A rise in the global population, growth in the Chinese economy, urbanization of other Asian countries and the increasing requirements of developed countries have created an unprecedented demand for industrial or base metals given their usage in a wide variety of applications in the construction and manufacturing businesses. However, of late, tepid global economic growth and a slowdown in the Chinese economy have emerged as major headwinds for the global metal industry.
Let's have a look at how some of the base metals have fared so far and the road ahead –
Iron Prices Going Downhill
Iron ore prices had a bullish run in 2013, in contrast to other base metals, thanks to heightened demand from steel end-consumers, particularly in the Chinese construction sector. However, the scenario changed dramatically in 2014. In March, the industry was dealt a severe blow, with iron ore prices suffering the sharpest one-day drop since the 2008-2009 financial crisis, tumbling 8.3% to close at around $105 per ton. This represented an 18-month low for iron ore prices.
Since the first quarter, iron ore prices had somewhat recovered but again plunged to $89 per ton in June -- the weakest performance since September 2012. In August, prices again slid below the $90 per ton threshold.
So far this year, the commodity has lost 33% of its value. Overall, prices have been impacted by myriad reasons such as excessive inventory along with abundant supply of iron as mining companies increased their output, as well as tight credit and slow economic growth in China. Global steel production, as per the World Steel Association, rose by a meager 2.4% in the first seven months of 2014, mainly dragged down by a slowdown in China's output that affected demand for iron ore, its main ingredient.
The lowering price trend has resulted in the closure of high cost iron ore miners and the reduction of exports from non-traditional suppliers such as Indonesia, Mexico and Vietnam. Falling iron ore prices have impacted the second-quarter results. Mining giant Vale S.A. (VALE - Analyst Report) reported a 15% plunge in its second-quarter profit due to the fall in prices of iron ore, its main product. However, its peers BHP Billiton Limited (BHP - Analyst Report) and Rio Tinto plc (RIO - Analyst Report) reported an increase in earnings mostly attributable to their cost reduction efforts which helped mitigate the effect of lower iron prices.
Threat of Oversupply Looms for the Iron Industry
There is a threat of oversupply in 2014 as major iron ore producers, Rio Tinto, BHP Billiton, Vale and Fortescue Metals Group Limited (FMG.AX) have ramped up production. They intend to continue exploring for iron ore in Australia despite lower growth forecasts for China and weaker iron ore prices, betting on continued strength in iron ore demand over the long term. Thus, Australia, the world's top exporter of iron ore, will rev up its shipments.
Brazil, the second largest explorer, will follow suit. Vale, which alone contributes almost 85% of Brazil’s iron ore, is expected to increase its iron shipments by 22% in the second half of fiscal 2014 compared with the first half. In case this excess supply is not matched by adequate demand, it will expose the market to a risk of further decline in prices.
Per the World Steel Association, global apparent steel use is expected to increase 3.1% in 2014, following the 3.6% growth in 2013. In China, apparent steel use had soared 6.1% in 2013 on support from government infrastructure investment. However, this year the government's efforts to rebalance the economy will lead to 3% growth in apparent steel usage in 2014.
An impending slowdown in China's growth is bound to affect prices as China is currently the largest producer of steel and consequently the largest consumer of iron ore, accounting for around 60% of the global seaborne market. Thus the mismatch between the excess supply and demand for iron ore will keep iron ore prices subdued in the near term.
Prices Regain in 2014 Following a Lull in 2013
In 2013, aluminum prices slid and particularly in the fourth quarter, London Metal Exchange (LME) aluminum prices fell to a four-year low, given the oversupply of the metal in the market (evidenced by large aluminum inventories in LME warehouses). Supply outpacing demand led to the dismal performance, which was aggravated by rising inventories.
After hitting a four and half year low of $1,675 per ton in February, the base metal has dramatically regained ground surging 24% to over $2,000 in August. The upward trajectory was driven by a 10% drop in LME inventories so far this year and tightening of aluminum supply due to production curtailments by aluminium producers. Furthermore, production cut down in Brazil, as electricity prices surged to records this year, led to the supply constraint.
Aluminum companies are benefitting from the rising aluminum prices. The world's largest aluminum producer, Rusal, swung to profit for the first time in the last five quarters. U.S. aluminum giant Alcoa Inc. (AA - Analyst Report) also reported better-than-expected results with adjusted earnings skyrocketing 157% from the year-ago quarter.
Future of Aluminum Industry Lies in Automotive and Aerospace Industries
After aluminum prices bore the brunt of chronic surplus, the global aluminum industry is going through a substantial change in the supply-demand picture. In the first six months of 2014, Rusal has effectively cut aluminum production by 10.8%. Likewise, Alcoa has taken up a number of restructuring measures (including closure of smelters) and is aggressively pursuing cost-cutting actions.
Alcoa, during the second quarter, completed the curtailment of 147,000 metric tons of smelting capacity in Brazil at Sao Luis (Alumar) and Pocos de Caldas. In August, Alcoa announced that it will permanently shut down its Portovesme primary aluminum smelter in Italy that will cut the company’s smelting capacity by 150,000 metric tons to 3.6 million metric tons a year. Alcoa has set the goal of lowering its position on the world aluminum production cost curve to the 38th percentile by 2016. Once all announced curtailments and closures are executed, Alcoa will have its operating smelting capacity reduced by 1.2 million metric tons, or 28% since 2007.
