Commodities Comment. Solving the met coal problem GLOBAL. Latest news

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1 GLOBAL LME cash price % change US$/tonne day on day Aluminium 1, Copper 5, Lead 2, Nickel 9, Tin 20, Zinc 2, Cobalt 55, Molybdenum 14, Other prices % change day on day Gold (US$/oz) 1, Silver (US$/oz) Platinum (US$/oz) Palladium (US$/oz) Oil WTI USD:EUR exchange rate AUD:USD exchange rate LME/COMEX stocks Tonnes Change Aluminium 1,863,050-14,250 LME copper 279,875-4,025 Comex copper 130, Lead 181,425-2,850 Nickel 374,964-1,512 Tin 3,510 0 Zinc 370, Source: LME, Comex, Nymex, SHFE, Metal Bulletin, Reuters, LBMA, Macquarie Research, April April 2017 Solving the met coal problem Since the announcement of prolonged Queensland rail outages in the aftermath of Cyclone Debbie last week, there have been a number of coal consultant projections of 2011-style supply outages and $300/t met coal prices. However, we think there are various factors which buffer against this. To be clear, in the short term the spot price for met coal will certainly go up, and perhaps quite rapidly. We d expect producers with spare coal to target a scarcity premium in the Indian spot market, given this region is most exposed to Queensland supply. This once again highlights that a commodity such as met coal will always be more exposed to potential supply shocks given its lack of geographical supply diversity vis a vis peers, given ~50% of seaborne tonnage comes from Queensland. However, given actual damage to mines is limited, the overall production loss from plan may be relatively negligible. And assuming full capacity is restored on the rails in time, there should be a period of shipment catch-up after the outage. Add to this the fact that US met coal is already back in the market plus supply in China looks ample at present (meaning potential coke exports), while buyers are less brand sensitive than in the past, and we are looking more at a price spike than any prolonged price shelf. We may also see some upside in scrap prices as a second order effect. Meanwhile, although there is much less impact on the thermal coal market, given Pacific Basin pricing was already on the rise pre-cyclone, this does make a relatively high annual benchmark price for JFY contracts more likely. Latest news US car sales disappointed in March, adding to the unease that the economy is not as good as survey data suggests. The seasonally adjusted annual rate fell to 16.6m, the lowest in over two years, and down 0.3% YoY, the third consecutive month of YoY contractions. For the industry, our US autos analyst argues that it is a healthy dip, with incentives (discounts) modestly lower MoM. For palladium demand, however, we can t see any upside, especially as small sedans gained market share. Things look better in Europe. From early national data releases we estimate Eurozone car sales were up 11.3% YoY. But this will have been flattered by two extra selling days in most markets, meaning the underlying increase was probably ~3%. A full reckoning of the European market will need to wait until Thursday, when the UK, which in March accounts for nearly one-third of the European market, reports sales data. With that caveat, the diesel share looks to have continued its downward slide, with the % market share in the big four Eurozone markets falling to 47%, from 48.9% in February and 51.3% a year previous. More bad news for platinum. In the Grasberg copper mine saga, PT Freeport Indonesia (PTFI) has been awarded a temporary special mining licence by the mining ministry, which should allow it to resume exports until October 10 th. We have been here before, the government made the same announcement back in February, but this time the arrangement does not mandate signing up to the new IUPK licence (and abandoning the existing COW contract), even if talks by the October expiry do not result in a longer term agreement. The latest deal thus looks more likely to prompt a temporary restart of exports, but this does require final permitting from the Trade Ministry which has yet to happen. Bloomberg quoted a spokesperson for PTFI as saying that exports were likely to resume soon. We estimate Grasberg s disruption at ~125kt so far of contained copper. Please refer to page 6 for important disclosures and analyst certification, or on our website

