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M O R G A N S T A N L E Y R E S E A R C H October 6, 2010 Global Metals and Mining Team Our highest-conviction commodity exposures are in base and precious metals in the short term. We expect bulk commodities to trade in narrow ranges close to current prices over the coming quarter. Preferred commodity exposures by sector: • Base metals – copper, nickel and tin • Precious metals – gold, silver and palladium • Bulks – iron ore and thermal coal Highest-conviction Overweight equities: • Kobe Steel • US Steel • Fortescue Metals • Implats Limited • Tata Steel • Xstrata • POSCO • Kazakhmys • Mechel Global Metals Playbook: 4Q10 Focus on currencies, China and India Research Global Accelerating weakness in the US currency, driven by fears of renewed quantitative easing (QE) to confront sluggish US growth, is proving to be a boon to commodity markets, especially as growth risks from fiscal policy normalisation, the European sovereign debt crisis, policy tightening in China and high unemployment in the USA and Europe persist. Cyclical growth is going through a soft patch after moderating from unsustainably high levels in 1H 2010. However, net positive growth, especially as China achieves a soft landing, is still supportive of raw material demand. Base metals outlook: After a significant correction in 3Q 2010, we expect resilient growth in emerging markets to deliver renewed relative and absolute outperformance in 4Q2010 and 2011 in this sector, especially in our favoured metals – copper, nickel and tin. Precious metals outlook: Currency concerns relating to the possibility of renewed QE and a prolonged period of negative real interest rates in the US are likely to drive strong investment demand for gold and silver. Auto demand recovery remains a positive for the platinum group metals (PGM). Bulk commodity outlook: Emerging market industrialisation remains a key long-term driver of demand for steel-making raw materials and thermal coal, but current prices are challenging for steel makers and thermal power generators. Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. += Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account
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M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010 Global Metals and Mining Team
Our highest-conviction commodity exposures are in base and precious metals in the short term. We expect bulk commodities to trade in narrow ranges close to current prices over the coming quarter.
Preferred commodity exposures by sector:• Base metals – copper, nickel and tin• Precious metals – gold, silver and palladium• Bulks – iron ore and thermal coal
Global Metals Playbook: 4Q10 Focus on currencies, China and India
ResearchGlobal
Accelerating weakness in the US currency, driven by fears of renewed quantitative easing (QE) to confront sluggish US growth, is proving to be a boon to commodity markets, especially as growth risks from fiscal policy normalisation, the European sovereign debt crisis, policy tightening in China and high unemployment in the USA and Europe persist.
Cyclical growth is going through a soft patch after moderating from unsustainably high levels in 1H 2010. However, net positive growth, especially as China achieves a soft landing, is still supportive of raw material demand.
Base metals outlook: After a significant correction in 3Q 2010, we expect resilient growth in emerging markets to deliver renewed relative and absolute outperformance in 4Q2010 and 2011 in this sector, especially in our favoured metals – copper, nickel and tin.
Precious metals outlook: Currency concerns relating to the possibility of renewed QE and a prolonged period of negative real interest rates in the US are likely to drive strong investment demand for gold and silver. Auto demand recovery remains a positive for the platinum group metals (PGM).
Bulk commodity outlook: Emerging market industrialisation remains a key long-term driver of demand for steel-making raw materials and thermal coal, but current prices are challenging for steel makers and thermal power generators.
Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision.For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.+= Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account
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October 6, 2010Global Metals Playbook, 4Q10
Table of contentsExecutive Summary 4
Top Picks 6
Key Changes 7
Economic and Commodities Outlook 10
Base Metals
Aluminium & Alumina 21
Copper 25
Nickel 28
Lead 31
Zinc 34
Precious Metals
Gold 38
Silver 41
Palladium 44
Platinum 46
Rhodium 48
Steel & Bulk Commodities
Steel 52
Met Coal 55
Iron Ore 58
Mined Energy
Thermal Coal 63
Uranium 65
Top Equity IdeasKobe Steel 69 Harunobu Goroh
US Steel 70 Mark Liinamaa
Fortescue Metals 71 Craig Campbell
Implats Limited 72 Simon Kendall
Tata Steel 73 Vipul Prasad
Xstrata 74 Ephrem Ravi
POSCO 75 Charles Spencer
Kazakhmys 76 Ephrem Ravi
Mechel 77 Dmitriy Kolomystyn
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October 6, 2010Global Metals Playbook, 4Q10
Global Commodities Team
1 Morgan Stanley & Co. Incorporated 2 Morgan Stanley C.T.V.M. S.A. 3 Morgan Stanley & Co. International plc 4 Morgan Stanley India Company Private Limited 5 Morgan Stanley Asia Limited 6 Morgan Stanley Australia Ltd 7 Morgan Stanley MUFG Securities 8 Morgan Stanley Taiwan Ltd 9 OOO Morgan Stanley Bank 10 RMB Morgan Stanley (Proprietary) Ltd + Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.
Global Metals & Mining (Australia) Latin America Steel, Metals & Mining, Pulp & Paper (New York/São Paulo/Mexico)Peter Richardson 6+ 61 3 9256 8943 Carlos de Alba 1 1 212 761 4927Joel Crane 6+ 61 3 9256 8961 Bruno Montanari 2+ 55 11 3048 6225
EMEA Metals & Mining, Steel (London) Non-Japan Asia Metals & Mining (Singapore/Seoul/Hong Kong)Ephrem Ravi 3+ 44 (0)20 7425 2127 Charles Spencer (team leader) 5+ 65 6834 6825Carsten Riek 3+ 44 (0)20 7425 3075 Hyunjae Lee (Seoul coverage) 3+ 82 2 399 4850Markus Almerud 3+ 44 (0)20 7425 9870 Sandy Niu (China coverage) 5+ 852 2239 1520Alain Gabriel 3+ 44 (0)20 7425 8959 Mean Phil Chong 5+ 65 6834 6194Hannah Kirby 3+ 44 (0)20 7425 6014 John Lam 5+ 852 2848 5412
EMEA Metals & Mining, Steel (Moscow) Asia Oil & Gas Coal (Hong Kong)Dmitriy Kolomytsyn 9+ 7 (495) 287 2309 Wee-Kiat Tan 5+ 852 2848 7488Timur Salikhov 9+ 7 (495) 287 2118 Sara Chan 5+ 852 2848 5292
China’s Manufacturing PMI and Export Growth, 2005-2010
Source: Thomson Reuters, OECD, Morgan Stanley Research
Global Manufacturing PMI and OECD Leading Indicators, 2002-2010
Base metals: Following the recent correction, we are positive towards base metals and have strengthened our price forecast profile through 2012. This reflects our expectation that modest growth and continued supply constraints will be reflected in falling inventories and strengthening prices. While we are cautious on those metals with a forecast market surplus over the 2010-2012 period (aluminium, lead and zinc), we continue to prefer the deficit markets of copper, nickel and tin.
Precious metals: Fiat currency concerns have reappeared as the US Federal Reserve contemplates renewed QE to confront sluggish growth and persistently high levels of unemployment. This development, with associated downside risk to the US dollar, is likely to underpin continued growth in investment demand for gold and silver. Auto demand recovery remains a positive for the PGM complex.
Bulk commodities: Despite lingering concerns over construction sector demand in China and consequences for Chinese steel inventory, production and prices, the longer-term outlook for steel-making raw materials remains strong as emerging market growth continues to underpin demand for all types of steel.
Chinese Manufacturing PMI (LHS) China Export Grow th, 3mma (RHS)
yoy % chg
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October 6, 2010Global Metals Playbook, 4Q10
1H 10:Broaden sector exposure on strengthening growth, but caution on gold as US dollar strengthens
2H 09: Shift of emphasis: Precious metals rally on US dollar weakness
1H 09: Attractive sectorre-entry point: Base metals rally on Chinese restocking
Executive Summary Sector strategy evolution going into 2011
1H 10: Emerging markets drive growth; sub-par recovery in OECD; USD strengthening in response to European sovereign debt crisis
1H 09: Strong policy stimulus, better credit conditions, rising liquidity, turn in leading indicators
2H 2010/1H 11: Real economic recovery continues, but bounce-back factors fade; private sector activity grows modestly with increasing measures to address structural imbalances; China hard landing fears abate, but below-trend US recovery is a key risk
2H 09: Expansionary policies maintained; further rise in leading indicators; coincident activity lagging (except in China); USD weakening
2H 2010/1H 2011: Increase exposure to base metals, add silver to gold and palladium in precious metals, but be more selective in bulk commodities
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October 6, 2010Global Metals Playbook, 4Q10
Source: FactSet, Morgan Stanley Research
Top Picks Global Highest Conviction Equity Overweights
Kobe Steel Solid earnings recovery driven by specialty steel and non-steel business; ITmk3 iron making business in EM could be an additional growth driver
US Steel Attractive risk-reward on a 12-month view; leverage to iron ore, energy drilling and US SAAR to drive upside
Fortescue Leverage to tight iron ore markets as high-cost Chinese supply has difficulty maintaining production
Implats Our top pick in platinum due to its industry-leading operating costs and deeply discounted Zimbabwe growth opportunity
Tata Steel Steel prices shaping up well; improvement in Corus operations to surprise positively; Indian operations approaching a step up in growth
Xstrata Diversified producer with leverage to several favored commodities – copper, nickel, platinum/palladium, thermal coal
POSCO Global steel markets look to be recovering into 2011-12 from cycle trough levels in 2009; recent Chinese steel production cuts are lifting prices and reducing exports
Kazakhmys Play on copper, plus benefits from stake in ENRC (ferrochrome, iron ore, aluminum)
Mechel Attractively valued steel and coal producer; should continue to benefit from strong coking coal demand in Asia
Fundamentals and easy money are key to metals forecasts• Base metals: Mark-to-market impacts have been positive for our CY 2010 forecasts. We have also reinforced our rising profile of prices through 2012 based on our forecasts of a continued cyclical recovery in industrial production.
• Copper, nickel and tin remain our preferred exposures in the complex based on resilient Chinese demand, improved OECD off-take, and constrained supply in all of these metals.
• Precious metals: We have made the most material positive changes to our forecasts for gold and silver. This reflects our perception of the strong and continuing impact on investment demand of currency concerns relating to the possibility of renewed Quantitative Easing in the US and a prolonged period of expansionary monetary policy elsewhere in the OECD.
