From GS on coking coal and iron ore.Iron ore & Coking coal: A...

From GS on coking coal and iron ore.

Iron ore & Coking coal: A tale of two commodities

Both are used in the making of steel. One commodity - coking coal - has fallen over 50% from its high. Seaborne traded volumes have increased 14% and Chinese domestic production is up 9%. Productivity gains have been driving unit cost reductions, with costs falling c.40% over the past 2 years. The other is iron ore.

We believe that the recent developments in the coking coal market provide a fantastic microcosm into the industry dynamics of a commodity moving into oversupply. And we believe this real life example in coking coal provides a warning to the iron ore bulls. Industry dynamics change, weakening prices place pressure on companies to reduce cost and thus expectation of marginal costs support levels fall. We believe that the pricing and market supply dynamics in coking coal lend credit to our view that the iron ore price needs to spend a period below the perceived long-term price to bring the market back in to balance. This is what is occurring in the coking coal market now, with a price of $120/t versus long term expectations of closer to $160/t.

The main points where we draw correlation from coking coal to iron ore are:

1) Price pressure is a fantastic driver of cost reduction
Coking coal costs have fallen by c40% in Australia over the past 2 years and are now back at the levels we saw in 2010. Whilst a falling A$ exchange rate has helped, the fall in coking coal prices has forced the miners to focus on productivity gains and cost reduction. BHP, the industry leader has delivered unit cost reductions - from c.$160/t to c.$105/t in the past 2 years - with volumes up 32%. Clearly the focus of the world’s largest producer of coking coal is not about managing markets, but managing costs. The focus to reduce costs has seen forecasts of marginal costs support reduce, leading to a lowering of future price expectations.
BHP has delivered a 30% reduction in costs in just 18 months in its coking coal business

2) Productivity gains are here to stay

The cost out story has largely been driven by improved productivity. Productivity is the industry buzz word. Productivity (measured in tonnes per employee) fell significantly from 2001 to 2011 for both BHP and the broader Australian coal sector. The reduction in productivity was driven by a combination of chasing the marginal value tonne and deteriorating labour relations & utilisation. Productivity has returned for BHP coking coal (+30% in past 2 years) and it is also improving for the Chinese coal sector. And if it can be delivered in coal, why couldn't productivity gains be delivered in iron ore domestically in China as well?

3) Neither China nor the West is cutting coking coal volumes despite the lower price

The major plank for the iron ore bulls is that surplus traded seaborne iron ore will replace high cost domestic Chinese production and thus we will get an orderly retreat down the cost curve. Why do we expect this when China has not cut coking coal volumes despite the fall in price.

Chinese domestic coking coal production volumes are up 9% (50mt) in the past 2 years. And in the West, despite the US coal sector being cash flow negative, US coal exports were flat from 2012 to 2013 and we forecast them to fall only slightly in 2014.

If we haven't seen the reduction in coking coal volumes given the weak prices, why are we expecting iron ore mines to shut the minute that they are uneconomic?

What's next?

Given what we have seen occur in the coking coal market in the past 18 months, we believe we will see a similar playbook in iron ore. Prices will fall, productivity will improve, and costs will reduce — ultimately shifting markets expectations of marginal cost support lower. In our view, the only way to buck this is a sustained period of weak prices to knock out that marginal production. And that is why we continue to believe that for FY15/16/17 that an iron ore price sub $85/t is likely.