectionism and the scrapping of the US ratification of the Paris Convention, were expected to put upward pressure on gold prices. Gold prices did spike on Election Day as it became clearer that Trump might become the next US president.
Most of the gains, however, were given away by the end of Election Day, with gold prices falling by over US$140/oz in little over a month. The price adjusted to a number of factors, such as a toned-down acceptance speech by Trump, the potential inflationary effects of his big infrastructure spending program and the near-certain increase in US Fed interest rates in December.
Miners still cautious despite surging prices
The sustainability of these price surges is uncertain as supply-and-demand fundamentals are not as strong as the prices would suggest. Miners are, therefore, taking a more cautious approach than during the previous cycles. Several coal miners both in Australia and the US, for example, have commented that they will neither bring production back nor increase production to take advantage of current coal prices. This signifies a move away from building production at any cost.
Focusing on managing ongoing sector volatility is key as discussed in our recent paper Navigating volatility: do you change your business or the way your business works?
Commodity price movements
Aluminium prices increased by 14% in first 10 months of 2016 to average US$1,566/t as inventory declined on production cuts in China, Russia and the US. However, prices are forecast to average US$1,556/t in 2016, down 6.5% from 2015 as the market is skeptical that these cuts may be temporary and could be withdrawn as the prices recover. High-level trends:
- For the first time since 2009, aluminium production fell by 1.2% to 33.12mt in the first seven months of 2016. Chinese output decreased by 3.1%.1
- A recovery in aluminium prices will trigger the restart of some production, e.g., China Hongqiao plans to expand to 6.5mtpa (from 5.9mtpa).2
- Producers in Iran and UAE are also planning to expand to meet growing demand from global automakers.
- Aluminium cash costs continue to decline due to lower energy and alumina costs, with the average cash cost declining from US$1,550/t in 2015 to US$1,380/t in Q3 2016.2
- As producers seek to maintain market share, they are more likely to focus on implementing cost-cutting strategies rather than reducing aluminium production.
- Chinese aluminium producers are reevaluating their product portfolios and moving into higher value products.
1 “Commodities Review,” Societe Generale, 7 September 2016, via FACTIVA.
2 “Commodities Quarterly,” Deutsche Bank Research, 3 October 2016, via FACTIVA.
While the surge in coal prices has been driven by a lack of supply, the extremity of the response seems unjustified as it has not been driven by a catastrophic event, but rather by the introduction of state-mandated production cuts in China and a simultaneous increase in imports. High-level trends:
- Premium Australian hard coking coal spot prices surged by 293% to over US$300/t in 2016 and Newcastle thermal coal prices have increased by 35% over the year to over US$70/t.
- In the first nine months of 2016, China cut its coal output by 10.5% to 2.46bt while imports increased by 15.2% to 180.18mt. The supply shortage has exposed both the extent of production cuts in the global coal market as well as the lack of capital investment in the sector, since prices started to decline in 2011.
- Although China is trying to control prices via a range of initiatives to bring back production, it is unlikely to take effect in the near term.
- In the rest of the world, miners are cautious about restarting suspended production and are testing the sustainability of price increases. They appear to have learned lessons from the build-at-any-cost attitude that was adopted during the top of the cycle.
- Metallurgical coal prices have increased more than those of thermal coal as it is a smaller market in which production, particularly from Australia, has been disrupted.
Copper prices reacted to positive sentiment after the election of Trump, experiencing their strongest week in 30 years in November. Prices hit over US$5,500/t, almost a 17% increase since the start of the year. The market is expected to remain volatile in the near term with a strong theme of cautious optimism. High-level trends:
- The US election has had a positive influence on prices, particularly on the promised increased infrastructure spending.
- Prices reacted positively to data, indicating an 8.3% hike in China’s fixed asset investment during the period of January–October.3
- The copper market has started reassessing the narrative of chronic oversupply. Chilean copper production, in particular, is at the risk of disruption in the coming year. Its greatest challenge comes from labor negotiations, with some key collective agreements to be finalized in 2017.4
- Long-term fundamentals are very attractive due to a limited number of new projects, depleting mines and the declining quality of the ore being mined.
- The market is likely to be in balance this year and the next with the following years subject to project success. There are calls for a surplus in 2018–19, but this could easily swap to deficit on project delays.
3 “Copper gains on signs China spending more on fixed assets,” Reuters News, 14 November 2016.
4 “Rio Tinto ‘cautiously optimistic’ about copper market in short term,” Reuters News, 14 November 2016.