• In the platinum group metals, we continue to favour palladium over platinum on expectations of reduced Russian stockpile disposals of palladium. Modest forecast price adjustments in both metals are designed to reinforce this call. Source: Morgan Stanley Research estimates
Key Changes
Base Metals:Period
New Old Chg New Old Chg New Old Chg New Old Chg New Old ChgUS$/lb US$/lb % US$/lb US$/lb % US$/lb US$/lb % US$/lb US$/lb % US$/t US$/t %
Bulk commodities – an unchanged but positive price profile• Steel-making raw materials: Despite some persistent market concerns about the strength of demand for steel-making raw materials in 2011/12 and fears regarding the growth in new capacity over this timeframe, especially in iron ore, our fundamental analysis highlights continued strength in premium products (hard coking coal and high-grade iron ore) as seaborne markets struggle to provide sufficient supply to match the anticipated growth in steel production, at least until 2012. We have left our rising price profile for these products unchanged as a result. Weaker coking and direct injection coals are likely to trade at the lower end of their historical discount range to hard coking coal to reflect easier supply conditions in these markets in the near term.
• Thermal coal continues to be the quiet achiever in the bulk commodities markets. Recent resilience in seaborne prices in Asia during the 3Q correction and anticipated moderate increases in prices over the forecast period reflect our view that the tightening impact of strong demand in the traditional East Asian markets, the continued growth in Chinese net imports, and the growth in Indian imports will deliver higher prices over the forecast period out to 2013. We have made no changes to our rising forecast price profile over this time frame.
Source: Morgan Stanley Research estimates
Key Changes
PeriodNew Old Chg New Old Chg New Old Chg New Old Chg New Old ChgUS$/t US$/t % US$/t US$/t % US$/t US$/t % US$/t US$/t % US$/t US$/t %
PeriodNew Old Chg New Old Chg New Old Chg New Old Chg New Old Chg New Old Chg New Old ChgUS$/t US$/t % US$/t US$/t % US$/t US$/t % US$/t US$/t % US$/t US$/t % US$/t US$/t % US$/t US$/t %
A soft patch in 2H 2010 followed by reacceleration in 2011
Global Outlook: A soft patch in 2H 2010, clearly evident in the trend in the global purchasing managers’ index (PMI), should give way to renewed acceleration in growth in 2011 and into 2012 as ongoing policy stimulus in advanced economies offsets much of the negative growth effects of household, corporate and government deleveraging in an extended period of global healing after the crisis of 2008-09.
Emerging Markets are a key to this global growth recovery and to demand for industrial raw materials and energy. Robust emerging market growth is increasingly being driven by domestic demand, with a diminishing reliance on exports. By contrast, developed economies are more slowly transitioning away from debt-driven consumption and construction demand towards exports and capital expenditure. The difference in the pace of growth between emerging markets and developed markets is driving a two-speed global economy.
Liquidity and inflation risks favour commodities as an asset class: With central banks in major developed economies fearful of weakening growth and deflation, we now expect a super expansionary policy of low interest rates and abundant liquidity for an extended period, skewing global inflation risks to the upside. Low interest rates, ample liquidity, and medium-term inflationary risks provide a strong cocktail of support for commodities in general, and gold in particular, as investors fear the impact of this environment on the value of fiat currencies.
e = Morgan Stanley Research estimates Source: IMF, Brook Hunt, Morgan Stanley Research
China’s PMI is pointing to a reacceleration in output in 2011
Key Growth and Inflation Indicators in China, 2005-2010
Source: Thomson Reuters, Morgan Stanley Research
US ISM Manufacturing PMI vs G3 Industrial Production, 1996-2010
Economic Outlook
• Global PMIs are our favoured leading indicator of demand for industrial raw materials.
• In late 2Q and 3Q 2010, global and key regional PMIs softened following a period of unsustainably high readings in late 2009 and 1Q 2010.
• While the correction started in China in response to policy-tightening measures introduced to cool an overheating property sector in Tier 1 cities, it has since become evident in other emerging and developed markets.
• In our view, the transition to lower but sustainable growth rates is a reflection of the waning effects of stimulus-driven restocking in developed markets and the impact of moderate policy-tightening measures in emerging markets.
• We expect this corrective phase in global industrial output to linger through 4Q 2010 before an extended period of monetary easing in developed markets and an easing of cyclical inflationary pressures in emerging markets result in renewed strength in industrial output in 2011.
• We already see signs of this trend in the renewed growth in China’s industrial output, despite the intensification of measures against the top end of the property sector; this augurs well for continued commodity demand growth going into 2011.
Retail Sales Industrial Production Fixed Asset Investment Grow th(RHS)
yoy % chgyoy % chg
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October 6, 2010Global Metals Playbook, 4Q10
Currency impacts: Quantitative Easing and the US dollar
China Spot Iron Ore (fob) in USD/t, AUD/t and BRL/t, Relative Performance
Source: Thomson Reuters, Morgan Stanley Research
Gold and Platinum Spot, ZAR/oz and USD/oz, Relative Performance
Key Sector Themes
• With investors increasingly inclined to expect a reintroduction of quantitative easing (QE) by the US Federal Reserve, renewed downward pressure on the US dollar has increased markedly, with benefits to a wide range of US dollar-priced commodities.
• As we expect an extended period of expansionary monetary policy to combat the risks of deflation and weak growth in developed markets, even though we are less certain on the likelihood of the formal adoption of QE2, a weaker dollar is likely to persist into 2011.
• However, the key risk for commodity markets is that growth in H2 2010 and 1H 2011 exceeds market expectations and results in less expansionary monetary policy and a sharply higher US dollar.
• This risk is unlikely to be realized before the end of 1Q 2011, however, providing a clear opportunity for sustained strength in US dollar commodity prices, especially if the dollar comes under further downward pressure from stronger Chinese and commodity producer currencies.
• The obverse of a weak dollar, against the backdrop of strong commodity prices, is also expected to be the continuation of strong producer currencies such as the A$, the C$, the Brazilian real and the South African rand (ZAR).
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Spot Iron Ore FoB US$/t Spot Iron Ore FoB A$/t Spot Iron Ore FoB BRL/t
China’s crackdown on property and energy-inefficient sectors
Source: CEIC, Brook Hunt, CRU, Morgan Stanley Research
Key Sector Themes
• Throughout much of 2010, investors have struggled to measure the demand impact of two key policies in China: the crackdown on high-end property speculation and inefficient energy practices.
• In our view, fears of a policy-induced hard landing in the broader economy as a result of policy-tightening measures directed at the high-end property market are starting to fade, and such fears never formed a key part of our base case.
• Two consecutive months of rising manufacturing PMI readings in August and September suggest that the worst effects of slowing construction demand on output and new orders are passing.
• As part of the 11th Five-Year Plan, China ordered the closure, by the end of September 2010, of thousands of outdated and inefficient plants in an effort to reach ambitious energy consumption-reduction targets in 18 industries. In an intensification of this campaign, at the beginning of September, the central government ordered some provinces to cut power to meet emission targets, given the limited time available to meet these targets.
• The table below details our estimate of total 2010 output affected by the measures. Iron and steel have been the hardest hit, and we believe this will translate into slightly stronger steel pricing. The very modest declines in copper and aluminium smelting should have little-to-no effect on global markets, as base metal smelters are already operating in an environment of low utilization rates as capacity build has exceeded mine production levels.
• While the impact of these measures on some of these industries has been notable in the short term, its impact as measured by industrial output is showing signs of fading now that the deadline for implementation has passed.
Chinese capacity to be phased out by 3Q10Capacity to be
• Inventory financing deals, in which producers and financial intermediaries take advantage of contango markets, persistently low interest rates, and abundant warehousing facilities, have been an important feature of base metal markets over the past two years.
• While such deals have been evident in nickel and zinc, they have been most persistent in aluminium, where oversupply has largely supported a full cost-of-carry contango term structure since late 2008.
• In our view, although these deals have tended to defer the necessity of eliminating excess capacity, they have provided ongoing price support by reducing metal availability. However, with expiry of some of these term financing arrangements, or as a result of flattening in the forward curve due to producer selling, the signs of change in aluminium financing deals are increasing as longer-term yields start to decline.
• In our view, continued oversupply and falling financing yields are driving a transition in the aluminium industry to an environment in which a small number of large physically backed exchange traded funds (ETFs) replace the current plethora of financing deals. We expect this development to start in late 4Q 2010 or 1H 2011.
Source: Thomson Reuters, Morgan Stanley Research
Yield on 3m, 15m and 27m Aluminium Financing Deals Yield on 3m, 15m and 27m Nickel Financing Deals
Base metal fundamentals to differentiate performance
Morgan Stanley Base Metals Outlook in Order of Preference
Source: WBMS, ICSG, INSG, ILZSG, Morgan Stanley Research estimates
Source: Thomson Reuters, Morgan Stanley Research
Relative Performance of LME Metals since Jan 2009
Commodities Outlook
• Base metals, having undergone a significant correction in 2Q and early 3Q 2010, are likely to show continued price appreciation in 2011-12.
• In our view, this reflects the combined influence of improving physical market fundamentals, continued investment demand, and, in some cases, inventory financing arrangements or ETFs.
• Our preference in this sector remains for those metals where the potent combination of sustained emerging market demand growth, limited refined production growth, and low inventories provides the basis for a sustained backwardation in nearby prices and elevated cash prices.
• In order of preference, the metals that will most likely meet these criteria are copper, tin and nickel.
• We are more cautious, at the present time, on those metals such as aluminium, lead and zinc whose markets will be slower to return to deficit and where supply discipline or restraint is noticeably less evident.
• However, we are cognisant that inventory financing deals in aluminium, or their successor in the form of physically backed exchange traded funds, will provide price tension and support, despite weaker fundamentals.
Precious Metals – the US dollar and gold back in focus
Relative Performance of Gold, Silver, Platinum and Palladium since Jan 2009
US Treasury Inflation-linked Securities vs Gold Price
Commodities Outlook
• We expect gold and silver to benefit strongly from continued investment demand for products that provide returns in either a deflationary or inflationary environment.
• In our view, investors have become increasingly concerned about the continued decline in consumer price inflation in the US and some other major developed economies, raising fears of a protracted period of deflation and low growth.
• This has raised demand for investments that retain real purchasing power in a period of falling prices and weak demand, while also providing protection against the return of future price inflation.
• This simultaneous fear of deflation and future inflation has its roots in the anticipated policy response to the current US growth environment, renewed quantitative easing (QE). The feared expansion in liquidity and currency devaluation that might accompany QE are also viewed as potentially inflationary, fuelling the demand for real assets such as gold and silver that preserve purchasing power.
