As China is turning into a global price setter for coal, the latest surprise devaluation of CNY should impact coal more than iron ore, notes Goldman Sachs Group Inc (NYSE:GS).

Christian Lelong and Amber Cai of Goldman Sachs in their August 14, 2015 research note titled: “Iron ore fundamentals unscathed by weaker CNY” believe iron ore prices have a further 30% to fall over the next 18 months.

CNY devaluation to have muted impact on iron ore market

Lelong and Cai point out that among bulk commodities, coal is particularly exposed to the CNY devaluation, as the rest of the world relies on Chinese imports to balance the seaborne market. They note imported coal must be priced competitively against domestic coal, thereby turning China into the global price setter.

On the contrary, the Goldman Sachs analysts reckon the impact of the recent currency devaluation by China on the iron ore market is likely to be muted. The analysts believe the unexpected FX tailwind will be welcomed by domestic miners, though imported ore will continue to displace Chinese concentrate.

Tracking the recent price movements, Lelong and Cai point out that iron ore prices increased 2% wow to $57/t as persistent concerns about Chinese demand were offset by low inventory levels and the potential of supply disruptions at import terminals in Tianjin. The analysts note while metallurgical coal prices dropped slightly to $85/t, thermal coal prices remained flat wow at $59/t.

The following table captures the bulk commodities snapshot:

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Taking a closer look at iron ore prices and export activity, Lelong and Cai point out that exports from Brazil and Australia have often disappointed in the past four months. The analysts note volumes were consistently strong in June, but levels dropped once again at the start of the third quarter:

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Recovery in steel margins

Delving deeper into steel, the Goldman Sachs analysts point out that low inventory levels in China leave buyers exposed to further supply disruptions such as the explosion at a chemicals warehouse near the port of Tianjin that is likely to hinder the supply chain of local steel mills. The analysts reckon steel producers no longer have a buffer of surplus inventory to cushion the impact of sporadic supply disruptions, and iron ore prices have been hovering above the marginal cost of production.

As set forth in the following graphs, iron ore prices have also benefited from a rebound in steel prices as profit margins bounce back from record lows, while supply is likely to diverge further from demand in coming months as China enters a seasonally weaker period of steel production:

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Taking a different view from market consensus, Lelong and Cai believe that peak steel production will be followed by a contraction, with ongoing urbanization and development leading to lower consumption per capita. The analysts argue weaker commodity currencies are partly responsible for a 35% decline in their estimate of marginal production costs over 2014-16.

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The analysts point that the depreciation of the CNY pales in comparison to that of the A$ and the BRL. Lelong and Cai believe iron ore prices must undershoot relative to marginal production costs in order to correct the oversupply in the market. The analysts argue that after a relatively calm summer, the next phase of balancing will require a further 30% drop in iron ore prices over the next 18 months.

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