CBA: Iron ore to hammer nominal GDP, Budget

Via CBA today:

Australia’s key commodity prices to ease from here

We see Australia’s key commodity prices moving lower from here.
But despite lower commodity prices, Australia’s external sector should have another good year as export volumes continue to lift and the lower Australian dollar boosts our competitiveness.
An expected decline in the terms‑of‑trade will weigh on nominal GDP growth which we forecast to step down to ~4%/yr over the next 1½ years.

Overview

Australia’s external sector has been performing well despite momentum in the global economy slowing.  Solid trade outcomes have been underpinned by the unusually fortuitous combination of: (i) a lift in the terms‑of‑trade; (ii) a lower Australian dollar and; (iii) an increase in net exports.  We say unusual because the terms‑of‑trade and the AUD don’t often move in opposite directions (chart 1).

The improvement in our external position is reflected in the trade balance.  Australia has been posting big monthly trade surpluses.  And a first quarterly current account surplus was recorded in Q2 19 (i.e. the trade surplus was bigger than the net income deficit) since the mid 1970s.  We think that another current account surplus looks probable in Q3 19.  Looking further ahead, we expect solid trade outcomes to continue.  But our expectation is that commodity prices will trend lower which means that growth in export receipts will slow and so will nominal GDP growth.

This note is a summary of our views on Australia’s key commodity prices and higher level implications for the Australian economy.  Our detailed piece on The Outlook for Commodity Prices by CBA’s Mining & Energy Commodities Strategist Vivek Dhar can be found here.

CBA view on Australia’s key commodity prices to end‑2020.

Iron ore: Prices are forecast to ease a little from the current spot price of US$92/t to average US$85/t in the December quarter.  We expect prices to fall further through 2020.  Our forecast profile has the price of iron ore drifting lower to close next year at US$67/t.  Supply has recovered following disruptions earlier this year to production in Brazil and Australia.  Some key sectors in the Chinese economy that drive demand have also slowed.  Steel mill margins in China, which drive iron ore prices in the short term, continue to remain under pressure.

Coking coal: Premium coking coal spot prices declined more than 30% in the September quarter.  And some further modest falls look likely through to Q1 20.  From there we expect a modest recovery in prices as surplus concerns subside.  Our expectation is that the price of coking coal will average US$143/t in 2020 – significantly lower than prices of ~US$200/t from earlier this year.  China’s coal import restrictions remain the major drag on seaborne coking coal prices.

Thermal coal: Thermal coal prices have been on a downward trend this year driven by  i) coal‑to‑gas switching from low LNG spot prices, ii) weak power demand in Europe, iii) rising seaborne supply from Australia and Russia, iv) increasing supply from China and v) coal import restriction in China.  We expect thermal coal prices to track sideways between US$65‑70/t (6000kcal/kg, FOB Newcastle) through 2020.

LNG: With 70‑75% of Australia’s LNG exports tied to oil prices, we expect the fate of Australia’s realised LNG export price to broadly follow our Brent oil price outlook (with a 3‑4 month lag).  Our forecast profile for oil prices implies LNG prices will bottom by mid‑2020 at ~US$8.5/mmbtu, before rising slightly and stabilising at US$9.5/mmbtu in early 2021.  We expect oil supply to be matched with sagging demand via the OPEC+ alliance, who control ~45% of global supply.  The most notable risk for LNG prices lies in the spot market, where prices have fallen sharply from US$11.5‑12.0/mmbtu last September to spot prices of US$5.5‑6.0/mmbtu on surplus concerns as new supply comes online.

Implications

Our commodity price forecasts imply a downtrend in the terms‑of‑trade through to end‑2020.  Our model puts the terms‑of‑trade down by 7.9% in 2019/20 and down by 6.5% in 2020.  On the surface, this sounds like a poor result for the Australian economy.  But context is key.  In Q2 2019 the terms of trade sat 27.1% above its Q2 2016 trough.  So some retracement was always likely, particularly given the supply disruptions which kept the price of iron ore elevated were due to abate.

Nominal GDP growth, which is heavily influenced by commodity prices, is forecast to step down from 5.3% in 2018/19 to 3.9% in 2019/20 and 3.3% in 2020.  Such a result would see growth in Federal government revenue slow given the strong correlation between nominal GDP, the terms‑of‑trade and the tax take (chart 4).  This is broadly factored into the Government’s Budget assumptions.  Indeed the near‑term commodity price forecasts in the 2019/20 were a touch conservative and Government revenue to date has surprised to the upside.  An update of the Government’s commodity price forecasts will be in the Mid‑Year Economic & Fiscal Outlook (MYEFO) – scheduled for release sometime in December.

For the trade balance, the combination of rising export volumes but lower commodity prices means that the trade balance should shrink a little.  Notwithstanding, we still expect it to be sizeable compared to our recent history.  On the current account, we expect it to slip back into deficit from Q4 2019.  On our forecasts the deficit will average less than 1% of GDP through to end‑2020.  This will provide some support for the AUD.

From an investment perspective, the outlook for commodity prices remains supportive.  Commodity prices are still expected to sit above marginal cost for a lot of domestic producers and this should flow through to a lift in investment in the resources sector.  The latest ABS capex survey implies that nominal mining investment will rise by ~20% in 2019/20.  The RBA also expect resource investment to rise.  In the August 2019 Statement on Monetary Policy it was noted that, “mining investment is expected to turn around from being a drag on growth to making a material contribution over the latter part of the forecast period.”

It should be noted, however, that most of the investment slated over the coming years is linked to replacement production, where the investment decision is overwhelmingly compelling from a returns perspective. That is important because during the mining boom the lift in investment boosted production. That is not going to be the case in most instances this time around.

Risks

A heightened level of uncertainty in the global economy primarily driven by geopolitics means that the generic balance of risk to our forecast for iron ore, coking coal and thermal coal are all to the downside.

For iron ore, there is a reasonable risk that oversupply pressures push iron ore prices sharply lower to our end‑2020 forecast of US$67/t earlier than expected. Prices would then trend according to cyclical factors such as Chinese steel mill margins as the premium from the Vale dam disaster is eroded.

On coking coal, there is a material risk that China extends import restrictions through to 2020.  Downside risks to thermal coal stem from: i) policy‑driven decarbonisation; ii) China’s coal import restrictions extending through 2020; and iii) coal‑to‑gas switching encouraged by low LNG prices.  All three factors can significantly weigh on thermal coal prices.  Some seasonal support for thermal coal prices may be on the cards during the Asian winter period, but with economic headwinds elevated, we don’t expect these upside price risks to be notable.

For oil (and indirectly LNG), oil supply disruptions in the Middle‑East imply upside risks.  But we now consider these risks quite limited given the temporary price impact of the attacks on Saudi Arabia’s oil infrastructure last month.  While OPEC and allied producers continue to manage supply to prevent surplus threats, there is a risk that countries, particularly Russia, move away from supply discipline when the current accord comes for renewal in March 2020.  That is a key downside risk for oil prices.

Still too high, especially for coking coal but getting into the right ballpark. Nominal growth of 3.3% in 2020 will not be pleasant. That implies real GDP of 1.8% or so,  and the income impacts will be worse as wage growth falls away.

Recessionberg is going to have to cut spending to save his surplus!

David Llewellyn-Smith
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