Commodity Rally Not a Function of Costs or Demand – All on the Back of the Greenback Caustic Soda and TiO2 Vulnerable – Steel Should Follow Iron Ore

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 10th, 2016

Commodity Rally Not a Function of Costs or Demand – All on the Back of the Greenback

Caustic Soda and TiO2 Vulnerable – Steel Should Follow Iron Ore

  • We would have more faith in the recent commodity rally if input costs and demand were on the rise – but this is not true in either case
    • Expect another retreat for some of the prices and most of the equities
  • Coal pricing is down, which provides producers in China with continued low input costs
    • TiO2 remains considerably oversupplied and pricing remains subdued as capacity is added in China and not enough is being closed elsewhere
    • We have little faith in a caustic soda price increase holding in the second quarter also
    • Iron ore appears to be rolling over and is off its highs from earlier in the year; steel has not reacted accordingly as yet – it has lagged in the past but followed eventually
  • Global demand continues to trudge along
    • Outside of the US, the second derivative (change in the change) of year over year growth remains flat to negative
  • The US dollar is the wild card
    • Slower than expected pacing of interest rate hikes from the Fed, safety rally in the Yen conspire against dollar strength and offer support for commodities
    • This is the counterargument to the fundamentals but we defer to the fundamentals
  • Despite talk of curtailments in China, fresh lows in coal pricing are supportive of continued production there – news of strong demand in China likely includes the demand for export
    • We continue to believe the extent of the overcapacity in China is underestimated
  • TiO2 suppliers have been among the most sensitive to price movements and we think CC and TROX have downside risk back to the lows seen earlier in ’16 (~50% downside)
    • Another troubled commodity chemical stock, OLN, is also at risk of testing its lows as chlor-alkali pricing will likely remain depressed through Q2 at least and high debt levels will make equity more volatile
  • We have seen falling iron ore pricing precede a decline in steel prices several times over the past few years – if steel pricing comes under pressure we think US Steel (X) is notably vulnerable and could head quickly back towards $10 per share

Exhibit 1

Source: Capital IQ, SSR Analysis

Costs Down, Demand Dismal

Coal pricing at the Newcastle, Australia hub can be seen as a proxy for Chinese energy costs – that these prices have been on a steady downward trend for more than five years helps to explain the continued Chinese commodity overproduction.

Exhibit 2

Source: Capital IQ, SSR Analysis

Global GDP figures remain largely uninspiring. Of major economies, the second derivative (change in the change) of GDP growth was positive only for the US in Q4 ’15, and the margin of improvement is unimpressive. There is little sense of optimism that we are on the cusp of a breakout in any region of the world. Estimates out Friday point to the weakest quarter of growth in the UK since 2012.

Exhibit 3

Source: Bloomberg, SSR Analysis

More Trouble for Commodity Chemicals

TiO2 and chlor-alkali producers have been the most harmed by Chinese overproduction, and we look for these stocks to again be the first to feel the pain. We see price increases as unlikely in the near-term as capacity reductions in the West are not enough to offset increases in China – at least not yet. In one recent IHS publication they show global PVC operating rates declining through 2018, from current levels which are already the lowest in 30 years – the chart below shows EBITDA growth expectations for the TiO2 and Chlorine producers in the US – 2016 vs 2015 – we believe that no-growth or possible further declines are the most likely outcomes.

Exhibit 4


Source: Capital IQ, SSR Analysis

Recent History of Failed Metal Rallies

Most commodity price rallies in recent years have been short lived. There is the thought that the Chinese take advantage of any boost in pricing to flood the market, sending pricing to new lows. We have seen this time and again in iron ore, aluminum, and copper to a less pronounced extent.

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

(US) Steel Looking Vulnerable

Recent trends show steel pricing has lagged the change in iron ore pricing, but subsequently followed. Currently we see a situation where iron ore is rolling over again, but steel has plateaued after its recent rally. Shares of US Steel have traded higher along with steel pricing, but the stock has been equally if not more sensitive to downturns in pricing, and any sign of weakness in steel could send it back down again in short order.

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

Dollar a Wild Card and a Risk

Commodities generally rally in a weakening dollar environment and this is the real counterargument to our view today. We would continue to focus on the scale of oversupply versus the move in currency.

Exhibit 9

Source: Capital IQ, SSR Analysis

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