• We continue to expect PGMs to benefit strongly from improved industrial usage in the automotive and chemical industries in the medium term, and from residual strength in the jewellery fabrication market in China, and constrained South African production. We also continue to favour palladium over platinum, given the growing signs of reduced Russian palladium sales from inventory.
Gold Price US$/oz (LHS) US 5-year TIP, yield % (RHS)
INVERTED SCALE
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Bulk Commodities – steel-making raw materials the key focus
Source: WSA, CEIC, Morgan Stanley Research
Commodities Outlook
• In steel-making raw materials, the close relationship between the Chinese steel price, the inventory cycle, and raw material prices has been cemented by the move to index-linked quarterly pricing. In turn, this has resulted in significantly more volatility in iron ore and coking coal quarterly price outcomes during 2010.
• Despite enhanced volatility, the trend of China’s rising dependence on imports for supplies of premium iron ore and coking coal products continues, as growing automotive production, further infrastructure growth, and expanding social housing programs have underpinned demand for crude steel.
• We expect that these trends, supplemented by developments in other emerging market domestic steel markets, will provide the basis for continued growth in iron ore and metallurgical coal demand and production over the 2010-2015 period.
• Anticipated delays in adding to future mine and logistics capacity are likely to underpin an elevated pricing environment in iron ore and coking coal for significantly longer than the current market consensus anticipates.
• Logistical constraints will also feature prominently in an elevated price environment for thermal coal, at least until 2013, we expect.
EU (27) US Brazil China India Japan South Korea Taiw an Export Spot Coking Coal (RHS)Spot Iron Ore (RHS)
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October 6, 2010Global Metals Playbook, 4Q10
Key risks to our viewCommodities Outlook
• Growth risks in China: While a soft landing scenario in China is now considered consensus, the most recent tightening measures designed to cool urban property markets indicate that spill-over risks to the broader economy remain.
• Growth and deflation risks in the US: The risk of sluggish growth and persistently high unemployment amid rising deflation risks, while not our base case view, could pose a material challenge to US economic recovery. The probability of QE 2 and its attendant medium-term risks could be higher than our base case indicates.
• Covert protectionism: The “race to the bottom” in foreign exchange markets is a covert form of trade protectionism and a sign of growing anti-globalist sentiment. This tendency, when coupled with other symptoms such as toughening anti- immigration policies, could harm the recovery in global growth and trade.
• European sovereign debt crisis: Recent developments in the Irish banking sector highlight the potential for this contagion risk to erupt once again, with negative implications for a broad range of risk assets. e = Morgan Stanley Research estimates Source: Morgan Stanley Research
Base Metals:Period
Bull Base Bear Bull Base Bear Bull Base Bear Bull Base BearUS$/lb US$/lb US$/lb US$/lb
Still underperforming – despite the rise in cancelled warrants
Source: Thomson Reuters, Morgan Stanley Research
LME Aluminium Cancelled Warrants
Although prices strengthened in the final stages of 3Q 2010, aluminium remains the clear laggard of the complex in 2010. LME 3-month aluminium ended Q310 at US$1.06/lb (US$2,345/t) while copper was at US$3.65/lb (US$8,035/t). The last time copper traded at this level, aluminium was around US$1.30/lb (US$2,900/t).
Although LME stocks have slowly declined to their lowest level since 2Q 2009, there is more to this story than a simple pick-up in demand. A sharp move in cancelled warrants during September fuelled speculation of an imminent launch of a physically backed ETF. In our view, while such a product may excite some investors, the existence of a physical fund is unlikely to transform the fundamentals of the market despite an anticipated relocation of exchange stocks into these funds. While a successful launch of a physically backed aluminium ETF would, as now, have a price- tensioning impact, over the longer term, we expect the weaker fundamentals of the global aluminium market to undermine absolute and relative performance in aluminium, and ultimately affect investor returns.
e = Morgan Stanley Research estimates Source: CRU, WBMS, Morgan Stanley Research
Primary Aluminium Market Balance vs Price, 2002-2015e
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YTD Avg Aluminium Price Suggests 98% of Producers Remain Profitable
Aluminium
Despite continuous market speculation over the potential for a tightening market as a result of inventory financing deals and forced capacity shutdowns in China, our estimate of 2.9Mt growth in global production this year compares unfavourably with a 2.5Mt increase in demand. We estimate that 2010 will be the fourth consecutive year of global market surpluses, a fundamental trend that has necessitated the innovation of inventory financing deals to forestall a significant fall in prices below marginal costs. This development has come at the cost of a fundamental and effective purging of excess capacity from the global aluminium industry.
Monthly output in China has shown modest declines after peaking in May – an encouraging sign given an anticipated market surplus of 1.4Mt this year. Despite these cutbacks, we forecast output in China will increase 26% this year vs 2009. While we expect provincial energy rationing to temporarily limit output growth, we also are fearful that if recent price strength carries through 4Q 2010, producers will be motivated to ramp up again.
Source: CRU, Morgan Stanley Research
Global Production Has Consistently Outweighed Demand since 2006
0 4000 8000 12000 16000 20000 24000 28000 32000 360002010 cos t curve, US$/lb
Marginal cos t, US$/lb
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Cumulative production (Kt)
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SGA market balanced but wary of aluminium oversupply
Source: CRU, Thomson Reuters, Morgan Stanley Research
Chinese Production and Imports of SGA vs Price, 2007-10
Alumina
e = Morgan Stanley Research estimates Source: CRU, WBMS, Morgan Stanley Research
SGA Market Balance vs Price, 2002-15e
Smelter-grade alumina (SGA) prices firmed throughout 3Q 2010 on a lack of near-term availability and higher aluminium prices. Average prices for Caribbean and Australian material rose from US$300/t in July to US$338/t in September 2010.
Slowing Chinese output could dampen the outlook in the coming quarter, but non-China demand should remain robust. We expect Chinese output growth to slow on energy-saving initiatives and forced shutdowns. At the same time, non-China output – particularly in Asia – remains steady on rising smelter output.
Contract negotiations for 2011 appear headed for a 15.8% imputed linkage rate, although discussions between refiners and smelters are focussed not only on price but also on the pricing basis. This suggests to us that the move away from historical linkage rates to index-linked spot pricing is continuing, with a likely upward bias to price outcomes in coming years.
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M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
* Total exchange stocks, unwrought producer, consumer, port and merchant stocks at period-end as reported by IAI and WBMS e = Morgan Stanley Research estimates Source: IAI, WBMS, CRU, Morgan Stanley Research
Note: Exchange stocks include LME, SHFE and Comex. Source: Thomson Reuters, Morgan Stanley Research
e = Morgan Stanley Research estimatesSource: Brook Hunt, ICSG, Morgan Stanley Research
The copper market surprised even the strongest bulls by defying traditionally weak 3Q inventory and pricing trends. We've retained our conviction that supply/demand fundamentals remain the strongest in the complex, and we have raised our price profile accordingly. We now expect calendar year (CY) average prices of US$3.31/lb (US$7,300/t) in 2010 and US$3.60/lb (US$7,940/t) in 2011.
LME stocks have fallen every month since February, including a rare drop in August, a month when inventory almost always rises. Shanghai exchange stocks ended the quarter at their lowest level of the year. While the sustained recovery in global demand contributed to this trend, tighter market conditions are primarily a function of supply constraints.
Production downgrades from some of the world’s highest-profile operators (BHP Billiton, Freeport McMoRan, Kazakhmys, Antofagasta among others) have accelerated an already extraordinarily tight concentrate market. The ensuing drop in spot TC/RCs (treatment charges and refining charges) prompted a number of smelters to cut production this year and next and consequently led us to significantly increase our previously forecast global market deficit for 2010 and 2011.
MS Copper Supply/Demand Balance vs PriceCopper Exchange Stocks by Region:
Decline Has Been Regionally Broad-based
Copper
-1,000.0
-800.0
-600.0
-400.0
-200.0
0.0
200.0
400.0
600.0
800.0
2001 2003 2005 2007 2009 2011e 2013e 2015e0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
Apparent Surplus/Deficit (LHS) Average Annual LME Copper Price (RHS)
Source: ICSG, Brook Hunt, Morgan Stanley Researche = Morgan Stanley Research estimates Source: Thomson Reuters, Morgan Stanley Research
Coupled with weak supply growth, resilient demand has pushed the stock-to-consumption ratio nearly back to pre-GFC levels, a remarkable feat given market expectations for a protracted economic recovery. The latest statistics from the International Copper Study Group (ICSG) show the global market recorded a 281Kt deficit in H1 2010. Although supply-side factors are the primary contributor to the deficit, non-China demand has surprised to the upside. Consumption in the first half was up 5% YoY in the US, 12% in the EU and 37% in Japan.
In hindsight, China’s massive imports during 2009 not only signalled strong demand there but also left the rest of the market worryingly short of metal, particularly at a time when many consumers around the world have been operating at threadbare inventory levels. Apparent consumption in China is up just 3%, but as this figure includes imports, 2010 will be another record year in demand for refined metal. Scrap availability is becoming increasingly problematic for producers, which also helps explain why refined imports remain so strong – to the benefit of prices.Total Commercial Stock to Consumption Ratio,
Success of new laterite projects the key to future market balances
Nickel remains one of our most preferred exposures in the base metals complex, given our expectations for a tightly balanced market for the remainder of this year and into next. The mark-to-market effect has led us to increase our CY 2010 price expectation by 5.2%, to US$9.90/lb (US$21,820/t); we have also increased our 2011 forecast, to US$10.75/lb (US$23,700/t). Moreover, while we believe nickel pig iron (NPI) production will continue to impart a ceiling on average price performance, we think China’s longer-term energy conservation goals will lift costs of production and thus curtail NPI output.
The execution of the supply pipeline will likely dominate the degree of price strength in the coming quarters, with risks skewed to the upside against any project delays. Following the return of Vale Inco’s Sudbury operations, the global nickel market will depend on the success of a number of technically complex and high-cost new and brownfield laterite projects.
Nickel
Source: Brook Hunt, Morgan Stanley ResearchSource: INSG, WBMS, Morgan Stanley Research
Nickel Stock-to-consumption RatioThe Nickel Market Depends on the Success of a Small Number of Laterite Projects
Project (Kt) 2011e 2012e 2013e 2014e 2015eOnca-Pum a (Brazil) 11 28 48 57 63Bar ro Alt o (Brazil) 16 28 39 45 50Goro (New Caled on ia) 22 40 52 60 63Larym na (Greece) 15 19 22 24 26An t am (Ind onesia) 65 73 75 77 79Soroaka (Ind onesia) 85 90 99 101 102Total New/Expansion 214 278 334 364 383% Share Glob al Prod 13% 15% 17% 19% 20%MS Market Balance -1 25 57 15 7
Total commercial stocks (LHS) Stock to consumption ratio (RHS) Avg ratio
Kt Days
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M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
Stainless steel production back above 2007 peak levels
After dipping to a 2010 low of 116Kt in late July, LME nickel inventories recorded a modest 5Kt rise by the end of September, signalling a return to traditional seasonal market patterns during 3Q. We expect inventories to resume a declining trend in the coming quarter as stainless steel production accelerates.