2 Q109 Q209 Q309 Q409 Q110 Q210 Q310 Q410 Q111 Q211 Q311 Q411 Q112 Q212 Q312 Q412 Q113 Q213 Q313 Q413 Q114 Q214 Q314 Q414 Q115 Q215 Q315 Q415 million tonnes Macquarie Wealth Management Solving the met coal problem Since the announcement of prolonged Queensland rail outages in the aftermath of Cyclone Debbie last week, there have been a number of coal consultant projections of 2011-style supply outages and $300/t met coal prices. However, we think there are various factors which buffer against this, most notably that the damage is to infrastructure (which has excess design capacity and can thus catch-up) rather than mines such that we are looking at a short-term price spike rather than a prolonged price shelf. Rail outages do create a near-term bottleneck: The announcement by Aurizon that several of its coal haulage networks need repairs should not be understated. While there are ~50 operating mines in Queensland, there are only 4 major rail networks serving the Bowen Basin. And of these, the ~110mtpa Goonyella corridor to Dalrymple Bay and Hay Point coal terminals make up the majority of capacity, and this is the one facing the longest repair time. Aurizon state that repairs will take 3-5 weeks, while there may be speed restrictions in place after completion. In the near term, there will be efforts to reroute coal with Aurizon's backing. However this will likely be at the margin given the Blackwater system already operates close to capacity. With the addition of the Northern Missing Link (post the 2011 floods) there is the potential to use Abbot Point, but we view this as only really an immediate option for Glencore given they already use the terminal, and even then it does tie up valuable railcars in longer hauls. There will be port stockpiles to offer a window of continued shipments in the very near term. The experience of 2011 shows it took 3-4 weeks for exports to drop markedly after the floods. This highlights the overreliance on Queensland for seaborne met supply: At ~135mtpa, Queensland makes up roughly half of global seaborne met coal exports. And while this is small relative to the Chinese domestic market, it is highly important in global price setting. With this, met coal will always be more exposed to potential supply shocks given its lack of geographical supply diversity vis a vis peers, with the shortages of 2008 and 2011 fresh in the memory. Fig 1 Q saw a 15mt QoQ drop in Australian met shipments as a whole lost 26mt over 2010 Fig 2 The seaborne met coal market is highly reliant on Queensland Australian Quarterly met coal exports Mozambique, 2% Russia, 5% Share of global met coal exports, 2016 US, 12% Canada, 10% Other, 5% New South Wales, 19% Queensland, 48% Source: ABS, Macquarie Research, April 2017 Source: Customs Data, Macquarie Research, April 2017 Look to Indian buyers for panic: With little hard coking coal domestically to speak of, Indian steel mills and coke manufacturers are highly reliant on supply from Australia. Last year Australian coal made up over 80% of Indian coking coal imports, while at 26% India was the largest destination for Australian hard coking coal exports (vs. 23% China, 16% Japan). Japanese buyers will not want to seem too desperate during contract negotiations, while the Chinese have alternative domestic suppliers. We would view Indian buyers, who have less developed relationships and greater reliance on spot tonnes, as the ones most likely to panic in the short term. We expect near-term spot prices to rise, and perhaps rapidly, as we expect producers with spare coal to target a scarcity premium in the Indian spot market. 4 April

3 Macquarie Wealth Management So near term, there is certainly scope for a price spike. And given this, contract discussions will be further delayed, with potential for a provisional contract price which may be reassessed in a month s time. However, we think there are several factors which may stop this being an event of 2011 s magnitude and longevity (it took seven quarters for the price to return to pre-flood levels then). Demand environment is good, but not 2011 good: While supply quite rightly received the headlines during the Queensland floods of , at the same time global steel apparent demand was running up ~8% YoY, with all major regions contributing. Scrap was tight, iron ore was tight and coking coal prices were already in excess of $200/t FOB prior to the floods. Both China and ex-china were strong. At the moment, much of the same is true but growth rates are over a very weak base. We don t see the same scope for desperation among steelmakers as there was back in 2011, as order books aren t quite as good. Buyers are inherently more flexible: Part of the reason for this is that coal buyers have adapted their strategies post Previously, coke oven managers perhaps used only one or two different blends of coal, making them inelastic buyers during outages. When certain of these coals simply weren t available in 2011, they had to become more flexible in terms of blending different types of coal, making them less prone to panic. Swing suppliers are already primed: When Australia has been disrupted previously, there has been a short lag while US coal (and other swing supply) reacts to higher prices. This time round, given where prices have been, US coal is already in the market and looking for a home. From 28mtpa in Q3 2016, Q is set for a ~45mtpa run rate for US exports. Meanwhile, the recovery in Mongolian supply is helping to alleviate any potential concerns Chinese buyers may have. Infrastructure capacity allows catch up: This is the biggest factor to consider for the view beyond the short term. Queensland coal shipments are ~195mtpa. Total rail capacity is ~235mtpa. Port capacity is ~255mtpa. Thus, mine output is the bottleneck, and by all accounts the lasting impact of the cyclone is limited. While this coal may not have a route to market at present, when it does given infrastructure has only been operating at ~80% capacity there is plenty of scope for catch-up. Obviously there are some operational and geographical considerations which may limit full utilisation, but at present we would expect overall annual exports to be more or less the same, just the timing of these exports dependent on when the rails are back up and running. We believe many of the consultants are assuming short-term problems are lost forever logic and simple mathematics would suggest this won t be the case. Chinese coke exports will likely rise: In the aftermath of the 2011 floods, China switched from a ~60mtpa net met coal importer to balanced external trade in a three month period, helped by a strong export arbitrage. While we don t expect to see met coal exports in the near term, given coke inventories are relatively high and steel output looks to be peaking, elevated coke exports are certainly possible. Back in 2011 a 40% export tax on Chinese coke was an impediment to these this tax no longer exists. 4 April

