Six months ago, at the time of our half year results for the 2019 financial year, an air of prudent caution permeated commodity markets. On balance, events since that time have justified that caution.
The result has been a mixed price performance by our key commodities.
In the weeks leading in to our results for the 2019 financial year, commodity price and financial market volatility was heightened amidst deepening policy uncertainty.
We revised our near–term world growth mid–case downwards twelve months ago to reflect the negative impact of rising trade protection, partially offset by more expansionary domestic policy settings. While we retain that forecast in this update, we acknowledge emerging downside risks based on recent policy signposts. While end–use demand has been somewhat stronger than expected in the calendar year to date, and monetary policy settings in many economies have been eased, the continuing uncertainty with respect to trade remains a stark negative offset.
For the 12 months ahead, we assess that directional risks to prices across our diversified portfolio are weighted more to the downside. We anticipate average benchmark prices for steel making raw materials are likely to remain above long run marginal cost, but we expect to see lower prices in financial year 2020 than in the year just concluded. Product differentials in both commodities are expected to remain favourable for higher quality producers, albeit narrower than the extremes of recent history, as steel industry profitability normalises.
As the events of the past few weeks have amply demonstrated, oil and copper prices are highly susceptible to swings in global policy uncertainty. We consider the commodity–specific fundamentals of both oil and copper markets to be sound. We estimate that their forward looking short–term fair value ranges are similar to six months ago, but we have a bias towards the lower half of those ranges over the coming year.
Looking beyond the immediate picture, in the medium–term, we see the need for additional supply, both new and replacement, to be induced across most of the sectors in which we operate.
In many cases, this could lead to higher–cost supply entering the cost curve.
This projected steepening of cost curves can reasonably be expected to reward disciplined owner–operators with high quality assets.
On the demand side, we continue to see emerging Asia as an opportunity rich region. China, India, ASEAN and the global impact of China’s Belt and Road initiative are all expected to provide additional demand for our products.
As the true economic costs of trade protection are progressively recognised by global consumers, we anticipate a popular mandate for a more open international trading environment will eventually emerge.
Looking even further ahead, the basic elements of our positive long–term view remain in place.
Population growth and rising living standards are likely to drive demand for energy, metals, and fertilisers for decades to come.
New demand centres will emerge where the twin levers of industrialisation and urbanisation are still developing today. The electrification of transport and the decarbonisation of stationary power will progress. Comprehensive stewardship of the biosphere and ethical end–to–end supply chains will become even more important for earning and retaining community and investor trust.
The ability to both provide and demonstrate social value to our host communities and to our customers will be a core enabler of our strategy and a source of competitive advantage.
Against that backdrop, we are confident we have the right assets in the right commodities in the right jurisdictions, with attractive optionality, with demand diversified by end–use sector and geography, allied to the right social value proposition.
Even so, we remain alert to opportunities to expand our suite of options in attractive commodities that will perform well in the world we face today, and will remain resilient in the uncertain world we will face tomorrow.
Table of contents
Global economic growth
World economic growth is likely to be at the bottom of the recent range of 3¼ to 3¾ per cent in real terms in calendar year 2019. That is down from an average of 3¾ per cent in the prior two years. Each of the big five economies – the US, China, India, Europe and Japan – are expected to record either flat or slower growth versus calendar 2018.
Global trade growth has slowed from around 5½ per cent in calendar year 2017 to around 3¾ per cent in 2018 and, held back by policy headwinds, it is on track for a very disappointing outcome below the expected growth rate of GDP in calendar 2019.
Consistent with elevated policy uncertainty and lower business confidence, total flows of foreign direct investment declined for the third consecutive year in calendar 2018. Flows to emerging markets were steady, with modest growth in Asia; while inflows recorded by advanced economies fell markedly1.
Looking ahead, our base case is that world GDP growth registers around the mid–point of a 3 per cent to 3½ per cent range in calendar 2020, which is similar to the projected outcome for 2019. A large positive or negative deviation from the status quo on trade policy could push that outcome either as much as +¼ per cent higher or as much as –½ per cent lower. Recent policy signposts are supportive of that asymmetric view of the risks. The IMF and the OECD expect world growth of 3.5 per cent and 3.4 per cent in 2020 respectively.
While we stress that an increase in trade protection is not, on its own, a recessionary level shock for the global economy, it is an exceedingly unhelpful starting point for the pursuit of broad based growth across regions, expenditure drivers and industries.
As a complementary point, we encourage policymakers to prioritise structural reforms at home as the surest route to sustainable productivity growth, and ultimately, prosperity.
These points highlight the importance of continued and vocal advocacy for free trade, open markets and high quality national and multilateral institutional design by corporations, governments and civil society.
In this environment, it is important to emphasize that many advanced and emerging economies are still seeking to open up further and increase their exposure to international trade and cross–border investment. Prominent current examples include the parties to the European Union–Mercosur agreement, the Belt and Road Initiative, the Regional Comprehensive Economic Partnership and the Comprehensive and Progressive Trans–Pacific Partnership.
Financial conditions have eased somewhat in the United States, with policy interest rates having been cut in July, with further modest decreases expected. The change in the US monetary policy stance has brought some welcome relief to emerging markets, particularly for those with large hard currency external financing requirements and a reliance on portfolio inflows to service their deficits.
The US dollar has been relatively steady over the last twelve months. On a real, trade–weighted basis, it is around 2 per cent higher YoY.
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While we stress that an increase in trade protection is not, on its own, a recessionary level shock for the global economy, it is an exceedingly unhelpful starting point for the pursuit of broad based growth across regions, expenditure drivers and industries.
China’s economic growth is expected to slow modestly in the coming years. We expect real GDP to register between 6 per cent and 6¼ per cent in both 2019 and 2020. These estimates are unchanged from six months ago. They reflect the likely impact of US trade protection on the export sector as well as an appropriately calibrated countervailing domestic policy response. A further deterioration in trade relations with the United States2 could push the growth outcome towards our low case assumption, which is 5¾ per cent.
News–based measures of policy uncertainty3, which tend to lead swings in economic activity, show that trade tensions have had a material impact on the mindset of the Chinese people.
In calendar year 2019 we anticipated that: infrastructure would rebound after a disappointing 2018; housing would be resilient; the automobile market would improve progressively after a very weak calendar 2018; the pronounced strength seen in the machinery sector in recent years would dissipate; while exports would slow. Developments in the year–to–date have met our expectations with respect to infrastructure and exports. Housing has been moderately firmer than expected. The larger surprises have been in autos and machinery. Autos are still very weak. Machinery held up remarkably well in in the early months of the calendar year, partly due to export front–loading and partly due to domestic sales aimed at servicing the infrastructure upswing. The sector has since shown signs of decelerating, in line with our original expectations.
Within the above construct we anticipate that national level housing policies and rhetoric will remain directed towards limiting speculation, building rental markets and fine–tuning the shantytown redevelopment programme. On the latter point, we note that the shantytown plan for calendar 2019 is significantly reduced from last year, which will create a significant headwind for the volume of sales. Housing starts, though, have been firm, and should record healthy growth year–on–year. The pipeline of work presently under construction remains solid.
We note with interest that the State Council has designated a ‘leading small group’ to monitor and manage employment. This may be a signal that China’s leaders are increasingly prepared to pursue trade–offs between their medium term reform objectives and the need to maintain stability at home in the context of the very uncertain international trade backdrop.
Over the longer term, our view remains that China’s economic growth rate should moderate as the working age population falls and the capital stock matures. China’s broad production structure is expected to continue to rebalance from industry to services and its expenditure drivers are likely to shift from investment and exports towards consumption.
Nevertheless, China is expected to remain the largest incremental contributor to global industrial value–added and fixed investment activity through the 2020s even as its growth rates mature.
Within industry, we expect a concerted move up the manufacturing value–chain; and a concerted move outwards, with an emphasis on South–South cooperation along the various Belt–and–Road corridors. More broadly, we anticipate environmental concerns will become an even more important consideration in future policy design than they are today.
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Over the longer–term, our view remains that China’s economic growth rate should moderate as the working age population falls and the capital stock matures.
Major advanced economies
After a very strong performance in 2018, the US economy has decelerated in calendar 2019. We expect it will slow further in calendar year 2020, which is of course an election year.
Long–term nominal bond yields in the US remain historically low at the time of writing, and the curve has been inverted out to ten years, at times, in recent months. That partly reflects the growing unease among market participants about the use by date of the current expansion, which at ten years, is already three years longer than the historical average. Notably, corporate debt levels as a proportion of GDP are now higher than in the lead–up to either the 1991 or 2001 downturns in which the corporate sector was culpable.