According to the top European stainless steel makers, demand fell 10-20% in 3Q, but is poised to pick up in 4Q. According to the International Stainless Steel Forum, stainless steel output returned to pre-crisis levels in H1 2010. While the destocking cycle appears to be over and inventory levels have normalized, according to the stainless producers, increased order inflow indicates some consumers believe the global economy is strengthening. Total stainless production is currently forecast to increase by 20.7% in 2010, to a new record of 30.3Mt, of which 72.2% is estimated to be in austenitic grades. The modest projected increase in the market share of ferritic steels is consistent with a strong production recovery in the global automotive industry.
Nickel
Source: CRU, Thomson Reuters, Morgan Stanley Researche = Morgan Stanley Research estimates Source: Brook Hunt, Morgan Stanley Research
Global Stainless Steel Production on Road to Sustained Recovery
LME Nickel Price vs Benchmark East Asian Stainless Steel Price
China’s Robust Production Growth Is Pushing the Global Lead Market Balance Further into Oversupply
Lead
Source: ILZSG, Brook Hunt, Morgan Stanley Research
Lead Stock-to-consumption Ratio, 1996-2010
LME lead delivered one of the top price performances of the quarter on stronger than expected demand in Europe and the US, although a small build in inventory over the period ensured the market remained in surplus. We nevertheless upgraded our price outlook in line with the generally positive tone for industrial and auto demand and are now expecting prices to average US$0.95/lb in 2010 (US$2,100/t) and US$0.97/lb in 2011 (US$2,145/t).
After showing positive signs in the first half of the year, the decline in the stock-to-consumption ratio stalled in Q3 as Chinese refined production reached a record high in August. Although China’s aggressive production growth profile over the next two years will help work off the lion’s share of the concentrate surplus, the primary refined market will likely remain oversupplied until 2012.
Rolling 12-month balance (LHS) YoY chg in global refined production
Kt
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M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
Shanghai Futures Exchange lead contract imminent
e = Morgan Stanley Research estimates Source: Thomson Reuters, Morgan Stanley Research
China Trade Position in 2010 Has Been Benign, But Imports Could Increase with SHFE Contract
Lead
Source: CRU, Morgan Stanley Research
Lead End-use Demand Breakdown, 2009
We remain concerned that some of the rebound in demand was a result of stimulus policies in many parts of the world designed to reignite auto markets, and we expect consumption growth to slow into next year. However, we are constructive on the longer-term outlook for end-use, particularly in emerging markets on the back of greater uptake in battery use.
One important development in the global lead market is the imminent launch of a lead futures contract on the Shanghai Futures Exchange, with the timing most likely early in 2011. The move will be a welcome development, as it will increase the visibility of the metal within China, but will also serve as an important investment tool for smelters to hedge their price risk. We understand that Chinese producers have been stockpiling metal in anticipation of this development; a lead contract could also mean greater inflow into the country, as the investment community will also become involved.
Source: ILZSG, Brook Hunt, Morgan Stanley Research
Rolling Zinc Market Balance vs Consumption Growth, 2002-2010
Zinc
Source: ILZSG, Brook Hunt, Morgan Stanley Research
Zinc Stock-to-consumption Ratio, 1996-2010
Zinc fundamentals remain the weakest of the base metals, with global inventories at the beginning of 4Q sitting essentially where they began 3Q3 – the highest in 15 years. Nevertheless, prices climbed in concert with the rest of the complex, and, as a result, we increased our 2010 calendar year estimate to US$0.96/lb (US$2,130/t) but kept our 2011 price unchanged at US$0.99/lb (US$2,170/t).
Similar to aluminium, the phenomenon of inventory financing has ensured that prompt physical markets remain tight, as illustrated by strong regional premiums and low spot TCs. According to Metals Bulletin, around 50% of zinc inventories are likely tied up in long-term inventory financing deals.
While we expect these conditions to underpin the global market over the next year, we think consumption will finally catch up to production by 2012. We forecast an 8.2% CAGR in demand in the BRIC economies for 2010-15. However, we believe prices will continue to underperform relative to other LME metals until we see clear evidence of a reversal in current inventory trends.
Total commercial stocks (LHS) Stock to consumption ratio (RHS) Avg ratio
Kt Days
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M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
* Percentage change in zinc usage per percentage change in industrial production** Europe excl. PP on 51% Zn gradeNote: Total commercial stocks as reported on a revised basis by the ILZSG at period-end; non-commerical stocks held in the US stockpile are excluded, as disposals are treated as an additional source of refined supply.e = Morgan Stanley Research estimates Source: ILZSG, CRU, Morgan Stanley Research
Investment demand the price driver on currency debasement fears
Source: WGC, GFMS, Morgan Stanley Research
• Identified and implied investment demand has increasingly become the main driver of demand in the gold market. Since 2002, investment demand as a percentage of total demand has increased from 14% to 41.4% in 2009. We expect these percentages to rise further, to 46.9% in 2010 and 48.9% in 2011. In Q2 2010 alone, investors bought 274t of gold via exchange traded funds (ETFs).
• This development is predominantly a measure of fear regarding the purchasing power of the world’s major fiat currencies, especially the US dollar and the Japanese yen. In our view, investors have become increasingly concerned about the risk of a protracted period of deflation and low growth in the developed world. This has raised demand for investments that retain real purchasing power in a period of falling prices and weak demand.
• However, judging by the flood of money into inflation-adjusted government bonds as well as gold, investors are also worried about future inflation. This paradoxical fear of current deflation and future inflation has its roots in the anticipated policy response to the current US, Japanese and European growth environment. Most notably, gold investors are concerned about renewed quantitative easing (QE) and an anticipated expansion in liquidity and currency devaluation that is also viewed as potentially inflationary, fuelling the demand for real assets that preserve purchasing power.
Total Gold Investment Demand vs Gold Price, 2000-09
Reduced central bank sales add to the bullish outlook
e = Morgan Stanley Research estimates Source: WGC, GFMS, Morgan Stanley Commodity Research
Gold has been a particular beneficiary of this safe-haven demand since the US FOMC alluded to the possibility of renewed QE in the minutes of its September 2010 meeting. However, this allusion also coincided with resurgent fears over the European sovereign debt crisis following news of higher bank bailout costs in Ireland, rating downgrades in Spain, and concerns regarding capital adequacy of European banks following the publication of Basel III guidelines.
In addition, despite these resurgent fears over European sovereign debt and the health of some European banks, European central bank net sales of gold actually fell in the first year of the third Central Bank Agreement on Gold, to only 6.2t. Given purchases by non-European central banks, the official sector is likely to be a net buyer of gold in 2010, and net selling will probably be smaller than previously anticipated.
As a result, we have raised our 2011 gold price forecast in our base case by 14.3%, to an average US$1,315/oz, and in our bull case, which anticipates a more aggressive level of dollar weakness and a protracted period of negative real interest rates, we have raised our price forecast to US$1,512/oz from US$1,380/oz.
Net Gold Producer Hedging vs Gold Price, 1998-2010e
Gold
e = Morgan Stanley Research estimates Source: WGC, GFMS, Morgan Stanley Commodity Research
Market to tighten on sustained investment and fabrication demand
Source: Thomson Reuters, Morgan Stanley Commodity Researche = Morgan Stanley Research estimates Source: GFMS, CRU, Morgan Stanley Commodity Research
On the back of our upgrade to gold price forecasts, we have also lifted our average silver price expectations, to US$18.47/oz in 2010 and US$20.23/oz in 2011. At the same time, we are forecasting the gold/silver ratio will normalize to the long-term level of 63:1, meaning a slight outperformance versus gold over the next two years.
Investment flows have continued to support prices amid the sovereign debt crisis in Europe, with tonnage in the largest ETF climbing to just 3% below its all-time peak. Silver’s enduring safe-haven demand has helped offset the sharp decline in total fabrication demand that has come about in recent years as a result of not only the impact of the global financial crisis on jewelry, electronics and other end-use markets but also the structural decline in photographic demand driven by the growth in digital photography.
However, a recovery in fabrication demand is now under way as a result of improved economic conditions. We expect the combination of investment and fundamental demand to support prices at 30-year highs in 2010 and 2011 before easing safe-haven demand amid improved economic conditions in 2012 takes the edge off elevated prices.
Global Silver Supply/Demand Balance and Price, 2000-2015eGold/Silver Ratio, 2000-2010
Silver
40.0
50.0
60.0
70.0
80.0
90.0
Oct-00 Oct-02 Oct-04 Oct-06 Oct-08 Oct-10
Average Ratio
2000-2008 Avg = 61.1
2009-present Avg = 66.2
-2000
-1000
0
1000
2000
3000
4000
5000
6000
2001 2003 2005 2007 2009 2011e 2013e 2015e-
5.00
10.00
15.00
20.00
25.00
Fundamental Balance (LHS) Silver Price (RHS)
tonnes US$/oz
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M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
e = Morgan Stanley Research estimates Source: CRU, GFMS, Silver Institute, Morgan Stanley Research
Platinum Group Metals Fundamentals still favour palladium over platinum
We continue to view palladium as the most likely of the three major platinum group metals to return to deficit despite the fact that we have trimmed our 2010 platinum, palladium and rhodium forecasts by 2%, 1%, and 2%, respectively, to adjust for Q3 outcomes. For 2011, we have adjusted our price forecasts by -3%, +3%, and -9%, respectively, reflecting our preference for palladium in this skew.
For our forecast view on palladium to materialize, a cessation, or material reduction, of Russian strategic stockpile sales will have to unfold. Even with such a reduction in supply, large above-ground stocks still exist in Switzerland that are likely to provide some initial protection against a material supply-side price squeeze, at least in the early stages of the current economic recovery.
e = Morgan Stanley Research estimatesSource: Johnson Matthey, GFMS, CRU, Morgan Stanley Research
e = Morgan Stanley Research estimatesSource: Johnson Matthey, GFMS, CRU, Morgan Stanley Research
Palladium Production by Country, 2002-15e Global Palladium Balance, 2002-15e
Global Balance (LHS) Production (RHS) Consumption (RHS)
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M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
Global Autocatalyst Demand, 2004-2014e
Palladium
Palladium Consumption by End Use, 2002-15e
Physical demand underpins investor appeal
Demand for palladium from autocatalytic converters is likely to outpace platinum demand as the economic recovery continues, since vehicle production growth is stronger in palladium-intensive regions such as China, the US, and other emerging markets.