4 Macquarie Wealth Management Fig 3 We see spare capacity in the infrastructure chain relative to mine output Fig 4 US met coal exports have recovered to ~45mtpa owing to the Q price rise Queensland coal capacity Mtpa US seaborne met coal exports Thermal Moura Newlands Blackwater Abbot Point Gladstone Met Goonyella Hay Point DBCT Mine Rail Port Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: C&M, Macquarie Research, March 2017 Source: C&M, Macquarie Research, March 2017 Some scope for scrap substitution: Steelmakers who are worried about availability of met coal may well choose to turn back blast furnace output slightly and blend more scrap into the basic oxygen furnace to compensate. This is particularly true as scrap still looks relatively cheap versus iron ore. Thus the second order effects of this outage could be a rebound in the iron ore pellet premium and maintenance of the 62% premium over 58% iron ore, plus higher global scrap prices which would in turn push US steel prices higher. Thus all in all, after a short-term spike on this rail outage, we feel there are many mitigating factors which could see a rapid return to normality once the Goonyella corridor is back online. And the impact on annual shipment volumes would be relatively limited. It would essentially be a case of too little coal now, too much coal into mid-year particularly should this encourage more swing capacity into the market. We would also be wary of any new projects being sanctioned on the back of any price jump (as happened in 2011), given our medium-term trend is still for slightly negative met coal demand growth CAGR. We still expect a spot price return to ~$ /t by year end. What would be the risks to this normalisation view?: There are perhaps three main ones. Firstly that infrastructure repair takes longer than expected, either due to future weather events or more severe damage than currently assessed. This would certainly prolong any period of higher prices. Secondly, as happened in 2011, once the rails are back up and running we find that mines were actually more impacted. This would mean tonnage losses on an annual basis. Lastly, was China to also start restricting met coal supply again as they did last year, this could create a double impact in the market should China need to once more pull on imports. This could certainly see pricing back at $300/t, but we would view this as a low probability event given China s desire for stability this year. Knock-on benefits to thermal: While Queensland is naturally met-heavy, there is also a lesser thermal coal impact. It is worth bearing in mind that met will be given priority on restarted rail. Moreover, unlike met, Chinese inventories for thermal are low at key importers, hence the recent price strength in the Pacific Basin pre-cyclone. The fact that PCI availability out of Australia was already tight and has been disproportionally impacted in terms of the Goonyella outage may also see increased volumes of thermal cross over into the met market (we would also expect to see increased demand for Russian anthracite). This makes our forecast of $87.5/t FOB Australia for the Japanese fiscal year contract more likely, particularly given the relatively high thermal quality in Queensland. 4 April

5 Macquarie Wealth Management Tuesday 04 April 2017 Prices Closing price * Closing price * 04-Apr Apr Apr Apr-17 % ch. day 2017 YTD Ave 2016 US$/tonne US /lb US$/tonne US /lb on day US$/tonne US$/tonne LME Cash Aluminium 1, , ,774 1,605 Aluminium Alloy 1, , ,570 1,555 NAASAC 1, , ,765 1,704 Copper 5, , ,576 4,863 Lead 2, , ,179 1,872 Nickel 9, , ,814 9,609 Tin 20, , ,160 18,006 Zinc 2, , ,658 2,095 Cobalt 55,750 2,529 55,750 2, ,449 25,655 Molybdenum 14, , ,582 14,453 LME 3 Month Aluminium 1, , ,778 1,610 Aluminium Alloy 1, , ,582 1,577 NAASAC 1, , ,785 1,725 Copper 5, , ,594 4,867 Lead 2, , ,183 1,878 Nickel 9, , ,868 9,657 Tin 20, , ,140 17,912 Zinc 2, , ,669 2,102 Cobalt 55,750 2,529 55,750 2, ,466 25,758 Molybdenum 15, , ,583 14,472 * LME 2nd ring price hrs London time. Year-to-date averages calculated from official fixes. Gold - LBMA Gold Price (US$/oz) Silver - LBMA Silver Price (US$/oz) Platinum - London 3pm price (US$/oz) Palladium - London 3pm price (US$/oz) Oil WTI - NYMEX latest (US$/bbl) EUR : USD exchange rate - latest AUD : USD exchange rate - latest 1,258 1, ,167 1, Exchange Stocks Change since last report Cancelled End-16 Ch. since (tonnes) 04-Apr Apr-17 Volume Percent warrants stocks end-16 LME Aluminium 1,863,050 1,877,300-14, % 854,925 2,202, ,125 Shanghai Aluminium 332, , % 0 100, ,604 Total Aluminium 2,195,376 2,209,626-14, % 854,925 2,302, ,521 LME Copper 279, ,900-4, % 115, ,825-31,950 Comex Copper 130, , % - 80,112 50,632 Shanghai Copper 307, , % - 146, ,778 Total Copper 717, ,344-3, % 115, , ,460 LME Zinc 370, , % 184, ,850-57,375 Shanghai Zinc 183, , % - 152,824 30,262 Total Zinc 553, , % 184, ,674-27,113 LME Lead 181, ,275-2, % 103, ,900-13,475 Shanghai Lead 72,218 72, % - 28,726 43,492 Total Lead 253, ,493-2, % 103, ,626 30,017 Aluminium Alloy 14,220 14, % ,980 1,240 NASAAC 129, , % 0 97,380 31,920 Nickel 374, ,476-1, % 96, ,066 2,898 Tin 3,510 3, % 335 3, Source: CME, LBMA, LME, Reuters, SHFE, Macquarie Research 4 April

6 This publication was disseminated on 04 April 2017 at 21:46 UTC. 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