On the demand side, aluminum consumption is expected to improve on a global basis spurred by the automotive and packaging industries -- the key consumer markets. The automobile market is also becoming increasingly aluminum-intensive, given the metal's recyclability and light-weight properties. The global push to improve fuel efficiency in vehicles is expected to more than double the demand for aluminum in the auto industry by 2025.
The airline industry is also expected to boost demand for the metal. To capitalize on the lucrative aerospace market, Alcoa has agreed to buy U.K.-based leading jet engine components maker Firth Rixson, a significant milestone in its portfolio transformation strategy. It reinforces the company’s aerospace business and strongly places it to capture additional growth in this developing market through a broad spectrum of high-growth, value-add jet engine components. Alcoa’s recent $1.1 billion agreement to supply key parts (including forgings) for Pratt & Whitney’s engines also underscores Alcoa’s continued efforts to profitably grow its aerospace business.
Following China, which accounts for over 40% of the global aluminum consumption, India appears promising given its current low level of aluminum consumption and high urban population growth. With demand remaining strong and the industry pulling the reins on supply, the aluminum market is likely to witness deficits for a prolonged period which creates a supportive backdrop of high aluminum prices.
Copper Price Makes a Comeback
For the most part of 2013, oversupply, lack of demand and growing bearish economic outlook for China, the world’s largest consumer of copper, kept copper prices in check. During the first half of 2014, copper prices declined based on concerns about slowing growth rates in China and an outlook for higher near-term supplies. During the mentioned period, copper prices have averaged $3.14 per pound, down 8.2% over the prior-year comparable period.
In August, copper prices made a comeback, rising 3.3% last week amid signs of a strengthening economic recovery in the U.S which is expected to support strong copper demand, being the world’s second-biggest consumer of industrial metals. However, weakness in the Chinese economy will continue to be a drag considering that it accounts for about 40% of the world's annual demand.
Copper Demand Will be Driven by Pickup in Economic Activity
Along with excess supply that has depressed copper prices, miners have been plagued with rising costs. Copper companies have reduced their budgeted future capital expenditures, exploration and other costs and are looking to rid themselves of some of their saleable assets.
Notwithstanding the current volatility in prices, we have a long-term bullish stance on copper, supported by its widespread use, limited supplies from existing mines and the absence of significant new development projects. In the near term, prices will be influenced economic activity in the U.S. and other industrialized countries. Revival in demand from China will also act as a catalyst.
Sector Q2 Earnings Scorecard – Growth Picks Up
Within the Zacks Industry classification, the metals-ferrous and non ferrous industry falls under the broader Basic Materials sector (one of the 16 Zacks sectors). With all the companies in our coverage under the Basic Material sector having reported their results, the curtains have fallen on the second-quarter earnings. Overall, earnings increased 8.6% in the quarter on the back of 3.4% increase in revenues. Moreover, the Basic Material sector had a beat ratio (percentage of companies coming out with positive surprises) of 66.7% in Q2.
There has been a marked improvement from the first quarter of 2014 wherein sector earnings had declined 3.8% while revenues had nudged up 1.2%. This depicts a better picture compared with what we have witnessed in the recent quarters. For further details about earnings for this sector and others, please read our 'Earnings Trends' report.
Q3 & Beyond – Momentum to Continue
For 2014, earnings at the sector are expected to grow at a rate of 9.3% in the third quarter but decelerate to 6.9% in the fourth quarter. Overall, in 2014, the sector’s earnings are projected to grow 8.3%. In 2015, the growth will accelerate at a brisk pace to 19.3%.
Industry Ranking & Outlook – Positive on Aluminum and Copper, Neutral on Iron
Within the Zacks Industry classification, the iron mining and non-ferrous mining industries are broadly grouped in the Basic Materials sector (one of 16 Zacks sectors). We rank all of the 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available in the Zacks Industry Rank page.
The way to align the ranking and outlook from the complete list of Zacks Industry Rank for the 260+ companies is that the outlook for the top one-third of the list (Zacks Industry Rank of #87 and lower) is positive, the middle one-third (Zacks Industry Rank between #88 and #173) is 'Neutral' while the outlook for the bottom one-third (Zacks Industry Rank #174 and higher) is negative.
The non-ferrous mining industry features in the top 1/3rd with a Zacks Rank of #56 indicating that the outlook is positive. The iron mining industry features in the middle tier with a Zacks Industry Rank #108, indicating a neutral outlook.
Please note that the Zacks Rank for stocks, which are at the core of our Industry Outlook, has an impressive track record, verified by outside auditors, to foretell stock prices, particularly over the short term (1 to 3 months). The rank, along with Expected Surprise Prediction (ESP) (Read: Zacks Earnings ESP: A Better Way to Find Earnings Surprises) helps in predicting the probability of earnings surprises.
To Sum Up
At the onset of 2014, the outlook for industrial metals was bleak as increased supply and insufficient demand exerted a downward pricing pressure on commodities. But six months into the year, the situation has changed with once laggards -- aluminum and copper -- showing signs of revival. These base metals prices will improve on the back of growth in the U.S. and an improving global macroeconomic scenario, as well as an improved supply and demand balance. A positive Zacks Rank and projected earnings growth for 2014 instills optimism in the so far faltering non-ferrous mining industry.
On the other hand, a glut in supply and current high inventories will keep iron prices in check, justifying a neutral outlook for the iron mining industry. A revival of the Chinese economy and correction of the supply-demand imbalance will be instrumental in driving growth in the industry.