In the near term, we expect this demand dynamic to be reflected in investor/speculative positioning rather than underlying physical demand, as the market is still in surplus. This dynamic should result in elevated volatility. We also view heightened investor interest as a sign of anticipated recovery in economic activity more than an indication of safe-haven precious metal appeal. The recent Chinese government decision to extend tax subsidies on automotive purchases should also be supportive of real demand and speculative interest.
e = Morgan Stanley Research estimatesSource: Johnson Matthey, GFMS, CRU, Morgan Stanley Research
e = Morgan Stanley Research estimatesSource: Johnson Matthey, GFMS, CRU, Morgan Stanley Research
Autocatalyst (net) Jew ellery Investment Chemical Electrical Dental
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M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
¹ Before 1986, Chemical demand is included in Other estimates.² Between 1986 and 1998, Chinese demand is included in our Rest of the World estimates.e = Morgan Stanley Research estimates Source: Johnson Matthey, Morgan Stanley Research
Demand for platinum: We see the platinum market as requiring support from investor/speculative interest in anticipation of a tightening market in the near term to maintain upward price momentum. On a medium-term view, we expect that the price support from auto and industrial demand growth required to squeeze out price-elastic jewelry and investment demand will be positive for pricing. We think these demand developments will outpace supply growth in the medium term, with positive benefits to prices.
AngloPlat has indicated that it has flexibility to add 150-200koz pa to its 2010-2011 target of 2.5moz pa, depending on the demand environment. Besides being an indicator of the demand environment, we see this supply flexibility as tempering speculator interest in the sector. On 16 November, Johnson Matthey will publish its Platinum 2010 Interim Review. Of particular interest will be their observations on the demand/restocking environment for PGMs from the auto sector and palladium supply from the Russian strategic stockpile.
e = Morgan Stanley Research estimatesSource: Johnson Matthey, Morgan Stanley Research
e = Morgan Stanley Research estimatesSource: Johnson Matthey, Morgan Stanley Research
Platinum Production by Country, 2002-15e Global Platinum Balance, 2002-15e
Global Balance (LHS) Production (RHS) Consumption (RHS)
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M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
¹Before 1980, Investment demand is included in Other estimates.²Before 1993, estimates include Eastern Europe; for 1993 and subsequent years, demand in this region is included in European figures.e = Morgan Stanley Research estimates Source: Johnson Matthey, Morgan Stanley Research
According to our analysis, the rhodium market appears to have the greatest percentage surplus of the major platinum group metals. We do not expect the market to move out of surplus in the near term, and the lack of easy investment vehicles makes it very likely that rhodium will underperform the other metals in the complex.
Rhodium is the most price-inelastic of the platinum group metals on both the supply and demand sides of the price equation. Thus, while rhodium is in surplus, we expect the price ratio to platinum to trade near the low end of its historical range.
At current price differentials, the incentive exists to substitute rhodium for palladium in nitrous oxide reduction applications in autocatalytic converters. While this is likely to be incremental in effect and not an obvious driver of demand in the near term, we expect it to underpin longer-term market tightening.
e = Morgan Stanley Research estimatesSource: Johnson Matthey, Morgan Stanley Research
e = Morgan Stanley Research estimatesSource: Johnson Matthey, Morgan Stanley Research
Steel 4Q price recovery unfolding; mid-cycle returns forecast for 2011
Reduced Chinese Production lifts Pricing… Production has declined 8% from the May peak to August, or an annualized 54mn tons, and production is forecast to remain at reduced levels in coming months due to government efforts to de- emphasize energy intensive & highly polluting industry. Our recent field visits confirm that MIIT’s targeted steel closures, which represent 6% of the country’s capacity, are well under way. This is helping to lift Chinese and regional pricing in 4Q.
…and Cuts Exports: Net exports have declined 65% from the June peak to August, or an annualized 32mn tons, and exports are forecast to remain at low levels based on our view of production. This should help reduce global oversupply and set up for a rebound in pricing and profits to mid-cycle levels in 2011.
Our forecasts remain broadly unchanged. We see 2010 as a transition year from the lows in 2009 towards a stronger phase of pricing & profits in 2011-12. We forecast operating rates of 84% in 2011, which is where the industry more broadly regains pricing power. Our average global benchmark HRC price for 2011 is raised modestly to US$705/t.
e = Morgan Stanley Research estimates Source: Morgan Stanley Research
e = Morgan Stanley Research estimates Source: Morgan Stanley Research
Steel Demand remains robust in BRIC, but cutting US
Chinese Demand forecasts remain broadly unchanged. In China we maintain our 2011e demand forecast of 8%, in-line with our forecast of floor-space-under-construction (FSUC) growth. Construction activity in China has received a significant boost from the Social housing segment, which appears to be showing up with a recent bounce in YoY FSUC growth to over 20%.
Reduced Euro-zone concerns. In Europe, we also leave our demand forecasts unchanged (+5% for 2011e), on reduced Euro-zone concerns. While steel demand in Southern Europe is still weak, we see stronger demand support in Northern Europe, especially from the car and capital goods industry (37% of the EU27 steel demand).
Cutting US Demand. However, we are cutting our US demand growth for 2011e to 9% from 18% due to a slower than previously expected recovery in demand for construction related steel. Recent architectural billings data point to continued declines in steel-intensive construction spending, with a trough potentially occurring in mid-2011.
Inventories low. Finally, we note that inventories are still comparably low, reflecting stockists’ and customers’ concerns about of adverse price fluctuations and end-of-the year stock clearing activities in Europe and the US.
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October 6, 2010Global Metals Playbook, 4Q10
Global steel summary supply/demandSteel
e = Morgan Stanley Research estimates. Source: Steel Business Briefing, World Steel Institute, Morgan Stanley Research
Source: Bloomberg, Morgan Stanley Research* 2010 figures is annualized number based on January-Aug 2010 actual data. Source: Thomson Reuters, Morgan Stanley Research
Metallurgical Coal
Chinese import growth set to continue: A rapid rise in structural import dependence in China in 2009 saved the seaborne market from a significant surplus. We estimate that net imports of all types of metallurgical coal rose from 3.6Mt in 2008 to 33.8Mt in 2009. We expect this development to be sustained over the full five-year forecast period, as the factors driving it are structural as well as cyclical.
Key factors in this development are the continued growth in Chinese domestic blast furnace iron and steel capacity, the modernization and relocation of Chinese blast furnace iron facilities to eastern coastal and riverside locations, transport infrastructure challenges, and quality constraints for domestic coal producers.
Based on eight months of trade data, our current forecast is for gross Chinese seaborne imports of 44Mt of metallurgical coal in 2010, and net imports of 42.6Mt, a 26% YoY increase. We expect the net import tonnage to rise to 58.5Mt by the end of 2015.
The China effect is still strengthening, but at a slower rate
Chinese Metallurgical Coal Net Import Balance, 2004-2010
Source: Wood Mackenzie, Thomson Reuters, Morgan Stanley Researche = Morgan Stanley Research estimates Source: Wood Mackenzie, Morgan Stanley Research
Major Metallurgical Exporters to the Seaborne Market, 2002-15e
Supply to remain challenged: We estimate that crude steel output in India and China will rise from a combined 623Mt in 2009 (China 566Mt, India 57Mt) to 908Mt in 2015 (China 796Mt, India 112Mt). This would lift demand for metallurgical coal from these two countries alone from 311Mt at estimated coke and PCI (pulverized coal injection) rates to 454Mt.
Infrastructure problems, especially in Australia, and limited supplies of premium hard coking coal, at a time when new large-scale blast furnaces require greater quantities of this material, will intensify pressure further in an already tight market. We are forecasting deficit seaborne markets until 2015.
We expect exports from Mozambique to the seaborne market to rise from 0.3Mt in 2011 to 8.2Mt by 2015. Mongolian imports into China are also rising quickly. Through August of this year, China imported 8.5Mt of metallurgical coal vs 4.0Mt for all of 2009.
Coking coal capacity growth to fall short of demand
Chinese Metallurgical Coke Exports vs Spot Price, 2004-2010
3Q China steel production cuts leave a cautious toneIron Ore
The new quarterly pricing structure appears to holding, despite some increased pressure for an even more rapid adjustment of contract prices with the Chinese spot market. Indicated 4Q 2010 contract prices for iron ore fines, basis 62% Fe, CFR North China are for a reduction of 13.8% from the level of 3Q 2010, reflecting the impact of weaker and more volatile spot pricing in 3Q as a result of reductions in Chinese crude steel output. This, in turn, reflects lower construction-related demand and a government drive to curtail energy-inefficient plants (see pages 13 and 52).
Weaker spot prices and enhanced volatility are symptomatic of a more cautious tone in the iron ore market, which has also been reflected in lower Chinese import volumes. An uncertain demand outlook appears to have encouraged steel mills to produce from stocks and delay purchases as domestic production of run-of-mine ore has passed the 1bn tonne level for the first time.
As mentioned earlier in this report, leading indicators of industrial output and construction activity are now suggesting that the worst of this adjustment has passed, a change that is also being reflected in resilient spot prices.
Chinese Pig Iron Production and Iron Ore Import Dependence, 2001-15e
Iron Ore and China HRC Prices and Forecast
Source: Bloomberg, Steel Business Briefing, Morgan Stanley Research
e = Morgan Stanley Research estimates Source: CRU, Steel Business Briefing, World Steel Institute, Morgan Stanley Research
100
200
300
400
500
600
700
800
170.8 268.3 412.5 470.7 596.4 680.4 745.040%
45%
50%
55%
60%
65%
70%
75%
Chinese Pig Iron Production (LHS) Chinese Import Dependency (RHS)
Spot Iron Ore CFR / MS Forecast, US$/t Spot China HRC, US$/t (RHS)
Morgan Stanley Forecast
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October 6, 2010Global Metals Playbook, 4Q10
Supply response has been strong, but not overwhelmingIron Ore
While demand has been uncertain, ore supply from the major exporting countries of Brazil and Australia has been rising faster than the overall seaborne market has. Although potentially negative, the impact of this development has been muted by a temporary reduction in Indian exports following an export ban on production from small mines in southern India and the seasonal impact of the monsoon season. We are forecasting a modest surplus of 6Mt in the seaborne market in 2010.