The US Federal Reserve’s forward policy guidance of a shift towards modest accommodation seems a prudent course. In addition to the commentary above, the context for that judgement is that the tailwind of fiscal stimulus is fading, inflation is moderate and some cyclical sectors and financial indicators are showing signs of fatigue. There is also nervousness in the business community about the financial and economic impact of the administration’s trade policies. That is offset by the reality of near full employment.
We note that the true costs of protectionism, particularly diminished consumer purchasing power, have not yet been fully felt by US households and businesses. Weakening domestic consumption, as purchasing power declines, and declining international competitiveness of US firms, as input costs rise and the intensity of competition in the domestic market declines, are the inevitable medium–term outcome of such a turn inwards. Further, it is very unlikely that the current policy mix in the US will lower the nation’s trade deficit, which seems to be a core, if misplaced, objective of the current administration. The US’ [non–oil] deficit is essentially a joint function of its low relative national savings rate and the US dollar’s role as the world’s principal vehicle currency.4
In Europe and Japan, economic conditions have softened. A material slowdown in the bellwether auto sector has been a headwind for both economies. In Japan specifically, the slowdown in the global electronics sector is also playing a part in limiting near term growth. In Europe specifically, rising political and policy uncertainty, at both a national and regional level, have hurt business confidence.
For both regions, where the limits of monetary policy effectiveness may have been reached and public sector finances are stretched, we gauge that any upside to growth in the medium–term will have to come from external demand sources.
Shorter term, the possibility of the US instituting global auto tariffs later this calendar year would clearly be a damaging development for both Europe and Japan.
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India’s economy is on a healthy medium–term growth trajectory, notwithstanding the typical emerging market difficulties it has experienced in recent times. Reform signposts have been positive, in general, underscoring the nation’s long run potential . We note in particular its increased attractiveness for foreign direct investment over the last half–decade; the introduction of a nationwide goods and services tax; an improved institutional setting for infrastructure planning and project execution; large scale efforts to bring rural residents into the formal identity and banking structure; and the determined efforts of policymakers to address non–performing loans in the banking system, particularly in the strategically important steel and power industries; and the recent announcement that sovereign debt will be issued abroad for the first time. This is a major step towards reducing the ‘crowding out’ of private investment from the domestic savings pool and possibly lowering external funding costs for private Indian entities while simultaneously increasing the stability of the nation’s balance of payments equation, which is at times precarious.
We had long identified the recently concluded general election as an important inflection point for India’s medium–term outlook. The strong electoral performance of the incumbent government of Narendra Modi provides a firm basis for the continuing pursuit of further economic reforms in its second term – notwithstanding any impact that national security concerns may have had during the campaign itself. Recent domestic policy developments in Jammu and Kashmir bear watching, as does the somewhat tense state of regional geopolitics.
Important signposts on India’s expanding resource and energy footprint include its new status as the world’s #2 crude steel producer; the fact it has overtaken China as our major customer for metallurgical coal; the fact it is now the #2 incremental contributor to global oil demand growth; its rise up the LNG import ladder; its firm position as a top five potash importer; its increasing relevance as a consumer of copper; and according to the IEA, in a year in which global energy investment was flat, it led all major regions with 6 per cent YoY growth in calendar 2018.
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Steel and pig iron
Global crude steel production growth was healthy in aggregate in the first half of calendar 2019, increasing by 5 per cent year–to–date as of June. That extends the strong rebound of the prior two years. However, growth has become less balanced from a geographic perspective, with China, and to a lesser extent India and the United States, now providing the lion’s share of the expansion. Pig iron output growth has kept pace with total steel production for the year as a whole, reflecting, in the main, strong operating rates among China’s blast furnace fleet.
Global utilisation stayed elevated and surpassed 80 per cent in the second quarter of calendar year 2019, up from the mid–to–high 70 per cent range last year, the highest since calendar year 2012. That is almost fifteen percentage points higher than at the cycle trough. Rising demand across all major regions and the ongoing impact of Supply Side Reform measures in China have led to the multi–year pick–up in utilisation rates and much improved profitability for mills. That said, profitability has been challenged in recent months, with benchmark hot rolled coil (HRC) prices under downward pressure in tandem with rising raw material costs.
In China specifically, the lift in profitability has allowed for a promising trend of improvement in sector–wide balance sheets over the last three years. A little over half of the targeted reduction in the liability–to–asset ratio (the full target being –10 percentage points from 70 per cent to 60 per cent) has been achieved to date. So while there is clearly much more to do on this front, and the pace of sector deleveraging has slowed in the first five months of calendar 2019 on revived capital expenditure, the direction of travel has been heartening for both the financial sustainability of the steel industry and systemic financial system risk .
In calendar 2019 to date, we have been surprised by the strength of end–use demand in China and by the elevated production run rates that have accompanied them. Machinery, one of the strongest major downstream sectors of the last two years, and the most exposed to the trade conflict, was expected to decline – but it has held up well until recently on the back of export frontloading and the anticipation of counter-cyclical policies at home. Infrastructure has been close to what we expected, while housing has been a little better. Rather than stabilising at a weak level as we anticipated, the automobile sector has deteriorated further.
The sum of these trends has been a reported YoY growth rate of close to 10 per cent, as per worldsteel figures, with monthly run–rates hitting the “mystical” 1 billion tonne level and year–to–date production at 992 Mt as of June. In our view this overstates the reality on the ground. We estimate that underlying growth is close to half of the reported rate.5 Even that reduced rate has been sufficient to create industry concerns about unplanned inventory accumulation and reduced profitability, both of which point to a near term slowdown in production.
We estimate that 80 per cent is China’s long run equilibrium crude steel capacity utilisation rate, consistent with the stated objectives of China’s steel industry Five Year Plan (2016–2020). That compares to slightly less than 70 per cent at the cycle trough and upwards of 85 per cent at the height of policy induced disruptions. We note that in the short term industry participants are becoming increasingly wary of the margin impact of potential net new supply brought online under the auspices of the capacity swap scheme.
More broadly, we firmly believe China will almost double its accumulated stock of steel in use, which is currently 7 tonnes per capita, on its way to an urbanisation rate of around 80 per cent6, and living standards around two–thirds of those in the United States, at mid–century. China’s current stock is well below the current US level of 12 tonnes per capita. German, South Korea and Japan, which all share important points of commonality with China in terms of development strategy, economic geography and demography, have even higher stocks than the US.
We estimate that this stock will create a flow of potential end–of–life scrap sufficient to enable a doubling of current China’s scrap–to–steel ratio of around 22 per cent by mid–century.
The exact path to this end–state is uncertain. Among the range of possibilities we consider, our base case is that Chinese steel production has entered a plateau phase, with the literal peak to occur no later than the middle of next decade. Our low case7 for China, which underpins our global view on steel making raw materials, assumes that the peak year is contemporaneous. The industry is then assumed to immediately embark upon a multi–decadal decline phase in the annual output of both steel and pig iron, highlighted by an even more aggressive long–run scrap–to–steel ratio increase than the doubling outlined above. Ex–China, in the low case, we discount India’s long–run capacity additions plans by 40 per cent.
The recovery in rest of the world output seen across calendar year 2017 and 2018 has stalled so far in 2019. Based on figures from worldsteel, global crude steel production excluding China was –0.3 per cent per cent lower year–to–date as of June 2019. That outcome is the balance of falling production in Developed Asia and Europe (a little less than half of total output ex–China combined) being offset by gains in India, North America, other Asia–Pacific and Middle–East and North Africa (MENA).
India has seen healthy crude steel output growth of 5.0 per cent year–to–date as of June 2019, while pig iron has grown by 5.3 per cent year–to–date. Both figures are slightly below the trend growth rates we expect from India over the coming decade. Demand is expected to improve in the short–term now that election uncertainty has been cleared, with infrastructure likely to be a key beneficiary. India’s output narrowly passed Japan’s a year ago, making India the second largest steel producer globally, a position we expect it to retain. In 2030, we estimate that the Indian low case for crude steel production will be almost double the Japanese high case for the same.
Steel production elsewhere in Asia has been mixed. Japan saw output contract by –3.6 per cent YoY (to 103Mt), while South Korea saw production expand by 1.1 per cent YoY (to 73 Mtpa) in the calendar year to June. Operational issues have been prominent in North Asia, alongside pronounced weakness in flat products due to weak global auto sales. Southeast Asia increased steadily, led by Vietnam and Indonesia amid a rapid build–up of blast furnace capacity in the region. Total “other Asia–Pacific” production is expected to reach almost 50Mt this year, representing 10 per cent growth from 2018.
Europe has seen a marked slowdown (–3.6 per cent YoY), with some mills curtailing production due to unfavourable demand conditions, and in some instances, higher carbon levies. Production has declined from a year ago in the three largest national producers, Germany, Italy and Turkey. The latter two examples reflect recessionary economic conditions. End–use trends across the region have been mixed, with flat products in cyclical difficulty but long products still experiencing solid downstream demand from construction. In Germany specifically, the dwelling stock has not kept pace with rising underlying demand, which implies that an extended period of rising building activity could be in prospect.
