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Morningstar | Glencore's 2H 2018 Profit Expected to Strengthen Despite Near-Term Price Headwinds. See Updated Analyst Note from 09 Aug 2018

Glencore's first-half 2018 net profit of USD 2.8 billion was 13% ahead of first-half 2017, but weaker than expected. This reflects relatively soft first-half production. Output and profit will skew to the second half with volumes for most of Glencore's key commodities expected to be more than 10% higher than the first half. The additional volumes will also benefit unit costs and margins as a high percentage of Glencore's costs are fixed in the near term.

Our 2018 and 2019 earnings forecasts are little changed at USD 0.57 and USD 0.45 per share and we retain our GBX 250 per share fair value estimate for no-moat-rated Glencore. The benefit of higher coal price assumptions is offset by reductions in the zinc, lead, and cobalt spot prices, leaving our fair value estimate unchanged. We now assume a cobalt price of USD 33 per pound, a zinc price of USD 1.25 per pound, and a lead price of USD 1.06 per pound, down 25%, 22%, and 11%, respectively.

Thermal coal prices have rallied since the beginning of 2016, with the current monthly FOB Australia price more than doubled from the depressed level of USD 50 in January 2016. This was boosted by China's supplyside reform, which limited coal supply by a 276-day production policy versus 330 days previously, as well as closures of small and inefficient coal mines. However, near-term demand has been stronger than we expected due to the recovery of industrial activity and extreme weather conditions. The latter boosted electricity demand for heating and cooling and limited hydropower output due to low waterflow. Coal-fired power generation in China grew 8% in first-half 2018. Longer term though, we expect China's demand for coal to slowly decline as energy production transitions away from coal.

In nominal terms, we've increased our forecast Newcastle export thermal coal price for calendar 2018 by 6% to USD 105 per tonne, in 2019 by 13% to USD 90 per tonne, in 2020 by 14% to USD 80 per tonne, and midcycle by 19% to USD 73 per tonne from 2021. The benefit of higher coal prices is partly offset by an assumption of commensurately higher cost in future.

While we're raising both our near-term and midcycle thermal coal price forecasts, we still see risks to the downside from current elevated spot levels of nearly USD 116 per tonne. At this level, thermal coal miners are highly profitable, and the price is trading well above the marginal cost, which we estimate at USD 68 per tonne in today's dollars. Key drivers of lower prices are capacity expansions in China, with repeal of the 276-day production constraints, growth in supply from Inner Mongolia, and loosening coal import restrictions. In addition, we think the improving coal rail-transport infrastructure, with China's new rail corridor, the Menghua line, commencing service in 2020, will also help to boost supply and flatten the cost curve. In the long-term, we think the decline in electricity-intensity of the Chinese economy and the shift toward an anything-but-coal energy policy will continue to dent coal demand and limit any material price increase.

Glencore's adjusted EBITDA of USD 8.3 billion was up 23% from the first half of 2017. A 35% increase in adjusted industrial EBITDA to USD 6.7 billion was the key driver of the result. The contribution from metals and minerals lifted 31% to USD 4.8 billion while energy products increased 19% to USD 2.2 billion. Higher prices for cobalt, nickel, coal, oil, zinc, and copper, delivered USD 1.9 billion of benefit with cost inflation and currency detracting by USD 0.7 billion. Production volumes were flat. The acquisition of the stake in Hunter Valley Operations benefited from May. The acquisition of the Hail Creek coking coal mine will also contribute from the second half.

Marketing EBITDA increased 10% to USD 1.6 billion, led by strong contributions from metals and minerals and energy products, up 17% and 23%, respectively. Trading volumes generally increased, and market conditions were favourable. Agriculture was the weak spot with margins and volumes suffering from poor seasons in Australia and Argentina. However, profits from Agriculture make the smallest contribution to the marketing division and Glencore is still tracking to the upper end of its long-term USD 2.2 to USD 3.2 billion EBIT marketing guidance range.

Full-year industrial volume guidance is little changed with just a small 2% reduction for coal to 132 million tonnes and 5% lower lead guidance of 285,000 tonnes. However, lead is an immaterial contributor to group revenue. Cost guidance has increased for copper to USD 1.03 per pound. There is a small reduction in zinc guidance to USD 0.24 per pound from USD 0.27 per pound previously with second half volumes expected to be stronger. Glencore also expects stronger coal margins of USD 44 per tonne in 2018 reflecting the sale of Tahmoor and the acquisition of the ex-Rio Tinto Hail Creek mine and the Hunter Valley Operations. Higher coal prices are also a benefit with Glencore assuming an average thermal coal price of USD 112 per tonne from Newcastle.