Gold prices are trading at a five-month low of US$1,212/oz as of 21 November 2016, primarily on a stronger US dollar and the expected increase in US interest rates in December. A sharp rise in the bond yield and increased investor risk appetite are also weighing down the prices. High-level trends:
- The election of Donald Trump and the ensuing uncertainty in the global markets were expected to lead to a surge in gold prices due to its safe-haven status. However, the pro-growth policy of the new US Government has turned out to be positive for financial markets, which has attracted investments away from gold, resulting in a fall in gold prices.
- The Indian Government’s demonetization policy has created a cash crunch in the Indian economy just before the peak gold demand season. This is further negative for gold consumer demand, which has already declined by 28% y-o-y in 3Q 2016.5
- An increase in demand for gold Exchange Traded Funds was offset by a weaker demand for jewelry, bars and coins, and central bank purchases, leading to a 10% decline in gold demand in the third quarter to 992t.6
- The long-term outlook for gold remains positive. Policy decisions in the US are expected to result in higher deficit spending. In addition, the possibility of revised trade policies and potential geopolitical risks arising from the new US administration may result in increased uncertainty, leading to potentially higher gold prices.7
5 “Trump and Modi take shine off gold,” Dow Jones News Wire, 17 November 2016.
6 “Gold demand trends — third quarter 2016,” World Gold Council, 8 November 2016.
7 “Precious metals daily: Gold strengthens, then sheds gains on Trump win; rally likely to resume,” HSBC Global Research, 9 November 2016.
- Iron ore prices hit US$80.83/t on 28 November 2016, representing an 82% rise so far this year. The rally was particularly strong in November after stabilizing at between US$59 and US$60 through September and October.
- Higher prices and production revisions this last quarter have restored some positivity to the market. Rio Tinto and Vale both downgraded their production forecasts for 2016 for a second time, while Roy Hill is expecting to hit their production rate target of 55mt/y in early 2017 rather than the end of 2016.8 Samarco remains on hold while the viability of a restart is assessed.
- Higher-cost miners remain closed and analysts are reluctant to change longer-term forecasts. This suggests the outlook for excess supply and reduced demand remains grim.
- Prices are now expected to average US$54/t–US$56/t for 2016, but they are still expected to average lower to between US$45/t–US$50/t for 2017.
8 “Roy Hill admits it is unlikely to meet 'aggressive' export target by year's end,” smh.com.au, 14 September 2016.
The increase in stainless steel output in China and the rising probability of disrupted supply from the Philippines have improved the near-term market fundamentals of the nickel market. High-level trends:
- Chinese stainless steel output has risen by 8% y-o-y in 2016, driven by better domestic demand. Rising completion of housing and increased sales of household goods in China are driving demand.9
- The suspension of nine nickel mines in Philippines has slowed NPI production in China. Production is estimated to be at 350kt in 2016 and is expected to slow to about 300kt in 2017. Reduced supply is therefore providing support to nickel prices.10
- Nickel prices are up by 20% year-to-date (YTD) and the expected supply deficit and increasing domestic demand from China will keep prices buoyant.
- Increased production from Indonesia will make up for some of the supply cut in Philippines but is unlikely to be sufficient to keep the market in balance.
9 “Commodities Quarterly — Hanging onto the gains,” Deutsche Bank, October 2016.
10 “Commodities forecast,” Credit Suisse, October 2016.
In the US, the expectation of US$500b on infrastructure spending in the next 12 months and US$1t over the next decade could translate into 22mt of incremental steel demand each year, indicating a 20% annual growth for the next five years.11
- The sharp surge in met coke prices to above US$300/t and iron ore prices to US$70/t will impact steel producers’ margins in the short term as they may find it difficult to pass on the full cost to end customers.
- China is meeting its targets in terms of removing excess steel capacity, but gaining control of production is proving a challenge. Chinese production was up by 4% in October 2016 as production came back online on higher domestic prices (up by 16% since the start of September 2016). It raises questions as to what kind of capacity is being removed. Unless productive capacity owned by the small to mid-size steelmakers in China is removed, production will continue to come back online as prices increase.
- North American steel prices remained comparatively subdued due to weak underlying demand and an increase in imports. Divergence in scrap and met coke prices will lead to mini mills outperforming integrated mills over next few quarters.
11 “Trump win to boost steel demand in US-Morgan Stanley,” Steel Guru, 15 November 2016.