Higher Commodities Forecasts, but Same Long-Term Outlook
Current prices still don't look sustainable.
Runups in commodity prices and OPEC’s recent production cuts have caused Morningstar’s equity analysts to raise their near-term forecasts, 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-fueled 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 (in real terms) 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 (NGLOY)/(AAL) to $2.50 (GBX 400) from $2.10 (GBX 320), for Teck Resources (TECK)/(TECK.B) to $9 (CAD 12) from $6.50 (CAD 9), and for Glencore (GLEN) to GBX 100 from GBX 60. 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.
We've raised our near-term copper price forecast to better reflect the recent runup in pricing to about $2.70 per pound from $2.10 just six weeks ago. However, we think the rapid price increase is largely unsupported by fundamentals and will be short-lived. In 2016, copper demand, particularly in China, has been stronger than we were expecting but so has supply--enough so that the recent copper price spike is surprising.
Although we've raised our near-term price estimates, our long-term price forecast for copper is unchanged at $2.00 per pound in real terms. We expect slipping Chinese demand in the important construction and power end markets will cause eventual copper price weakness. Our updated 2017 nominal copper price forecast is $2.40 per pound compared with a prior forecast of $1.90 per pound. Our forecasts in 2018 and beyond are unchanged.
Despite the lack of change to our long-term estimates, our fair value estimates for the copper miners did receive a boost. Higher copper mix and operating and financial leverage make some increases larger than others. For copper pure plays, including Southern Copper (SCCO), Freeport-McMoRan (FCX), First Quantum Minerals (FM), and Antofagasta (ANTO), fair value estimate increases ranged from 5% to nearly 30%. Still, we believe copper miners are grossly overvalued.
Heading into the year, we forecast essentially flat global copper demand in 2016 versus 2015, holding at about 23.1 million metric tons. Instead, according to the International Copper Study Group, worldwide copper demand is set to advance about 1.5% in 2016. China, which accounts for roughly half of global copper demand, drove the discrepancy between our forecast and actual results. We had forecast Chinese copper consumption would drop between 2% and 3% in 2016, driven by slowing building construction and power demand. Rather than shrinking, ICSG estimates Chinese copper demand will grow in low-single-digit percentage terms this year. We think demand exceeded our expectations thanks to China’s debt-fueled fiscal stimulus, but 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 copper stocks, which is risky given that earnings require debt to balloon further in China to support elevated commodity prices. We continue to believe Chinese copper demand will see headwinds as real estate activity fades to a level more commensurate with underlying urbanization trends and power spending shifts away from copper-heavy distribution to copper-light transmission. Our long-term estimates are intact.
Copper supply also looks as if it will finish higher than we had anticipated. Consistent with our forecast methodology of matching supply and demand annually, we had expected total refined copper production would be essentially flat in 2016 compared with 2015. Instead, ICSG estimates refined production will advance 2.2% in 2016--a higher growth rate than demand. With supply and demand both above our projections (and roughly in line with each other), we would have expected some upward pressure on prices from higher-cost mines setting market clearing prices. We saw this throughout most of 2016. We predicted a copper price of $2.00 per pound in 2016, but through September prices had averaged about $2.15. Only recently have prices jumped up to $2.70 per pound, with particular strength following the U.S. presidential election. To us, the recent strength looks more speculative in nature and could prove fleeting.
Jeffrey Stafford, CFA
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/bbl 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/bbl from $65.
Based on current 2017 supply/demand fundamentals, our new base case for the United States is a 500-rig scenario, in which the horizontal tight oil rig count increases 30% from today's 380 over the next six months. Our forecasts demonstrate that U.S. shale growth can be substantial at activity levels that remain well below predownturn levels. Our revised fourth-quarter 2018 forecast of 10.1 mmb/d is now more than 15% above third-quarter 2016 output of 8.7 mmb/d.
OPEC's production cuts will be short term in nature, if history is a guide. During the past 20 years, trough production levels have lasted no more than a year. Short of an unforeseen geopolitical event, OPEC will return to higher production levels most likely by the middle of 2018. A strong response from U.S. shale to higher 2017 oil prices is likely to increase the chance that cuts will be short term, as ceding market share to competitors is the one thing OPEC wants to avoid.
The short-term nature of OPEC's cuts and the long-term problem for oil prices that is U.S. shale means that our bearish $55/bbl WTI long-term price outlook is unchanged.
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