Growth in North America stood at 1.4 per cent YoY in the calendar year to June with a 121 Mtpa run–rate (with the US producing 89Mt, +5.4 per cent). However, growth seems destined to slow in the second half of the year, as demand has moderated and US HRC prices have fallen swiftly in recent months. The recent falls have unwound a large portion of the differential to European and Chinese benchmarks that emerged in early 2018 when the US administration first flagged their intent to introduce steel import tariffs.
The CIS (Commonwealth of Independent States), which has been a laggard region through most of the upswing, retained that status, with basically flat output in the half–year just concluded. The MENA region has witnessed a decent recovery and is on pace for high single digit growth in calendar 2019. That growth rate reflects both the depth of the previous contraction and a bounce in Iranian production.
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India’s output narrowly passed Japan’s a year ago, making India the second largest steel producer globally, a position we expect it to retain.
Iron ore prices (62 per cent, CFR) ranged between $72/dmt and $118/dmt over the first half of the calendar year, averaging around $92/dmt. The Brumadinho tailings dam tragedy in Brazil and a patchy production period for the other seaborne majors, in aggregate, have kept the supply fundamentals tight against a backdrop of firmer than expected end–use demand in China. Seaborne lump premia have remained strong, trading a few cents above $0.30/dmtu for most of the second half.
Seaborne supply conditions for the remainder of this calendar year and next are highly uncertain, both in aggregate and in terms of quality profile. While we do not think that the current constraints on Brazilian exports are informative for long run equilibrium pricing, we anticipate that the normalisation process could be a multi–year event. There could be considerable volatility in pricing as the fundamental adjustment process plays out. We estimate that ore stocks at Chinese ports may well fall further in the second half of this calendar year. The position as of late July, with stocks sitting slightly below 120 Mt, already represents a spectacular degree of decline from the 142Mt closing position for calendar 2018.
Price sensitive seaborne supply has not returned to the export market at scale. That is a rational response to the transitory nature of current conditions. However, a large portion of Chinese domestic iron ore concentrate production is economic at current prices, and utilisation rates have increased modestly in response, as expected. The June 2019 data show that the domestic run–rate has increased to 217Mtpa, up from 196Mtpa at the end of calendar 2018. Notably, the run–rate was steady from May to June, indicating that further incremental supply from this source could be flattening out. Going forward, we expect that, in addition to structural market based drivers, safety and environmental inspections are likely to have a material influence on the average level and seasonal volatility of Chinese domestic iron ore production.
Our coastal blast furnace customers in China are currently experiencing reduced margins vis–à–vis those they enjoyed in 2017 and for much of 2018. High seaborne iron ore prices have reduced the competitive advantage these customers normally enjoy relative to inland blast furnaces with captive iron ore and scrap–based EAFs.9 This has encouraged an increase in commercial blending arbitrage on the coast. Logically, this has led to a reduction in realised spreads both above and below the 62 per cent index.
In the medium to long–term, the on–going Supply Side Reform, the expected migration of steel capacity to the coastal regions, the inexorable trend towards larger furnaces and more stringent environmental policies – Chinese controls, holistically, are now the most demanding in the world – are all expected to underpin the demand for high quality seaborne iron ore fines and direct charge materials such as lump. The South Flank project, which was approved in June 2018, will raise the quality of our overall portfolio, in addition to increasing the share of lump product in our total output.
We remain of the opinion that around two–thirds of the movement in product quality differentials since the introduction of Supply Side Reform will be durable. The recent narrowing of differentials is an anticipated development on the path to this gravity point.
We continue to contend that the long run price will likely be set by a higher–cost, lower value–in–use asset in either Australia or Brazil.
Our low case for the iron ore price is predicated on a contemporaneous peak in Chinese pig iron production; a heavy discount to India’s long–run steel capacity addition plans; the return of a low–margin environment for Chinese steel mills, with an adverse impact on quality differentials; and transformational productivity gains for all of the major seaborne producers.
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While we do not think that the current constraints on Brazilian exports are informative for long run equilibrium pricing, we anticipate that the normalisation process could be a multi–year event.
Metallurgical coal prices10 have ranged from a low of $192/t FOB Australia on the PLV index to a high of around $216/t over the first six months of the calendar year. MV64 has ranged from $172/t to around $188/t; PCI has ranged from $119/t to $130/t; and SSCC has ranged from $88/t to $120/t. Three–fifths of our tonnes reference the PLV index, approximately.
For the half year as a whole, the PLV index averaged $205/t, basically unchanged from the previous half. The differential between the PLV and MV64 indexes has averaged 13.6 per cent in the calendar year to date, down –1.7 percentage points from the previous half.
Similar to our view on iron ore, our technical and market research, in addition to extensive customer liaison, indicate that the premia presently being attracted by high quality coking coals are predominantly a structural, as opposed to cyclical phenomenon, although there is certainly a transitory component to them that will fade with time.
In coming years, most committed and prospective new supply is expected to be in the mid quality bracket. And while there is a developed and growing market for mid quality coking coal in, for instance, India and south–east Asia, the relative supply equation underscores that a durable scarcity premium for true PLV coals is a reasonable starting point for considering medium terms trends in the industry.
We have been pleased to see further growth in the met coal derivatives market, with traded turnover relative to the physical market rising at a faster pace than iron ore futures did at a similar stage of development.
Demand growth has become increasingly mixed on a regional basis. Indian pig iron production has increased by around 5 per cent YoY, driving a steady increase in import volumes (across all met coal categories). Longer term, we anticipate India and south–east Asia will be the main sources of incremental growth in seaborne demand for metallurgical coal. Traditional markets in North Asia were flat on a year ago at about 100Mt, annualised, in June. Europe, meanwhile, has been weaker. On the supply side, coal throughput and vessel queues at the major Queensland ports did not normalise to the extent hoped in calendar 2018, but the first half 2019 has seen an improvement. As a result, annualised Australian exports are 4.4 per cent higher YoY in the calendar year to June 2019. Some of that improvement is due to more reliable mine–to–port logistics.
Metallurgical coal exports from the United States and Canada responded to attractive seaborne prices in calendar 2018, but they have fallen back a little in the latest updates. Exports from Mozambique have been lower than expectations, again, but Mongolian landborne exports have increased markedly. Domestic Chinese hard coking coal supply has contracted marginally (around –1 per cent YoY) against a background of safety and environmental pressures; while China’s total coking coal imports were up by 24 per cent per cent YoY to 73Mt annualised in June. Shipments from Australia to China were up 6.4 per cent YoY to around 39 Mt annualised.
We estimate that since the start of the Supply–side reform, Chinese capacity has declined by between 10 and 15 per cent, with output down a lesser amount in the high single digits. The gap reflects higher utilisation of more efficient, modern capacity – the space for which was created by the closure of less efficient, less safe and less environmentally conscious operations, with water stewardship now a major regulatory theme.
The continued policy focus on environmental considerations, should increase the competitiveness of high quality Australian coals into coastal China, at the margin. Uncertainties in this regard are the future level of Mongolian exports (mainly mid volatile, low sulphur) and US–China trade relations (US met coal imports are on China’s retaliatory tariff list). Further, while there also remains potential for intra–year import curbs during lower demand periods, our view is that in the future, as in the past, these curbs will tend to mostly impact upon energy coal and lower grades of met coal with higher sulphur content, and/or on cargoes destined for lower tier ports. The vast majority of premium met coal cargoes are destined for tier one ports. Strained geopolitical relationships beyond the US–China trade issue are a further source of uncertainty.
We maintain our constructive medium–term outlook for metallurgical coal prices, especially in the PLV bracket. The Supply Side Reform and heightened environmental, safety and water controls in China, and depleting premium–quality supply in traditional export basins, are all constructive for the market. In the medium–term, enhanced value–in–use realisation for low volatile matter, low impurity, high “coke strength after reaction” products and Chinese supply–side discipline are both expected to pertain. So while prices will always fluctuate widely within and across years based on both cyclical and idiosyncratic influences, as they have done in recent months, it seems reasonable to suggest that met coal prices can sustain above long run marginal cost, on average, for some time to come.
Our low case for the PLV coking coal price is predicated on a contemporaneous peak in Chinese pig iron production; a heavy discount to India’s long–run steel capacity addition plans; the return of a low–margin environment for Chinese steel mills, with an adverse impact on quality differentials; a return to excess capacity and lax environmental controls in Chinese coal mining; and sizeable productivity gains for all of the major seaborne producers.
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We maintain our constructive medium–term outlook for metallurgical coal prices, especially in the PLV bracket. The Supply Side Reform and heightened environmental, safety and water controls in China, although depleting supply in traditional export basins, are all constructive for the market.