As we have previously noted, market developments in 2011 and 2012 are likely to be more positive than the currently cautious market tone suggests, as continued growth in Chinese and other emerging market steel production, difficulties in raising domestic ore grades in China, and anticipated slippage in the timetable for new mine project development combine to keep the seaborne iron market in close balance, at least until 2012.
We have left our price profile unchanged from the 3Q 2010 Playbook, but have increased our forecast lump premium to reflect an anticipated higher premium for direct charge materials in the Asian market.
e = Morgan Stanley Research estimates Source: CRU, Steel Business Briefing, World Steel Institute, Morgan Stanley Research
Global BOF Crude Steel Production, 2001-15e
e = Morgan Stanley Research estimates Source: CRU, Steel Business Briefing, World Steel Institute, Morgan Stanley Research
0.0
200.0
400.0
600.0
800.0
1000.0
1200.0
1400.0
2001 2003 2005 2007 2009e 2011e 2013e 2015e
Mt
China Japan Europe Russia and CIS North America Rest of World
Iron Ore Project Pipeline vs MSe Market Balancemillion tonnes 2010 2011 2012 2013 2014 2015
PricesAnnual Average Prices (JFY annual negotiated FOB price prior to 2010)Australian Iron Ore Fines price (USD$/t) 18.10 19.73 23.03 39.50 47.01 51.47 92.58 62.08 121.55 135.00 140.00 135.00 130.00 125.00Australian Iron Ore Lump price (USD$/t) 23.12 25.18 29.40 50.41 59.99 65.69 129.08 71.68 137.59 167.11 176.60 173.54 165.35 153.69
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October 6, 2010Global Metals Playbook, 4Q10
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October 6, 2010Global Metals Playbook, 4Q10
Mined Energy
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October 6, 2010Global Metals Playbook, 4Q10
e = Morgan Stanley Research estimates Source: China Customs Statistics, McCloskey Coal, Morgan Stanley Research
Chinese Net Thermal Coal Trade Balance, 2002-10
Thermal Coal
Source: McCloskey Coal, Bloomberg, Morgan Stanley Research
Regional Thermal Coal Prices vs Historical and Forecast Contract Prices
Chinese net import demand continues to underpin strong growth in the seaborne thermal market, increasing deficits and supporting high prices. At the end of August 2010, Chinese thermal coal imports were reported at 60.7Mt, compared with the full-year total of 57.6Mt in 2009. The annualized rate of imports for 2010 is now running at 91Mt, and we forecast further growth, to 119Mt of imports, out to 2015.
The other major long-term story in the thermal seaborne market has been the rise in Indian imports. This year alone, India is likely to lift its import volumes by 25.8%, to 73Mt from 58Mt in 2009. By 2015, growth in Indian thermal power generation capacity should raise import volumes close to 115Mt annually, a level that would match the anticipated size of the Chinese and Japanese markets at that time. Because of these developments and continued infrastructure-related supply constraints in the Asia/Pacific market, we are forecasting annual deficits in the seaborne market out to 2014.
China and India are key to the Asia/Pacific seaborne market
-60
-40
-20
0
20
40
60
80
2002 2003 2003 2005 2006 2007 2008 2009 2010e
Kt
Net Imports
Net Exports
0
20
40
60
80
100
120
140
160
180
200
Jan-02 Jul-03 Jan-05 Jul-06 Jan-08 Jul-09 Jan-11
US$/t
New castle Index Richards Bay Contract Thermal Coal
Morgan Stanley Forecast
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October 6, 2010Global Metals Playbook, 4Q10
e = Morgan Stanley Research estimates. Source: Wood Mackenzie, McCloskey Coal, Tex Report, Morgan Stanley Research
e = Morgan Stanley Research estimates Source: UxC, Morgan Stanley Research
Total Kazakhstan Production and Olympic Dam to Make Up 50% of Global Production by 2020e
Uranium
Source: UxC, Morgan Stanley Research
The combination of a constrained supply growth profile and international attempts to reduce greenhouse gas emissions gives the uranium market an attractive longer-term outlook. Although the current market appears adequately supplied, nearly balanced conditions leave the market vulnerable to supply shocks and/or new build announcements.
An adequately supplied market will greatly depend on a small number of large-scale projects. The steady, two- year erosion in uranium prices has translated into difficult mining breakeven points, particularly for new projects. With current prices restricting profits, reliable supply gains are increasingly dependent on Kazakh mines. In the longer term, the fate of BHP Billiton’s Olympic Dam expansion project should have a significant impact on the global uranium market.
Although relatively few nuclear plants have opened since 1990, new capacity is rapidly coming online, and the planned project pipeline is briskly increasing, primarily stemming from the emerging markets (China, India, Russia) but also among the developed economies that have concerns over carbon emission costs and energy supply security.
An adequately supplied market, but vulnerable to shocks
Existing and Projected Nuclear Power Plants to 2015
0
10
20
30
40
50
60
70
80
2010e 2015e 2020e
ROW Kazakhstan Olympic Dam
MtOp erat ing
Net Cap acit y
(Gw e)
New Builds
Net Cap acit y
(Gw e)
% Share New
Capacity
To t al Cap acit y
(Gw e)Asia & Mid East 116 85.7 97 101.0 65% 186.7E Europ e & Russia 68 48.6 28 24.5 16% 72.7West ern Europ e 129 122.4 6 12.3 8% 134.7Nor t h Am er ica 124 114.4 10 11.4 7% 125.8S Am er ica & Af r ica 6 4.6 5 5.5 4% 10.2
Total 443 376 146 155 530
66
M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
e = Morgan Stanley Research estimates. Source: UxC, WNA, Morgan Stanley Research
Kobe Steel (5406, ¥195, OW, PT ¥280) Relatively appealing short run, seeds of fresh growth for longer run
Why Overweight?
Expect top-line growth from appeal to emerging market demand via an independent growth scenario in areas including machinery, resource engineering, steel production plant, construction machinery and cast steel.
Emerging possibility of full entry to upstream business drawing on 3G iron reduction technologies.
Reversal from overly pessimistic scenario with fresh confirmation of bottom in steel product spot prices and real earnings capability for blast furnace steelmakers as a whole
Key Value Drivers
Recovery in line operating rates, and associated earnings contributions, with progress in adjusting inventory of specialty steel (mainly for automakers) and aluminum/copper rolled products
Effects of increased construction machinery manufacturing capacity in China and expectations of bottoming machinery orders
Potential Catalysts
Much scope for consensus forecasts to rise in lead-up to 1H results
Chinese inventory and news on steel product prices bear constant watching
Watch news flow relating to ITmk3 projects as an important catalyst
Key Risks
Renewed and serious economic weakening in F3/11 2H, imposing heavy costs as blast furnace operating rates fall
A sharp retreat by automakers and other key users from strategic expansion of emerging market output capacity could shut the door on prospects of demand growth for high-grade steel products and materialize risk of lower FV P/E.
Long delays in Vietnam project schedule
Source: FactSet, MorganStanley Research
Price Target ¥280 Derived from the base case. Set at P/E of 11x on F3/13e EPS, the Big 2’s average level in the peak period 8x and with a 3ppt premium (on par with historical premium vs. Nippon Steel) for growing expectations on contributions from iron resource business. Cross- checks to 12x on F3/12e EPS.
Bull Case ¥340
F3/13e EPS ¥26 x 13
Clear economic recovery, centered on Asian emerging markets. Rising volume focuses market attention on Kobe as a growth stock. Besides steel business, steady earnings contributions from construction machinery/machinery hasten earnings improvement. Valuation also earns a c.2-point premium over the base case for mounting expectations of source iron business contributions.
Base Case ¥280
F3/13e EPS ¥25.5 x approx. 11
We expect economic recovery to maintain the current moderate pace, centered on Asian emerging markets. Overall we see capacity utilization remaining at c.90%. We also expect the metal spread to be upheld as steel product contract prices move in line with raw materials prices.
Bear Case ¥150
F3/11e BPS ¥185 x 0.8
Here, weaker Asian emerging market growth necessitates output cuts. Uncertainty over margins curbs the expected growth rate. P/B of 0.8x is in line with the bottom for earnings slumps at leading blast furnace steelmakers.
WARNINGDONOTEDIT_RRS4RL~5406.T~
¥280 (+44%)
¥ 195
¥150 (-23%)
¥340 (+74%)
0
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400
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¥
Price Target (Oct-11) Historical Stock Performance Current Stock Price
70
M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
US Steel (X.N, $43.63, OW, PT $62) Risk-reward skewed to the upsideWhy Overweight?
We believe US Steel’s vertically integrated flat-rolled segment will generate operating margins above expectations as higher industry raw material costs push up pricing.
With Chinese tubular blocked from US markets and rising shale activity, we see $4.7 billion of value in X’s tubular segment, which we also believe is not in shares.
Our North American autos team believes US sales could rise to 14 million vehicles in 2011 (consensus is closer to 12 million). Above- consensus auto sales could add close to 2 million tons of incremental flat-rolled steel demand, X’s primary product.
Key Value Drivers
High fixed costs make US Steel’s earnings highly leveraged to the steel price; every $10/t move in HRC tends to move shares by $1.50.
Potential Catalysts
October scrap price: We expect the October scrap price to fall $20/t to $30/t, which may create an attractive entry point.
We expect the company to release weak 3Q10 results on October 26. We think that could be a “buy the news” event since is has been well flagged.
Risks
As a high-beta name, the stock is vulnerable to a broad market sell-off.
Overcapacity in the US market could limit pricing.
Imports may tick up as struggling international competitors attempt to dump steel.
Source: FactSet, MorganStanley Research
Price Target $62 Our $62 price target is based on the average of two methods of mid- cycle valuation. One method applies a 4.8x multiple to mid-cycle EBITDA of $2.6b, the other applies an 8.9x multiple to mid-cycle EPS of $7.45. These multiples are in line with historical averages.
Bull Case $86
9.2x 2010 EPS of $9.30
Strong rebound in real demand in 2011. The hot-rolled coil price per ton averages to $825 in 2011. Operating rates average 84%. Tubular earns $800m.
Base Case $62
13.6x 2011 EPS of $4.55
Real US demand gradually climbs, China production recovers in 2011. The hot-rolled coil price per ton averages $670 in 2011. Operating rates average 75%. Chinese steel production climbs 7% in 2011, causing global cost-push price hikes.
