Australia's leading export earners under pressure

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Iron ore and oil prices have been savaged recently with negative ramifications for equity performance and Australia's export earnings and although the outlook remains uncertain, the prospects for the oil price are probably brighter than those for iron ore.
Iron ore is Australia's leading export, recording $66 billion worth of export income in 2014, while oil is an important benchmark for the price of Liquefied Natural Gas (LNG), which is our third-largest resource export, producing $18 billion worth of export income in 2014. Australian LNG exports are growing quickly, with export earnings expected to more than double over the next five years.

Iron Ore

Underlying iron ore demand continued to decelerate in 2015 with global steel production falling 2.9%, compared to growth of 1% in 2014. Chinese steel demand is core to the overall decline rate, with the Middle Kingdom's total steel production down 2.3% in 2015 and apparent steel consumption, or net exports, down 5.2%. The weakening Chinese property sector was the key driver, with new starts continuing to languish in Tier 3 and Tier 4 cities where significant inventory overhangs remain.

However, iron ore supply growth continues unabated. The major producers added roughly 160 million tonnes (mt) of supply over 2014 and an additional 80-100mt of low-cost supply growth was estimated to have entered the market in 2015. Anglo's Minas Rio is ramping up, Rio Tinto's 360 infrastructure was online by mid-year and Gina Rinehart's Roy Hill entered the market late in 2015.

Although 2016 is likely to be a similar story in terms of supply growth, issues at Samarco in Brazil and Roy Hill in Western Australia have tightened the market relative to expectations. New supply additions are currently expected to be about 40mt.
Low iron ore prices are eating into the cost curve in order to displace higher cost volumes and the price weakness also highlights the issue with using cost curve analysis to identify a perceived floor price. Iron Ore prices are expected to fall below the implied floor price until such time as the market is in balance. This is compounded by the apparent lack of rational economic behaviour by Chinese enterprises and the actual reduction in the cost curve, which is happening via weak currency and oil prices and producers sweating their assets.

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Oil

The oil market also remains under pressure, with the commodity declining a further 20% in the opening weeks of 2016.
OPEC continued its strategy to maintain production output levels despite current prices being below the fiscal breakeven oil price for many of their member countries. Saudi Arabia appears to have shifted from setting a price which wouldn't destroy demand to one aimed at curbing new supply, particularly from US shale producers. Despite recent commentary, an agreement between Russia and OPEC to cut production appears highly unlikely.

The oil market remains in oversupply, with inventories at record highs and likely to continue to grow near-term. This situation will probably be exacerbated by additional supply from Iran following the removal of international sanctions.

Nor have lower oil prices been a quick remedy for oversupply. US production has been especially resilient. The data continues to suggest that US explorers and producers (E&P's) have been able to maintain production despite steep capex cuts and heavy decline rates in their wells. We expect the combination of poor economics, capex cuts, hedge books rolling over and potential bankruptcies will finally result in significant declines in US shale output over the course of this year.

Despite all this, the medium-term outlook for oil looks relatively positive. This is primarily because oil demand growth is more influenced by emerging markets than by China, as opposed to the situation with most other commodities. Demand growth should also enjoy a potential tailwind from lower prices.

There has also been a significant reduction in E&P investment in Mexico, Brazil, the North Sea and China, while deferrals among higher cost deep-water and oil sands projects and high natural field depletion rates will likely reduce supply output levels.
At Ausbil Investment Management, we believe the favourable supply-demand equation should underwrite a recovery in oil prices over the medium-term.

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