Copper prices ranged from $5756/t to $6572/t ($2.62/lb to $2.99/lb) over the first half of the calendar year, averaging $6165/t ($2.80/lb).10 The price range and the average were remarkably similar to the prior half, despite the day to day perception of pronounced volatility. Price trends within the half, and beyond, were heavily influenced by the whip–sawing of expectations with respect to the US–China trade confrontation.
We assess that forward looking fundamentals for the remainder of calendar 2019 support an approximate trading range of $6000/t to $6,500/t, based on an average rate of disruption to primary supply (i.e. an outcome closer to the historical 5 per cent loss, up from a final estimate of around 3½ per cent in calendar 2018). A durable peace on the trade front would allow prices to return to the top of that range. Alternatively, without a visible reduction in trade uncertainty, the likelihood of the price being anchored in the bottom half of the range on average, with occasional forays below it (such as the circumstances prevailing at the time of writing), is high.
In contrast to steel, Chinese end–use demand for copper has been weaker than expected in calendar 2019. Dwelling completions11 have declined, the auto sector has remained weak, electronics have struggled and investment in the power grid is running behind budget at the mid–point of the calendar year. Offsetting those disappointments, machinery was more resilient than expected early in the calendar year and household appliances have been solid. The net result is that demand is now expected to grow by between 1½ and 2 per cent over calendar 2019. That assumes some catch–up spending on the grid, a stabilising impact from subsidies in autos and consumer durables, and a material slowdown in machinery.
Demand from the rest of the world has been weak. Housing starts in the United States have come off by around 80,000 annualised from their cyclical peak of more than 1.3 million achieved back in early calendar 2018. Business investment in the United States remains solid, but forward looking indicators, such as new capital goods orders, may have hit their cyclical peak late in calendar 2018. Upstream electronics demand growth decelerated notably across calendar 2018, and began to contract in the first half of calendar 2019. Global semiconductor sales are –14.6 per cent lower YoY as of May 2019. Auto sales are on track for a second year of decline at the global level in the 2019 calendar year. The weakness in autos and electronics is exerting a drag on demand from developed Asia and Europe.
Turning to supply, developments in calendar 2019 to date are pointing towards a primary supply disruption rate for the full year of close to the historical average of 5 per cent (the average being equivalent to a little over –1 million tonnes). That compares to around 3½ per cent in calendar 2018. The larger amount of supply disruptions year–over–year has been an offset to the weaker than expected demand environment described above.
Treatment and refining charges (TCRCs) for copper concentrates have experienced a steady march lower (i.e. terms more favourable to the producer) in the first half of the calendar year, partly reflecting the introduction of new smelting capacity in China and partly due to a shortage of high quality, low impurity material. The FastMarkets TC index has ranged between a high of $82.3/dmt and a low of $52.4/dmt12. That compares to the 2019 benchmark settlement (in which we do not participate) of $80.8/dmt. Shanghai Grade A cathode premia have settled at a lower level in calendar year 2019 to date. Recall that China’s low–grade scrap ban led to a jump in cathode imports in calendar 2018, which led to unusually high premia, especially in the latter part of the period.
Taking the longer historical view, a marked five year downward trend in TCRCs can be observed. We interpret this as a fundamental signal that the balance of demand for high quality concentrates, vis–à–vis their reliable and consistent supply, has been on a structurally tightening path. Supporting that observation, the steady downward trend in TCRCs has emerged at a time when the base price of copper has seen considerable two–way volatility, but without a clear directional trend for much of the period. As we move closer to the point where the copper market in aggregate moves into structural deficit (see below), it is possible that TCRCs could be lower, on average, in the coming five years than in the five years just gone.
Turning to the outlook for the aggregate copper balance, demand and supply (primary plus secondary) are expected to advance roughly in parallel for the next few years. Solid demand growth is expected to be matched with a combination of committed green and brownfield supply and rising scrap availability.
Developments in China will continue to be vital for the copper market. Major themes include the evolution of the regulatory environment for scrap imports; the scale of investments in domestic and regional scrap processing capability; lifecycles of copper intensive capital stock; technical standards for aluminium usage in power cables; substitution trends in renewables power equipment; and the evolution of policies towards the production and uptake of electric vehicles.
Looking at the first of these questions in more detail, China’s curbs on low grade scrap imports, which have now extended to a more controlled inflow of higher grade scrap, should be positive for primary demand, for a time. But beyond an inevitable adjustment phase, we do not believe this development is likely to sustainably alter longer run market balances, the incentive to invest in scrap processing capacity globally, or mine inducement dynamics. It could, however, have an impact on the incentives of local firms to invest in scrap collection and processing capacity at home. As time goes on, we expect that customs priority will be given to even cleaner scrap, with copper–contained possibly converging on an average of 85 to 90 per cent.
Subject to the above caveats on precise timing, a structural deficit is expected to open in the early–to–mid 2020s, at which point we see some sustained upside for prices. Grade decline, resource depletion, increased input costs, water constraints and a scarcity of high–quality future development opportunities are likely to result in the higher prices needed to attract sufficient investment to balance the market.
It is these parameters that are critical for assessing where the marginal tonne of primary copper will come from in the long run and what it will cost. We estimate that grade decline could remove –2 Mt per annum of mine supply by 2030, with resource depletion potentially removing an additional –1½ and –2¼ Mt per annum by this date, depending upon the specifics of the case under consideration.
Our view is that the price setting marginal tonne a decade hence will come from either a lower grade brownfield expansion in a low risk jurisdiction, or a higher grade greenfield in a high risk jurisdiction. Neither source of metal is likely to come cheaply.
Our low case for the copper price is predicated on stern competition for primary supply from scrap; on–going aluminium substitution in China; low case macro assumptions that constrain traditional end–use demand; low case EV penetration [below the vast majority of published mid–cases]; 60kgs of copper intensity per EV [–20kgs from the mid]; and low case macro cost inputs [for example USD/CLP close to 700].
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Grade decline, resource depletion, increased input costs, water constraints and a scarcity of high–quality future development opportunities are likely to result in the higher prices needed to attract sufficient investment to balance the market.
Crude oil prices ranged from a low of around $56/bbl to a high of around $73/bbl in the first half of calendar 2019. They were down by around –3 per cent from the average of the prior half. Our view at the time of our half year results was that the fair value range for the period ahead was likely to be lower than the $65/bbl to $80/bbl range of calendar 2018. That turned out to be a reasonable starting point for assessing the development of the market. The front–month Brent minus WTI spread was materially higher half–on–half, averaging a historically elevated $7.61/bbl in the period just concluded. The WTI minus MARS13 spread averaged around –$5/bbl in the first half of the calendar year (i.e. MARS at a premium to WTI), reflecting the impact of the tight market for sour crudes post the Venezuelan collapse and loss of Iranian barrels due to US sanctions. In calendar 2017, this spread was +$1.19/bbl.
In addition to traditional sources of price volatility, trade policy uncertainty has emerged as a powerful influence on investor sentiment towards oil.
Oil demand has closely followed the broader trend in economic activity, in both global and regional terms. The strong and broad based uplift of calendar year 2017 has progressively given way to a patchy regional picture in calendar 2019 to date, with solid growth in the US, China and India standing in contrast to weakness in Europe and developed Asia.
The liquids market opened calendar 2019 in mild surplus. We expect a small stock build this calendar year and next, with a net increase in supply of +1.8 Mbpd over the two calendar years. Within that, we anticipate OPEC crude output being reduced by a combined –2.4 Mbpd over the two years, with other producers, led by the US (+2.5 Mbpd of oil, +3.1 total liquids), adding a combined +4.2 Mbpd. Twelve months ago, the IEA was forecasting demand of +1.5 Mbpd in calendar year 2019, with risks to the downside. Those risks have since crystallized, with their latest projection being +1.2 Mbpd. A slightly stronger outcome is anticipated in calendar 2020.
US liquids production remains a key source of short term uncertainty. Our central case projects US supply to increase by around +1.8 Mbpd in calendar year 2019 (+1.4 Mbpd crude), down a little from the spectacular +2.2 Mbpd (16 per cent YoY) seen in calendar 2018. This outcome is eminently achievable based on resilient pricing founded on OPEC discipline; the opening of take–away infrastructure in the previously constrained Permian; and the very large inventory of “Drilled but Uncompleted Wells” waiting to take advantage of both factors.
Investment in upstream oil is expected to increase by around 6 per cent in nominal terms in calendar year 2019, according to the IEA. That follows a 4 per cent increase in calendar year 2017 and a 6 per cent gain in 2018. The value of investment remains around 40 per cent lower than at the nominal peak in 2014, or 12 per cent lower at constant 2018 costs. US shale has increased its share of nominal upstream investment by a further five percentage points, primarily at the expense of offshore conventional. A little more than half of the growth in shale spending had been due to rising costs in the prior two years – but cost inflation has been less of a factor in very recent history.
