A rally in commodity prices and OPEC’s recent production cuts have caused Morningstar’s equity analysts to raise their near-term forecasts for the sector, but the long-term outlook is unchanged.
Mined commodities and mining stocks have seen massive gains in 2016. The coking coal price has quadrupled, iron ore and thermal coal have doubled, and copper is up about 35% this year. Demand exceeded expectations thanks to China’s debt-fuelled fiscal stimulus. With approximately 80% of China’s steel used for investment-oriented activity, steel demand is particularly sensitive to China’s fiscal stimulus.
China’s leading share of commodity consumption means that relatively small changes in demand have outsize impacts on global markets. Markets also experienced short-term supply constraints, including weather-related disruptions in Australia, the Samarco failure, and China’s 276-day rule for domestic coal mines.
We still see meaningful downside for commodity prices from current levels but acknowledge prices will take time to normalize from recent tighter market conditions. For iron ore, we are raising our near-term forecasts to $60 per tonne in 2017 and $50 per tonne in 2018 from $35 per tonne previously. For metallurgical coal, we forecast $200 per tonne in 2017 and $120 per tonne in 2018, up from $80 per tonne previously. For contract thermal coal, we forecast $75 per tonne for the 12 months ending March 2018 and $60 per tonne for the next year, up from $55 per tonne previously.
Our long-term price forecasts are unchanged. By 2020, we continue to expect $35 per tonne iron ore, $80 per tonne met coal, and $50 per tonne thermal coal.
Based on higher 2017 and 2018 cash flow estimates, we raised our fair value estimates for Vale (VALE) to $3 from $2.60, for Anglo American (AAL) to £4 from £3.20, and for Glencore (GLEN) to £1 from 60p. However, we continue to view all of these shares as meaningfully overvalued.
While we're raising our near-term commodity forecasts, we still see risks to the downside. Current prices are well above the marginal cost of production. The drivers of lower prices are expanded coal capacity in China with repeal of the 276-day rule, growth in iron ore supply particularly from Vale and the restart of Samarco, the end of inventory restocking, a normalizing of speculative activity, and waning China stimulus.
We are making no changes to our long-term supply/demand forecasts or to our long-term commodity assumptions. Stimulus in 2016 has only postponed the transition from investment-led to consumption-led economic growth, in our view. Considerable optimism is now priced into mining stocks, which is risky, given that earnings require debt to balloon further in China to support elevated commodity prices.
There were some minor headwinds to iron ore supply with China’s domestic output down 10%, the loss of output from Samarco, a minor guidance downgrade from Rio Tinto (RIO), and Vale guiding toward the low end of its forecast range. For coal, the key supply issue was China’s 276-day rule, which constrained mines to producing for only 276 days per year versus 330 days previously.
Weather issues and capacity closures in Australia also contributed to the unexpected market tightness. Compounding the price action, iron ore, coal, and steel have also been subject to a cycle of inventory restocking. After Donald Trump’s election, inflationary speculation via commodities has added to the heat, particularly with Chinese investors subject to tight capital controls, a falling yuan, property market investment controls, and the poor performance of China’s stock market.
Oil Price Fair Value Raised to $60
OPEC's recent announcement of production cuts is a positive near-term development for world oil markets, removing more than 1 million barrels per day from an oversupplied system. Even after factoring in the inevitable U.S. shale response to higher crude prices, OPEC's cuts point to a meaningful supply deficit next year. Consequently, we have raised our 2017 West Texas Intermediate price to $60 per barrel from $50.
Improved near-term fundamentals come at a cost, however. Even a modest recovery in oil prices will encourage U.S. shale producers to further ramp activity so that they eventually replace almost all "removed" OPEC barrels with their own. Increased near-term shale activity means that oil prices are unlikely to remain elevated for long. The industry is awash in low-cost oil, and temporary OPEC cuts cannot alter this reality. Our long-term oil price assumption of $55 per barrel WTI is unchanged.
U.S. production growth will lag any increase in rig activity by six to nine months, which is why we're now more bullish on 2017 oil prices. But once it gets rolling, shale production should start to grow briskly, which means that much softer industry fundamentals are likely to return once OPEC unwinds its production cuts. If oil averages $55-plus in 2017, prices in 2018 will need to pull back to rein in shale activity. As a result, we have lowered our 2018 WTI forecast to $45 a barrel from $65.