Bear Case $28
1.5x 2009 Tang. BV of $19
Double-dip recession; China production does not rebound. The hot-rolled coil price per ton falls to $585 in 2011. Operating rates average 70%. While X troughed at 1.0x tangible book value in March 2009, we believe improved liquidity will prevent a fall to similar levels in a double-dip.
$62 (+42%)
$ 43.63
$28 (-36%)
$86 (+97%)
0
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60
70
80
90
100
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$
Base Case (Oct-11) Historical Stock Performance Current Stock Price
71
M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
Fortescue Metals (FMG.AX, A$5.27, OW, PT A$6.88) Cash flow to support expansions
Why Overweight?
We expect iron ore markets to remain tight because of high-cost Chinese supply that is having difficulty maintaining production.
FMG has undertaken aggressive growth targets. Our valuation and rating are based on the company attaining 150mt/pa of production by 2015.
Key Value Drivers
The ability to convert resources to reserves to provide a long-life asset base.
Potential to increase production in the longer term and reduce unit costs across an essentially fixed cost base.
Movements in iron ore prices.
Potential Catalysts
On the upside, announcement from the FMG board on expansion to 90mt or more.
Announcement of contracts to expand the production base, including rail and port facilities.
On the downside, any capital cost or schedule issues that could adversely impact cash flows
Key Risks
Shipped volumes vary from our forecasts.
Iron ore pricing is stronger or weaker than we forecast.
Production costs above/below our forecasts.
Source: FactSet, Morgan Stanley Research
Price target A$6.88 Price target is based on our sum-of-the-parts DCF valuation under our bull, base, and bear case assumptions weighted 20%, 60%, and 20%, respectively. In our model, we assume a WACC of 8.9% (risk-free rate of 6%, market risk premium of 5%, and beta of 1.3).
Bull Case A$9.09
20% Probability
Higher bull case commodity price assumptions, capex intensity is lower than we forecast and mine life extended: Iron ore peak price averages US$155/t in 2011.
Base Case A$7.54
60% Probability
Stable commodity price assumptions: Base case NPV valuation; increase in iron ore prices in 2010 of 110%, then a 12% rise in 2011, and a further rise of 4% in 2012. Long-term iron ore fines at US$61/t.
Bear Case A$2.67
20% Probability
Lower bear case commodity price assumptions, together with project delays and introduction of the Minerals Resource Rent Tax: Iron ore peak average price is US$119/t
in 2012.
WARNINGDONOTEDIT_RRS4RL~FMG.AX~
A$6.88 (+31%)
A$ 5.27
A$2.67 (-49%)
A$9.09 (+72%)
0
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2
3
4
5
6
7
8
9
10
Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11
A$
Price Target (Oct-11) Historical Stock Performance Current Stock Price
72
M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
Impala Platinum (IMP, R182, OW, PT R238) Sector-leading operating costs and discounted exposure to Zimbabwe
Why Overweight?
IMP suffered some productivity slippage at its core Rustenburg operation off a high base (but has shown a reversal off the H2’09CY trough) and continues to grapple with uncertainty regarding its Zimbabwe growth potential (although has moved forward with its phase II expansion).
Where IMP can outperform in the sector is due to its lower operating gearing (lower mining costs and its stable margin refining business) and thus is attractive to investors wanting exposure to the sector but wanting some protection against continued pressure on rand metal prices.
Key Value Drivers
We assume Zimplats grows to c.450koz Pt in 2020 and that Lease Area returns to c.1moz in 2014 (vs. 2010FY of 174koz and 871koz). We have strengthening conviction on delivery.
What’s in the Price
We estimate that the share price does not discount the Lease Area performance recovery, and applies at least a 40% discount to the Zimbabwe assets, and offers value on LT normalised margins.
We do, however, believe the stock discounts earnings recovery beyond 2011FY.
Potential Catalysts
Zimbabwe is a key catalyst – either political resolution or deterioration. This is the key differentiating potential driver for IMP in the sector.
Impala Lease Area – delivery on shaft projects and Merensky development and productivity.
Macroeconomics – reduced risk of double dip global recession is a key driver of risk appetite, metal prices and platinum equities as geared play on metals.
Source: FactSet (for historical price data), Morgan Stanley Research estimates
Price Target R238 Derived from base-case scenario. SA ops at 1xNPV and Zim ops at 0.6xNPV (but assuming growth to 450koz at Zimplats
by 2020).
Bull Case R278
Implies: 1xNPV of all ops
Upside from Zimbabwe discount unwind: Besides upside to rand metal prices, potential upward revisions exist from unwind of the 40% discount we apply to the Zimbabwe asset.
Base Case R238
Implies: 1xNPV of SA ops and 0.6x for Zim ops
Base case is 1xNPV of SA ops and 0.6xNPV of Zimbabwe assets. Assume LT real prices: Pt $1700/oz, Pd $567/oz, Rh $4250/oz.
Bear Case R138
Implies: Ave 1xNPV and 15x 2011CY PE
Downside from near-term earnings focus. Besides downside to rand metal prices, we see downside risk from further dilution in Zimbabwe (increased discount from 40% to 50%), or if market starts to focus more on 2011 P/E vs. NPV.
WARNINGDONOTEDIT_RRS4RL~IMPJ.J~
ZAR238.00 (+31%)
ZAR 182.25
ZAR137.76 (-24%)
ZAR278.70 (+53%)
0
50
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150
200
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300
Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11
ZAR
Price Target (Oct-11) Historical Stock Performance Current Stock Price
73
M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
Tata Steel (TISC.BO, Rs667.75, OW, PT Rs865) Steel prices shaping up well; Indian operations approaching a step up in growth
Why Overweight
Tata’s attempts to instill sustainability to its Corus operations seem to be progressing fast. We believe investor sentiment will improve materially in the next three to four quarters on this front.
We have a positive stance, more so than the Street, on steel prices
Indian operations will likely act as the short-term earnings drivers – we expect EBITDA growth of 27% in F2012 and 26% in F2013. Tata India should contribute about 70%, 65%, and 65% of consolidated EBITDA in F11-F13.
In F2H11 and F2012, we expect Corus to likely drive an earnings surprise as well as a stock re-rating as it shows sustainability in its margins around levels substantially ahead of market expectations. We expect EBITDA per ton of US$68t in F2011 and US$97/t in F2012.
Valuation of 4.3x F2012e EV/EBITDA seems to reflect an unduly dim view on Corus and on steel prices.
Key Value Drivers
Steel prices (on 1% increase, F2011E EPS rise 9%); raw material costs;
Successful Corus cost cutting; pace of Indian expansion project; attempts for raw material self-sufficiency at Corus.
Catalysts
Healthy steel exports data from China
Quarterly results in F2H11; evidence of sustainability in Corus earnings
More clarity on J’pur project in mid-C2011, progress on mining projects
Key Risks
Steel prices pull back sharply, property sector curbs in China, 3mt project in India is delayed substantially
Government intervention in steel pricing in India or increase in taxes
Sensex takes a dip following the recent rally
Source: FactSet, MorganStanley Research
WARNINGDONOTEDIT_RRS4RL~TISC.BO~
Rs.865 (+30%)
Rs. 667.75
Rs.385 (-42%)
Rs.1081 (+62%)
0
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1,200
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Rs.
Base Case (Oct-11) Historical Stock Performance Current Stock Price
Improving Corus, Strong Steel Price Trends are Key
Price Target Rs865 We value the stock by applying separate DCF models to three businesses: 1) the Jamshedpur plant; 2) Orissa project; and 3) Corus and other operations. We apply a WACC of 12.8%, risk premium of 6.5%, and risk-free rate of 7.86%.
Bull Case Rs1,081
12.8x Base Case F11E EPS
Steel price outlook improves further: 1) Steel prices higher than our base case by 10% for F2011 and 5% for F2012; and 2) Corus manages to curb costs by US$50/t vs. our base case of US$40/t in F2011.
Base Case Rs865
5.9x Base Case F11E EPS
Full pass-through by exposed steel makers: 1) F2011 and F2012 average prices for Indian steel operations of Rs34644/t and Rs37144/t, respectively; 2) average realization for Corus to rise by 19% in F2011 and 7% in F2012; and 3) increases in raw material cost per ton of 27% in F2011 and 5% in F2012.
Bear Case Rs385
4.6x Base Case F11E EPS
Steel prices weaken again, project delays: 1) Indian steel prices and Corus steel prices are lower than our base case by 15% in F2011 and 10% in F2012; 2) Orissa project fails to take off due to non-allocation of mines and other procedural issues; and 3) iron ore and coking coal prices are higher by 10%.
Shares are trading at 8.5x P/E and 5.0x EV/EBITDA 2011e, a significant and unjustified discount to the sector, in our view.
Growth potential from organic growth programmes does not appear to be reflected in the stock price.
XTA is a binary call on the commodity cycle among the big-4 London-listed diversified miners, in our view. It has, on average, a higher-cost asset suite, making it more leveraged to commodity prices, which works to its advantage in the current environment of rising commodity prices.
What’s in the Price
Another way to gain comfort on downside risk is to look at the worst-case scenario, which we calculate at £7.6/share (£3.4 previous trough + £2.20 cost savings + £2 of de-gearing) implying downside of c15% to our bear case against upside of 180% to our bull case.
Key Value Drivers
Cost transformations in Xstrata’s Nickel division could reposition the company from a third-quartile to a second-quartile producer.
Significant progress in the Zinc division by closing the high cost operations will have significant impact on company’s positioning.
Potential Catalysts
Changes in commodity prices; progress on growth projects; further bolt-on acquisitions in the medium term.
Key Risks
Execution risks to projects under development.
Regulatory risk of material changes in royalty or other taxation regimes.
Source: FactSet (historical price data), Morgan Stanley Research estimates
874
1574
2126584 37 79 115
437Price Target: 1574
0
500
1,000
1,500
2,000
2,500
BearCase
LowerCommodity
Price
Oz CarbonTax from
2012
RSPT inAustralia
BaseCase
Collahuasi1mt by2015
HigherCommodity
Price
BullCase
Price Target 1,574p
We set our price target of 1,574p at our base case DCF valuation using a WACC of 10% and LT growth rate of 2%. The key upside and downside risks are explored in our bull and bear case scenarios.
Bull Case 2,126p
We assume Xstrata’s copper operation Collahuasi reaches 1mt of production by 2012 and we also incorporate our global commodity team’s higher commodity prices in our numbers.
Base Case 1,574p
Set at our base case NPV valuation (assuming Copper at US$3.30/lb in 2010, US$3.60/lb in 2011 and US$1.95/lb in the long term; thermal coal at US$91/t in 2010, US$103/t in 2011 and US$70/t in the long term).