In the conventional space, an emphasis on brownfields is clearly evident, with around two–thirds of newly sanctioned projects fitting this description, up from around three–fifths back in calendar 2016. We expect to see increasing investment activity in the conventional space in the coming year, with the Middle East and Latin America leading the way in onshore and offshore respectively. We note with interest that the June quarter earnings reports of major oil field services companies noted a dichotomy between declining US onshore revenues and rising international revenues – a reversal of the trend seen in the recovery to date.
In the long–term, we continue to see compelling market fundamentals, underpinned by rising transport and industrial demand in the developing world in addition to a steepening cost curve underpinned by natural field decline.
We expect oil demand to grow by approximately 1 per cent per year over the next decade despite significant efficiency gains in the light–duty vehicle fleet. Our long run view on electric vehicles (EVs) is discussed below and is available in more detail here as part of our electrification of transport series.
On the supply side of the market, with natural supply decline of at least –3 per cent per year added to the demand growth referenced above, by 2030 we see the need for new production equivalent to at least one–third of total global production today. We anticipate US tight oil production starting to plateau in the mid–2020s, at which point its role in setting global oil prices would begin to diminish. That observation, the industry’s relative lack of exploration success in the last half decade14 and the weak investment in the conventional sphere in recent years, points to the need for known but more costly supply to be induced to fill the long run gap to demand.
By the mid–2020s, the marginal barrel is expected to come from a higher–cost non–OPEC deepwater asset.
Looking beyond the 2020s, on the demand side we see an expected peak in the mid–2030s in our central case followed by a sedate trend decline. The annual loss of demand is not expected to approach the rate of systematic decline of existing fields, even based on a highly conservative estimate of the latter. Therefore, we expect that the industry will remain in a permanent state of inducement and reserve replacement even beyond the peak in demand.
Our low case for the oil price is predicated on OPEC running without discretionary spare capacity; high case EV penetration [well above the vast majority of published mid–cases]; trend increases in fuel efficiency in the traditional fleet; low case macro inputs constraining non–transport demand; a conservative weighted global decline rate assumption of –3 per cent; and a demand peak in the mid–2020s, a full decade ahead of the central case.
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In the long-term, we continue to see compelling market fundamentals, underpinned by rising transport and industrial demand in the developing world in addition to a steepening cost curve underpinned by natural field decline.
Liquified natural gas (LNG)
The Japan–Korea Marker (JKM) price for LNG averaged $5.80/MMbtu DES Japan in the first half of calendar year 2019, more than 40 per cent lower than the prior half, with the price ranging from $4.26 to $8.95/MMbtu. Prices were weighed down by large increments of new supply coming on–line just as Asian demand growth was pausing for breath after the frenetic expansion of the two prior years.
Looking ahead, within our generally constructive outlook for LNG demand growth the key uncertainties are Chinese energy mix policies and the scale of competing supply of indigenous and pipeline gas; the level of investment in new gas infrastructure in India; the timing and scale of nuclear restarts in Japan and energy mix policies in South Korea. Outside Asia, the amount of Russian pipeline gas supplied to Europe also represents a swing factor for the outlook.
On the supply side, a large increment of new production has come to market in calendar year 2019. That follows the estimated 5.4 bcf/d of nameplate capacity that came online in calendar 2018, in a global LNG market of around 41 bcf/d. Despite the strong LNG demand growth that we project for the medium–term, current and committed capacity is likely to supply the market fully until the middle of next decade, with considerable overflow from Asia to Europe expected at times. Beyond the mid–2020s new projects will be required in a global gas market where the marginal supply looks likely to come from North American LNG exports under a range of scenarios.
Four of the five new projects earmarked for first gas in calendar 2019 are US export facilities; as are four of the seven projects due to come online in calendar 2020. That is a supportive signpost for the hypothesis that regional gas markets are on a path to harmonisation around a global benchmark.
Our low case for the LNG price is predicated on Qatar executing a market share strategy via the accelerated development of its North Field; Russian pipelines into Europe increasing market share by five percentage points; a low case macro environment curbing industrial and power demand; a ‘low carbon’ case for renewables penetration competing with gas in the power sector; and a cluster of optimistic FIDs by ‘portfolio players’; all of which serves to delay market balance by one full development cycle [from our central case timing of circa 2025].
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Eastern Australian gas
The East Australian natural gas market continues to evolve. The start–up of Queensland LNG projects in recent years has irrevocably altered the fundamentals of domestic price formation. Our firm assessment is that the industry will ultimately harmonise around an LNG benchmark. The likelihood of LNG imports being required as a seasonal source of incremental supply in the southern states has increased. This development would accelerate the harmonisation process, as would improving the transparency and depth of domestic price discovery mechanisms.
The domestic market was tight throughout the last eighteen months. Competing demand from LNG export projects and declines in conventional supply have both contributed to the extended period of tightness.
Whilst there is an ample resource base to meet long term domestic demand, the future cost to extract and process this resource appears to be rising. Further, constraints on onshore development hinder the efficiency with which the industry might otherwise operate. As traditional sources of supply fall off or plateau, new upstream investment will be required. To accommodate timely investment in competitive incremental supply, a clear and stable policy foundation is required.
We continue to believe that a more accommodative policy environment for onshore gas development – both conventional and unconventional – has the capacity to provide significant additional supply to the market at reasonable cost. Such an approach should help to encourage the new investment necessary to provide for reliable and affordable gas supply over the long term. It also has the clear benefit of allowing market forces to allocate capital where it will be most effective in achieving those ends.
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Australian power market
A wave of new renewable capacity has entered the National Electricity Market (NEM). This has arguably put the power sector on track to meet its share of Australia’s Paris emissions reduction target for 2030. Consequently, the Australian Government is focusing less on grid decarbonisation and more on improving the affordability and reliability of supply. Both these aspects of the NEM presently fall short of the levels required to ensure Australia’s international competitiveness or meet household and wholesale customer expectations. The first quarter of 2019 saw record high average spot prices in Victoria and South Australia which led to a marked increase in activity by the market operator to address capacity constraints. The possibility of generator retirements could place additional stress on the supply–demand balance in the medium term. At the same time, a preview of the long run promise of renewables has been offered by the incidence of negative power price events in some states over the last few months.
Due to falling technology costs and consumer preferences, it is likely that the NEM will continue to decarbonise, with or without government direction. We thus support measures like the Retailer Reliability Obligation and the Integrated System Plan that aim to improve system affordability and reliability, while also enabling grid decarbonisation and technology neutrality. Further affordability and reliability gains are also possible if State and Federal governments are able to provide the policy confidence necessary to reduce the risk of investment in new dispatchable capacity while meeting overall emissions reduction objectives in the market.
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Energy coal prices softened over the first half of the calendar year and were on a weakening trend as the period closed.
The gcNewc 6000 kcal/kg FOB Newcastle index averaged around $88/t over the half, down from around $111/t in the prior half. Prices ranged from a high of around $100/t to a low of around $69/t. The 5500kcal index averaged around $58/t over the same period, with a high of around $63/t and a low of around $51/t.
The spread between the spot indexes for gcNewc 6000 and Newc 5500 averaged a little over 50 per cent in the 2018 calendar year. The spread has remained at a similar level in calendar 2019 to date, exhibiting its resilience to a decline in base prices.
China’s energy coal requirements (excluding lignite) have declined in the calendar year to date. Slower growth in industrial demand for power and a clear uplift in hydro generation have combined to reduce its short term needs. Even so, as of July 2019, total coal imports (including metallurgical and lignite) for the calendar year to date were tracking around two–thirds of the total average imports received across calendar years 2017 and 2018. That is a little ahead of the pace that would imply a flat or lower outcome for total annual inflows versus the levels achieved in recent years.
India saw strong growth in imports in the calendar year–to–June (+25 per cent YoY), as a modest lift in domestic production (+3 per cent YoY) was unable to keep up with the needs of end–users.
The Atlantic and Mediterranean region has been weak. That partly reflects commercially driven coal–to–gas switching in parts of Europe, where relatively cheap pipeline gas and LNG imports, plus a steep rise in the price of European Carbon Allowances15, have driven generator behaviour. The recession in the Turkish economy has also had an impact on seaborne energy coal demand.
Longer–term, we expect total primary energy derived from coal (power and non–power) to expand at a compound rate slower than that of global population growth. Coal is expected to progressively lose competitiveness to renewables on a new build basis in the developed world and in China. In our view, the cross over point should have occurred in these major markets by the end of next decade on a conservative estimate. However, coal power is expected to retain competitiveness in India, where the coal fleet is only around 10 years old on average, and other populous, low income emerging markets, for a much longer time.
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Longer–term, we expect total primary energy derived from coal (power and non–power) to expand at a compound rate slower than that of global population growth.
Muriate–of–potash (MOP) prices16 have lost some momentum, having been on a slow–but–steady rally since mid–calendar year 2016. Brazilian gMOP17 prices slipped to $325–335/t CFR in July 2019, –$20 versus recent highs, but are still up 2 per cent YoY. Annual CFR contract prices for China and India still stand at $290/t. In July 2019, the midpoint free–on–board standard grade Vancouver benchmark was up by around 14 per cent YoY to $266/t and Canada’s Nutrien has reported eleven consecutive quarters of rising realised prices.
Global shipments in calendar 2018 were roughly flat. This is a creditable performance given the 10 per cent jump in sales the previous year. In calendar 2019 demand is facing some headwinds. These include a very wet spring in the United States, late onset of the monsoon in India and weak palm oil prices hitting farm incomes in south–east Asia. However, China and Brazil have bought heavily in the first half of the calendar year and Canadian exports (Jan–May) are 5 percent ahead of the previous year at 9.2 Mt. Exports from Belarus (Jan–May) are up around 4 per cent YoY at 4.8 Mt and exports from Russia are also slightly up.18 However, exports from Chile have almost disappeared – less than 100kt in Jan–Apr, compared to a record of 450 kt in the corresponding period in 2016 – as MOP production is being sacrificed in favour of lithium.
Brazilian import volumes (Jan–May) jumped 28 per cent YoY to 3.5 Mt, a new record for the first five months of a calendar year. Indonesia, the largest market in south–east Asia, saw imports (Jan–May) rise 16 per cent YoY, despite weak palm oil prices. Imports into China (Jan–May) are up 18 per cent YoY but India (Jan–Apr) declined by around 11 per cent YoY.19 The Indian result is in line with our directional expectations, with affordability notably strained by the combination of last year’s MOP contract price increase and a weaker rupee.
Sustained strong demand, allied to idle capacity within Canpotex, has enabled price gains over the past two years despite the ongoing introduction of substantial capacity additions in Canada, Russia and elsewhere. There are two greenfield mines under construction in Belarus, one due to be commissioned at the end of calendar 2019, the second planned for calendar 2021. However, EuroChem has pushed back commercial production at its Volgakaliy project to 2020, and Uralkali is slowing down construction of two replacement mines until the mid–2020s. Meanwhile, Russian fertiliser manufacturer Acron has announced debt financing to complete its Talitsky project, nearby Uralkali’s operations.
Turning to the long–term, demand for potash stands to benefit from the intersection of a number of global megatrends: rising population, changing diets and the need for the sustainable intensification of agriculture. While potash demand can be volatile from year to year, we anticipate trend demand growth of 1.5–2.0 Mt per year (between 2 and 3 per cent per annum) through the 2020s. The pace of demand growth is important, because the need for new supply to be induced will only arise once both the spare capacity held by incumbents and capacity additions that are under construction have been absorbed by the market.
Our low case for potash is predicated on all presently latent capacity returning to the market at disruptive speed; considerable brownfield and greenfield additions coming to market; a low case macro environment curbing both opex and capex costs; ‘cheap’ currencies in major producer jurisdictions; a five percentage lift in crop residue recycling; minimal dietary change and crop mix; and a similar end–state for soil K mining to what is observed today. All of which serves to delay market balance and the onset of inducement pricing to well beyond the 2020s.
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Nickel prices on the LME ranged from $10,440/t to $13,610/t over the first half of the calendar year, averaging $12,311/t. Along with other exchange traded metals such as copper, nickel prices were a casualty of the re–escalation in trade tensions in the March quarter of 2019, and re–re–escalation in July and August, which eroded investor confidence in pro–growth assets. After the financial year closed, uncertainty about the direction of Indonesia’s nickel ore export policies20 saw prices rise.
Nickel “first–use” is dominated by the stainless steel sector. It comprises more than two–thirds of primary demand today. China produces a little more than half of the world’s stainless steel and is far and away the major consumer of primary and processed nickel. Despite intense interest in the impact of electric vehicles on battery raw materials, we note that nickel demand from batteries is less than 5 per cent of consumption today. Nevertheless, with a rapid and prolonged drive towards the electrification of transport in prospect, there are plausible long run paths21 where batteries and stainless steel will become equally important consumers of nickel.
There are three key questions for the nickel market in the longer run. The first is how fast will electric vehicles penetrate the auto fleet? The second is what mix of battery chemistries will power those vehicles? The third is what will be the “steady state” marginal cost of converting the abundant global endowment of laterite ores to a high grade nickel product suitable for use in battery manufacturing?
You can read our views on the first two questions here and here respectively. On the third question, the signposts have been mixed, and in our minds, it will be a considerable time before there is real clarity in this domain.
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The dry bulk maritime freight industry is concluding a three year ‘era’ where the major focus of ship–owners was on re–establishing profitability through operating cost competitiveness and discipline with respect to fleet growth. The new era will be about sustainability, highlighted by the imminent onset of the IMO 2020 low sulphur fuel regulations.
We are entirely supportive of the IMO’s decision to impose a new, lower limit on the amount of sulphur present in marine fuels. The limit, of 0.5 per cent, down from 3.5 per cent today, will be binding from January 1st 2020. Somewhat further down the line, the global maritime industry, which is a major GHG emitter, will be required to halve its total emissions by 2050 versus a 2008 baseline.
BHP chartered vessels will be 100 per cent compliant with all implemented environmental regulations and we will continue to support regulatory authorities in their efforts to bring about a greener future for the industry.
We expect the majority of ship–owners will respond to IMO 2020 by bunkering compliant, low sulphur fuel oils. There is a ceiling on the proportion of the fleet that will choose to install scrubbing capability (with the number limited by both dry dock capacity, scrubber availability, national bans on the use of open–loop scrubbers in key coastal regions, including China, and the challenge to economics presented by the need to dry dock a ship that would otherwise be working). Owners with vessels close to the end of their effective lives may bring forward the scrapping date rather than incur additional costs. We have seen scant evidence of retrofitting to enable LNG bunkering. We anticipate a period of elevated crack spreads as the refining industry adjusts to the shock, wider sweet–sour differentials in the crude market22; and temporarily higher diesel costs for end–users.
We estimate that IMO 2020 will add between $1–2/t to WA–China freight & $3–4/t to Brazil–China. These figures are –$1 lower on all fronts from our previously published estimates, reflecting the out–sized impact on industry fundamentals of reduced Brazil–China iron ore exports in calendar 2019 and possibly beyond, not a change in IMO specific assumptions. An outward Brazilian voyage using ‘scrubbed’ high sulphur fuel oil will be more competitive than the $3–4/t cited above on July 2019 fuel futures prices.
So much for the short run response and impact. As we move into the second half of the next decade, an intense period of fleet replacement is scheduled to occur. This is the ‘demographic shadow’ of the shipbuilding boom that coincided with the China–fuelled commodity super cycle. This replacement wave offers a unique opportunity to dramatically alter the technological and environmental profile of the dry bulk fleet within a little over half a decade. If the participants in the industry ‘get this right’, the steep task of halving shipping emissions by 2050 may not seem as far off as it does today.
LNG–fuelled dry bulk vessels are expected to be a major element in ‘getting this right’. We have recently released the world’s first bulk carrier tender for LNG–fuelled transport, for up to 27 million tonnes of iron ore. Introducing LNG–fuelled ships into BHP’s maritime supply chain will eliminate NOx (nitrogen oxide) and SOx (sulphur oxide) emissions and significantly reduce CO2 emissions along the busiest bulk transport route globally.
Turning quickly back to recent industry developments, Capesize fleet growth was modest in calendar 2018, with fewer deletions offset by modest deliveries, which were the result of the lagged impact of weak orders around the cycle trough. The lower deletions were expected, given decent operating conditions and the record wave of scrapping seen across 2016 and 2017.
Looking ahead, while the demand for bulk tonne–miles will be highly uncertain whilst Brazilian exports of iron ore are constrained, the supply side of the sector offers narrower confidence intervals on a two year horizon. We anticipate that there will be something of the order of 22 Mdwt of net new Capesize capacity across this calendar year and next. Fleet growth is then expected to moderate in calendar 2021, with an expected lift in demolitions, as the early boom–time fleet starts to reach end of life.
We continue to lead the freight industry towards higher safety, productivity and environmental standards – or more colloquially, a greener, leaner, safer future. This will occur partly through our own commercial activities, such as opportunities in autonomous vessel development and our partnerships with respect to alternative fuels. We continue to engage proactively with sovereign entities and other regulators to leverage technological developments and promote improvements in safety and sustainability standards. We engage bilaterally and through our participation in Rightship, and with civil society and the broader community through our Mission to Seafarers program. Read more here.
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Inputs and inflation trends
Over the last six months, the “uncontrollable” element of industry wide operating cost inflation in US dollar terms has been broadly steady, reflecting mixed trends across the procurement landscape.