Bear Case 874p
We explore the downside risk in the stock by incorporating our global team’s bear case commodity price forecasts.
WARNINGDONOTEDIT_RRS4RL~XTA.L~
1,574p (+27%)
1,242p
874.00p (-30%)
2126.00p (+71%)
0
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2,500
Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11
p
Price Target (Sep-11) Historical Stock Performance Current Stock Price
POSCO has a strong competitive advantage (from technology; location and scale) giving it some of the highest margins found among its peers.
Its strategy aims to duplicate this advantage in new markets where growth potential looks promising, such as India and ASEAN. Additionally, its nearly debt-free balance sheet provides support to take advantage of opportunities.
We expect progress in the JV with India’s SAIL to be a major positive, as we believe the market is underestimating opportunities overseas, especially in India. We expect the Indian plant, using POSCO’s FINEX technology and SAIL’s low-cost iron ore to result in long-term earnings growth for POSCO.
Global steel markets look to be recovering into 2011-12 from cycle trough levels in 2009. Recent Chinese steel production cuts are lifting prices and reducing exports.
Key Value Drivers
Regional steel pricing: Regional steel pricing is set to bottom out on improving fundamentals. We expect global steel pricing to rise 9% in 2011.
Overseas opportunities: POSCO plans expansion in India, China, and Indonesia
Potential Catalysts
Finalization of JV with SAIL
Accelerated rebound in steel pricing
Key Risks
Slowing steel demand and falling pricing
Korean won appreciation against the US dollar
Source: FactSet, MorganStanley Research
Price target W650,000 Derived from our base case residual income model, which discounts our earnings forecast through 2021, normalized by a cost of equity of 12%. For shares trading in Korea, we use a risk- free rate of 5% and 6.5% risk premium, with a beta of 1.05.
Bull Case W850k
Implies: 10.5x bull-case EPS W80k
Stronger market and other positive scenarios: Normalized EPS of W80k, based on a bullish steel pricing environment. In addition, other accretive earnings scenarios (M&A and India project) add a total of W95k/sh to our valuation.
Base Case W650k
Implies: 10x base-case EPS W66k
Normalized EPS of W66k achieved by 2011: This is based on achievement of mid-cycle pricing/costs by 2011 due to steel market recovery. Volumes reach 40mt by 2012 from domestic growth strategy.
Bear Case W400k
Implies: 0.9x BV of W450k
Weak recovery through 2011: Steel pricing and profit remain depressed through 2011 due to oversupply and poor demand. Other negative scenarios, such as delays or cancellation of overseas projects, could deduct W 40k/sh from our valuation. Failure to reach cost-cutting target takes away another W40k/sh.
WARNINGDONOTEDIT_RRS4RL~005490.KS~
₩650,000 (+24%)
₩ 523,000
₩400000 (-24%)
₩850000 (+63%)
0
100,000
200,000
300,000
400,000
500,000
600,000
700,000
800,000
900,000
Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
₩
Price Target (Jul-11) Historical Stock Performance Current Stock Price
ENRC’s share price has a material impact on the value of Kazakhmys. Every 100p change in the ENRC share price adds close to 60p to the value of Kazakhmys. Depending on the value of the stub ex the market value of the ENRC stake, Kazakhmys occasionally provides a better way to play ENRC than ENRC itself.
Although Kazakhmys’ copper assets are not the lowest cash cost producers, they are still on the second quartile of the curve, thus giving operational leverage without exposing the company to burning cash in an eventual downturn. The company’s cheap valuation makes it our preferred pure copper play.
Key Value Drivers
Financing and leverage concerns have significantly faded after the recent stake sale of the power business and the significant FCF generated by the copper business.
Improvements in electricity tariffs in Kazakhstan provide further earnings growth potential beyond copper …
… however, the capex requirements to modernise the facilities reduce the value-accretion potential of the power business, despite the recent stake sale.
Potential catalysts
Potential bolt-on acquisitions in the non-ferrous metals in central Asia.
Completion of the feasibility study at Bozshakol by the end of 2010.
Announcement regarding the fate of the company’s stake in ENRC.
A potential sale of MKM, the German copper products business.
Q3 production results on October 28, 2010.Key Risks
Political risk associated with Kazakhstan.
Source: FactSet (historical price data), Morgan Stanley Research estimates
944
177 7
24 70
5 8 82 4 5
38 43 0 9Pric e targe t : 1,7 7 7
0
5 00
1,0 00
1,5 00
2,0 00
2,5 00
Be a rC as e
L o we rC om mo d ityP rice & N o
Co stIm prove m en t
L o we r E NRCvalua tio n
B aseCa se
Hig h er E NR Cva lu atio n
High e rC om mo d ity
P r ice
B u llCa se
WARNINGDONOTEDIT_RRS4RL~KAZ.L~
1,777p (+22%)1,461p
944p (-35%)
2,470p (+69%)
0
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1,000
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2,000
2,500
3,000
Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11
p
Price Target (Sep-11) Historical Stock Performance Current Stock Price
Price Target 1,777p
We set our price target of 1,777p at the base case DCF valuation, using a WACC of 11.3% and a LT growth rate of 2%. The key upside and downside risks are explored in our bull and bear case scenarios.
Bull Case 2,470p
Reflects our bull case ENRC valuation and flexing Kazakhmys operations on our bull case commodity price assumptions.
Base Case 1,777p
Based on base case NPV valuation (Copper at US$3.30/lb in 2010, US$3.60/lb in 2011 and US$1.95/lb long term).
Bear Case 944p
Based on bear case ENRC valuation and flexing Kazakhmys operations on our bear case commodity price assumptions.
77
M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
Mechel (MTL.N, $25.21, OW, PT $30.00) Attractively valued; should continue to benefit from strong coking coal demand in Asia
Why Overweight?
Coking coal is fundamentally strong which should drive the stock to our PT. Strong fundamentals should continue to drive coking coal prices up. We expect Mechel, which exports most of its output, to be one of the main beneficiaries. The stock is our top pick with implied upside potential of 19%.
Key Value Drivers
Strong coking coal demand from Asia should continue to benefit Mechel, which ships over 4mn tonnes of hard coking coal concentrate from Yakutugol. Exports will increase with the launch of the Elga project.
Low cash costs. The company has one of the lowest cash costs for coking coal concentrate (just $33/t in 2Q10, on our estimates) vs. the current spot price of $190/tonne fob Vostochny.
Bluestone Coal could add >7mn tonnes of hard coking coal starting 2013 (22% of total production) to the group, with the potential to lower cash costs to $60/t from $89/t in 2Q10.
Universal rail and structural mill. The project will increase rolling capacity to 1.1mn tonnes of high-value-added rolled steel products, including high-speed rails and long products.
Posiet port capacity expansion to 12mn tonnes by 2011 from c. 3mn tonnes to handle Mechel’s increasing coal export shipments.
Potential Catalysts
Rebound in spot coking coal prices (current price level is $200/t, down from $255/t in June).
Key Risks
High leverage: Mechel’s total debt was $6.4bn as at June 30, 2010 (net debt to 2010e EBITDA of 3x – among the highest in our coverage universe). But, it has unused credit lines of $490mn and $1.7bn of revolving credit facilities.
Fluctuations in coal and steel prices.
Source: FactSet (for historical price data), MorganStanley Research estimates
$30.00 (+19%)$ 25.21
$16.83 (-33%)
$45.74 (+81%)
0
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$
Price Target (Oct-11) Historical Stock Performance Current Stock Price
Price Target $30.00
Derived from base-case DCF (WACC of 13.1%, risk free rate of 7% and Russian/FSU equity risk premium of 7%, terminal growth rate of 1%).
Bull Case $45.74
Higher steel and coal prices: Prices in the steel, mining and ferroalloy divisions are 10% above our base case assumptions across our forecast period (2010-14). We include the Elga coking coal/Vanino port projects; 100% coking coal utilisation rates at Yakutugol; Bluestone coking coal cost/production optimisation.
Base Case $30.00
Conservative commodity forecasts and no Elga: Average billet export prices of $600/t in 2011 and $640/t in 2012. Average coking coal export prices of $227/t in 2011 and $247/t in 2012. Average coking coal domestic prices of $156/t in 2011 and $171/t in 2012. We believe the company will have to issue the remaining portion of already registered infrastructure bonds and commercial paper to be able to pay short-term debt, make interest payments and proceed with its capex.
Bear Case $16.83
Lower steel and coal prices, flat coal production from 2010 onwards: Prices in the steel, mining and ferroalloy divisions are 10% below our base case assumptions across our forecast period (2010-14). Coal production remains at 2010 level.
78
M O R G A N S T A N L E Y R E S E A R C H
October 6, 2010Global Metals Playbook, 4Q10
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Disclosures Section
Morgan Stanley ModelWare is a proprietary analytic framework that helps clients uncover value, adjusting for distortions and ambiguities created by local accounting regulations. For example, ModelWare EPS adjusts for one-time events, capitalizes operating leases (where their use is significant), and converts inventory from LIFO costing to a FIFO basis. ModelWare also emphasizes the separation of operating performance of a company from its financing for a more complete view of how a company generates earnings.
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Disclosures (cont.)The equity research analysts or strategists principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues.Morgan Stanley and its affiliates do business that relates to companies/instruments covered in Morgan Stanley Research, including market making, providing liquidity and specialized trading, risk arbitrage and other proprietary trading, fund management, commercial banking, extension of credit, investment services and investment banking. Morgan Stanley sells to and buys from customers the securities/instruments of companies covered in Morgan Stanley Research on a principal basis. Morgan Stanley may have a position in the debt of the Company or instruments discussed in this report.Certain disclosures listed above are also for compliance with applicable regulations in non-US jurisdictions.
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Disclosures (cont.)
Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months.
Analyst Stock RatingsOverweight (O or Over) - The stock's total return is expected to exceed the total return of the relevant country MSCI Index, on a risk-adjusted basis over the next 12-18 months.Equal-weight (E or Equal) - The stock's total return is expected to be in line with the total return of the relevant country MSCI Index, on a risk-adjusted basis over the next 12-18 months.Not-Rated (NR) - Currently the analyst does not have adequate conviction about the stock's total return relative to the relevant country MSCI Index on a risk-adjusted basis, over the next 12-18 months.Underweight (U or Under) - The stock's total return is expected to be below the total return of the relevant country MSCI Index, on a risk-adjusted basis, over the next 12-18 months.Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.Analyst Industry ViewsAttractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below.In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below.Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below.Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index.
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