Exchange rates in our key mineral producing regions were lower than in the prior half year. Pockets of inflation in controllable operating and capital costs have emerged across our businesses, including higher turnover rates in some segments of the workforce within Minerals Australia. Beyond these specific instances, our high level assessment remains that general inflationary trends in both opex and capex are benign by historical standards. We are accordingly comfortable that our pipeline of high quality minerals and petroleum projects, which are costed based on conservative escalators, can be delivered within budget.
Regionally, we underline that the sequence in which our businesses have exited their respective cost troughs over the last two to three years has been onshore petroleum (pre the shale divestment), Minerals Australia, Minerals America and offshore petroleum.
The Australian dollar and the Chilean peso both depreciated in the first half of calendar year 2019. These movements occurred against a backdrop of slim, or negative, interest rate differentials to the United States, softer prices for exchange traded commodities and a continuation of cautious asset allocation in global financial markets against the backdrop of global trade policy uncertainty. In Australia, six month ago, both consumer price inflation and local currency mining wage growth were running just below 2 per cent YoY, reflecting modest economy–wide price pressures and the presence of spare capacity in the labour market. Since that time, mining wage growth has edged up to 2.3 per cent YoY, but consumer price inflation has remained subdued.
The Reserve Bank of Australia (RBA) does not expect headline inflation to return to the bottom half of its target range of 2 to 3 per cent until at least the middle of calendar year 2021.23 That is despite the fact it has executed a pair of –0.25 per cent interest rate cuts in June and July 2019, which appear to have returned stability to the housing market. It also projects that national wage growth will remain relatively stable over this period.
In its pre–election update24, the Australian Federal Treasury projected nominal national wage growth of 2¾ per cent and 3¼ per cent in financial years in 2019/20 and 2020/21 respectively, up from an estimate of 2½ per cent in the financial year just concluded. In 2021/22 and 2022/23, they project wage growth of 3½ per cent in both years, against consumer price inflation of 2½ per cent, with the unemployment rate and employment growth both predicted to be steady at 5 per cent and 1½ per cent, respectively.
Labour markets are not tight in aggregate in our major minerals producing regions globally, with local currency wage growth subdued in Chile and a gradual recovery being observed in Western Australia and Queensland.
In Australia specifically, total mining sector employment reached 240 thousand in the June quarter of 2019. That is some –34 thousand, or about –13 per cent, off the previous cyclical peak.25 Looking at the data from another angle, total employment has increased by almost 13 per cent from the cycle trough, with almost 28 thousand jobs added during the recovery phase. Looking at it from a third angle, just over one–half of the peak–to–trough decline in employment of around –62 thousand has so far been recovered, industry–wide.
Against this backdrop of improving job creation, mining sector wage growth at the national level in Australia has lifted slightly from a year ago, and it is now back in line with the economy wide average of 2.3 per cent YoY. We note that despite higher volatility over the business cycle, since the beginning of the decade, the level of local currency mining sector wages have increased by about one quarter overall; a quantum of change essentially equivalent to the all–industries weighted average over that same period.
Notwithstanding those general trends, we continue to observe that certain segments of our minerals business face more pronounced upward pressure. This is most notable in niche skill subsets. The theme manifests most visibly in higher turnover rates in the labour hire segment of our operational workforce.
In Chile, mining wage growth has been soft by historical standards, with relatively flat numbers employed in the sector overall allied to a stubbornly high nationwide unemployment rate. The recent strike at Codelco’s Chuquicamata operation ended a period dating back to early calendar 2018 where the majority of expiring agreements in the Andean copper belt – and there were many – were renegotiated peacefully.
In addition to subdued wage growth, general inflation in Chile has also been modest, with outcomes across calendar 2018 and the first half of calendar 2019 consistently registering at the lower end of the Banco Central de Chile target band of 2 per cent to 4 per cent. While the Banco Central de Chile had previously projected inflation to accelerate towards 3 per cent YoY by the end of this calendar year, and had raised interest rates pre–emptively on that reasoning in the March quarter, that expectation has now been pushed out by one year. This development, in tandem with the dovish tilt among global central banks, led by the US Federal Reserve, has led to a turnaround in the outlook for Chilean monetary policy.
On the economy more broadly, Chilean policymakers remain confident that the capital project pipeline is robust, construction industry confidence is on the rise, and that the large scale immigration of recent years will have a positive impact on the nation’s trend growth trajectory. As a counterpoint, the International Monetary Fund projects that Chilean inflation will remain subdued out to the early 2020s, with the average rate over the next five years projected to be almost 1 per cent below the pre–GFC average; while the economy is expected to expand in a range between 3 to 3½ per cent over the same period, with a bias towards the lower end of that band.
Pervasive indexation in the local contracting structure will delay the recognition of the underlying movement in prices beyond the true cyclical turning point in domestic services costs.
A number of uncontrollable cost drivers across our minerals business such as diesel, explosives and steel products have levelled off in price over the most recent half, in most cases in line with movements in underlying commodity prices.
Benchmark indices for ammonia nitrate – a proxy for explosives costs – increased by between 2 and 3 per cent over the financial year in both Chile and Australia. Earth–moving tyre raw material costs were almost unchanged over the financial year at just 0.5 per cent YoY. A decrease in natural rubber prices broadly offset gains in carbon black, synthetic rubber and steel wire. Sulphuric acid prices increased markedly over the financial year for Chilean end–users due to a number of smelter outages that have come at a time of robust demand. The price peaked around $145/t in the second half of calendar 2018, but it had descended to just below $90/t at the end of the half just concluded. Chilean spot power prices in the northern grid edged up roughly 3 per cent over the financial year, with the second half reversing some of the strength seen in the first. Australian NEM spot power prices rose by approximately 11 per cent over the financial year, with a decline in first half prices more than offset by a considerable lift in the half just concluded.
The International Maritime Organisation’s low sulphur shipping fuel regulation is already impacting the diesel market as the various upstream and downstream players prepare for its formal introduction on the first day of calendar year 2020. We expect that the disruption will lead to an increase in refining spreads, and a wider spread between lower and higher sulphur crudes and higher diesel prices for end–users than would otherwise have been the case. However, as we noted in the crude oil commentary, the extended outages in Venezuela, a major exporter of sour crude to US refineries, is creating a shortage in that bracket that is masking the underlying impact of IMO in market pricing as of the time of writing.
The heavy machinery sector as a whole is three years removed from its sector–specific cycle trough, the recovery from which was due principally to a wave of replacement demand. In mining specifically, we had anticipated that the bulk of the replacement cycle in mobile equipment was going to be completed by the end of calendar 2020, based on the standard industry truck lifetime range of eight to 10 years. However, we now feel that ten years is too short as a base case lifetime assumption. We now believe that top tier producers may be able to extend that by up to five years. We have reached this position based on the combination of the ‘big data’ monitored by our Maintenance and Engineering Centre of Excellence, detailed studies of the productivity frontiers within our own business and diffusion of best practice, the gains observed by having our front line crews take genuine ownership of “shop floor” improvement, as well as our industry–wide analytical and benchmarking work. Bringing that finding back to the replacement cycle, we now believe it will be staggered across the entire first half of the 2020s, rather than compressed. The exact timing on a company basis will depend in large part upon the pace at which each producer converges upon the technical and cultural productivity frontiers.
Globally, earth moving equipment deliveries have increased strongly in consecutive years, with the 2018 calendar year unit total almost double that of the trough seen in 2016. Information available for the March quarter of calendar year 2019 points to another year of growth, albeit slim, following gains of 78 per cent and 36 per cent in calendar 2017 and 2018 respectively. Even so, we assess that ample spare capacity remains at major OEMs, which should allow for incremental volumes to be comfortably met from existing facilities. We note in particular that 2018 global deliveries represented less than one–half of the activity that was sustained at the cycle peak. Breaking out trucks with capacity above 200 Mt, deliveries in 2018 represented 44 per cent of the cycle peak. However, capacity may not be ample everywhere in the upstream supply chains of the OEMs. This impacts upon lead times and thus OEM competitiveness on a total–cost–of–ownership basis.
The relevant US producer price index for this category – mining machinery and equipment manufacturing – is +6.7 per cent higher as of June 2019, on a 12–month smoothed basis. The reputation of this series as a guide to industry cost trends, and as a suitable benchmark for use in procurement contracts, has been undermined by a non–fundamental level shift in the October 2018 release. The sub–index for parts is tracking at a lower +1.2 per cent YoY on the same smoothed basis as of June 2019, but on a simple YoY calculation, the rate of increase is much higher.
In the petroleum business, deepwater capital costs have recovered a little but they remain close to cycle lows. Our observations of recent activity in this segment, and the all–in cost assessments from the IEA and I.H.S. Markit, confirm it. Even so, vendor competition remains intense despite consolidation efforts to date; while ultra–deepwater drillship and semi–submersible utilisation rates remain very low at an average of 59 per cent and 41 per cent respectively across the financial year just concluded. Average utilisation rates across South Korean and Singaporean fabrication yards are roughly one–third and one–half of their peak levels respectively, while Chinese yards have seen utilisation rates pick up noticeably from their trough – but are still only 44 per cent in absolute terms. I.H.S. Markit estimates that deepwater capital costs are about 30 per cent short of the peak reached in 2014. That compares favourably to developments in North American onshore, where capital costs have reached 85 per cent of their 2014 level.
We anticipate it will take a considerable time for the current spare capacity in the deepwater segment to be fully absorbed by a combination of increased activity and retirements. Upstream price pressures – from the rig owner perspective – are meek. Shipyard capacity remains more than ample and steel prices are no longer rising. Collectively, that implies that the exit from the trough in day rates will be a cautious and protracted one. Some niche markets, such as harsh environments, may tighten a little bit ahead of the overall industry trend.
A rigorous approach to bottom–up cost driver modelling and advanced analytics, leveraging synergies across our commercial businesses, are expected to drive increasing cost competitiveness as industry wide cost curves steepen in the medium–term.
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Over the last six months, the “uncontrollable” element of industry wide operating cost inflation in US dollar terms has been broadly steady, reflecting mixed trends across the procurement landscape.
Sales of light duty electric vehicles (EVs, the sum of battery powered [BEVs] and plug–in hybrids [PHEVs]) expanded by 67 per cent YoY in calendar year 2018, with two million unit sales achieved for the first time. The EV share of total sales increased to 2.3 per cent, up from 1.4 per cent in calendar 2017.
Slightly more than half of all EV sales were in China, where consumers rushed to beat the reduction in subsidies. The EV fleet in China surpassed 2 million in calendar year 2018, with sales growth of 85 per cent YoY. Over the year China’s share of global EV sales increased by 5 per cent to 53 per cent. The growth in sales has slowed considerably in the calendar 2019 to date, reflecting the altered subsidy environment and the insipid background for new car purchases as a whole.
The new regulatory environment in China, whereby fiscal resources previously deployed on subsidies will instead be directly applied towards eco–system bottlenecks, most importantly charging infrastructure, is a positive signpost for EV take–up.
Our central case projection for the long term remains that by 2025 will constitute around 2½ per cent of the light duty vehicle fleet and close to 9 per cent of annual sales. By 2035 EVs will constitute around 14 per cent of the light duty vehicle fleet and close to 30 per cent of annual sales. However, our low case fleet share for the 2035 time horizon is now 7 per cent, up from 5 per cent a year ago. Further, revised projections for the broader fleet mean that a 14 per cent share in 2035 now means 275 million EVs will be on the road – representing around 40 million additional units than previously expected.
You can investigate the reasoning behind our EV forecasts here.
The first 100 million EVs on the road are expected to displace around 1.3Mbpd of oil demand circa 2030, equivalent to around 1¼ per cent of annual demand today. Constructing those same vehicles will take around 600kt of copper annually, equivalent to approximately 2½ per cent of annual demand. Looking somewhat further ahead, in our central case, EVs are expected to consume almost 7 per cent of the world’s electricity in 2050, by which time they will constitute around half the fleet and comprise around three–quarters of annual sales.
Our long run range comfortably covers the mid–case estimates of the majority of reputable external forecasters. To stylise, “greener” organisations and financial institutions are projecting sales either close to our mid case, or just above it; while more traditional industry groups are positioned between our low and mid cases, with a cluster of such projections situated close to our upgraded low.
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Our central case projection remains, that by 2035, EVs will constitute around 14 per cent of the light duty vehicle fleet and close to 30 per cent of annual sales.
Data and events referenced in this report are current as of August 13, 2019. The data is compiled from a wide range of publically available and subscription sources, including Bloomberg, Platts, Wood Mackenzie, CRU, Thomson Reuters, Argus, Fertecon, FastMarkets, SMM, AME, Parker Bay, MySteel, LME, COMEX, SHFE, ICE, DCE, SGX and I.H.S Markit, among others. All monetary values are in US dollars unless otherwise specified.
1 The US tax treatment of repatriated profits clearly contributed to the 2018 decline, but the peak in advanced economy flows was 2015, well before the policy change began to impact decision making
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2 Escalation from the status quo as of August 6, 2018. Growth could end up at this level in one of two ways. First, China could choose a timid counter cyclical response to a deeper trade shock, choosing instead to prioritise reforms. Secondly, China could attempt to stimulate, but find that the multiplier effect of its policies is held back by low levels of confidence. In our view, these two hypothetical visions of Chinese policy are both plausible, but not probable, hence they fit well in a low p20 style case.
3 The underlying data series referred to captures the relative frequency of references to policy and economic uncertainty in major media channels over time. They are available from www.policyuncertainty.com
4 The link between trade deficits and reserve [vehicle] currency status is known as the “Triffin dilemma”.
5 We cross reference the official figures with iron ore and coking coal consumption, growth in first and end use steel consuming sectors, mill utilisation rates and changes in steel making and rolling capacity, among other indicators, to arrive at our proprietary estimates.
6 We continue to see Chinese urbanisation as an opportunity rich trend for our Company. We are currently engaged with the Development Research Centre of China’s State Council to deepen joint understanding of how urbanisation may evolve in the context of the three parallel revolutions underway in energy generation, transport and information technology.
7 As highlighted here, the construction of plausible low cases for each of our commodities is a vital element of our Capital Allocation Framework.
8 Scrap costs have fallen in part due to pronounced weakness in the Turkish economy and the associated decline in its steel demand. Turkey is the world’s largest importer of steel scrap.
9 The abbreviations used in the metallurgical coal section are as follows – PLV: Premium Low–Volatile, MV64: Mid–Volatile 64, PCI: Pulverised Coal Injection, SSCC: Semi–soft Coking Coal, as published by Platts. All figures are rounded to the nearest dollar.
10 LME Settlement basis. Daily closes may differ slightly.
11 Note that dwelling completions are more important for copper use than dwelling starts – while the opposite is true for steel. We are also conscious that the veracity of the completions time series, which is the midst of a steep multi-year decline, is open for debate.
12 This was previously known as the Metal Bulletin index. Note that the specifications for this index were changed in April 2019, from a 28 per cent Cu basis to a 26 per cent Cu basis. The low recorded in the first half of calendar 2019 is an all-time low for the history of the index going back to 2014, but prior the indexation era, there were periods when TCs traded much lower.
13 MARS is a Gulf of Mexico oil and gas asset owned by Shell and BP that has grades that are somewhat similar to our GOM assets. The ‘commodity’ contract for MARS barrels is the closest public domain analogue for our GOM pricing.
14 The IEA reports that exploration spending as a share of total investment fell to almost 10 per cent in calendar 2018. With record low proportional exploration outlays, it is no surprise that discoveries are also close to their lowest level ever in 2018. Indeed, the worst single year for oil and gas discoveries from 2000 to 2012 would be the very best year in the period 2013 to 2018.
15 ECAs traded in an approximate range of €5 to €10 per ton from 2013 to the middle of calendar 2017. Since that time, the price has moved upwards consistently, reaching the high €20s per ton in the first half of calendar 2019.
16 CRU Fertilizer Week is the source of price data in this section.
17 Fertilizer–grade MOP is commonly sold in powder (“standard”) or compacted “granular” forms, abbreviated as sMOP and gMOP respectively. gMOP typically sells at a premium of US$10–25/t. Major markets for sMOP include China and India, while gMOP is prevalent in the Americas.
18 Russia’s monthly export data should be treated with considerable caution.
19 Trade data from I.H.S. Markit.
20 Our base case is that the current grace period for ore exports will expire as originally scheduled in 2022.
21 These paths depend in part on our range of internal views on EV penetration rates, fleet size and battery chemistry evolution. These are addressed here.
22 “Sour” crudes are higher in sulphur, “sweet” crudes are low in sulphur. Note that Venezuelan sour crude output collapsing over the last eighteen months or so is currently more than offsetting the underlying shift in refinery demand, if the WTI-MARS spread is anything to go by.
23 Statement on Monetary Policy, August 2019,available from https://rba.gov.au/publications/smp/2019/aug/pdf/forecast-table-2019-08.pdf
24 Pre–election Economic and Fiscal Outlook 2019, which was compiled before the Reserve Bank of Australia lowered interest rates in June and July, is available from https://treasury.gov.au/sites/default/files/2019-04/20190417_pefo_combined.pdf
25 These levels and changes are calculated based on ABS mid-month-of quarter data presented in original terms. Trend and seasonally adjusted series are mildly different with respect to both the most recent estimates and the level of the peak. See ABS catalogue 6291.0.55.003 for May 2019.