MARKET MOVER REPORT – What should you do with your miners?
assess the current situation in the mining industry. We evaluate what lead to the ‘Mining Boom’ and
factors attributed to its subsequent collapse. We assess the outlook for Australia’s two largest iron ore
producers and find a number of positive factors for the companies. Finally, we uncover the outlook for the
industry going forward.
Background:
Iron ore prices are well down from their glory days, declining some 42% over the past
year and 79% from their peak pricing at US$194 a ton in February 2011.
Why have prices fallen so hard?
China initially led the “Mining Boom” via its rapid capital investment led economic
expansion. Demand for many basic materials rose sharply after 2000, driven by
China’s surge in industrial growth. The Chinese demand propelled a doubling of
global steel production in the last decade, the primary driver of iron ore demand.
However, over the past few years China’s growth rate has been moderating and as a
result the demand for ore is also falling.
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The attractive margins that the iron ore producers were archiving in their hay days
attracted a multitude of smaller higher cost producers to the industry. Over the
period of strong production growth from 2000, the diversity of iron ore supply
broadened sharply (see chart below) and accordingly, competition increased.
The larger iron ore producers have taken to expanding their capacity in order to gain
market share and push higher cost producers out of the market. This is leading to
excess capacity and driving prices down.
Australia Miners
Iron Ore prices currently sit around US$42 (AU$60) a ton. RIO and BHP are the lowest
cost producers in the industry.
High cost and/or low grade producers are beginning to fail, especially in china.
According to Shanghai Metals Market (or SMM), an increasing number of mines are
shutting down operations in China due to the recent price plunge. The SMM
estimates, the output of state-owned enterprises (or SOEs) should be only 136 million
tons in 2015 compared to 149 million tons in 2014.
This is good for the more efficient producers as it reduces the competition and
address the current supply/demand imbalances in the sector. believes that over
time, the industry will have undertaken a significant transformation. We envision a
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material industry consolidation with remaining players focusing on efficiency and cost
reduction. Survivalists will be lean and proficient producers focused on profitability
and returning cash to shareholders.
We believe RIO Tinto and BHP are well placed over the longer term. Both Australian
producers operate in the lowest cost quartile of producers and therefore remain
profitable even at current prices. BHP stated that it is trying to bring its cash costs
down to $15 per ton in fiscal 2016 from $19 in fiscal 2015 and RIO cash costs are
down 21% year-over-year (or YoY) to $16.20 per ton in the first half of 2015. Both
have estimated revenues in the order of US$32-33 billion for 2016 and while their
leverage ratios remain relatively high (RIO 35% and BHP 40%), it is acceptable given
the industry standard.
Over time as inefficient mines are closed by the high cost producers, we believe it will
provide an attractive opportunity for remaining players to acquire cheap assets and
further expand their total capacity. As prices recover this will lead to greater
profitability.
Further, declines in the AUD are a positive for the Australian producers as it directly
increases the amount they receive for their Iron Ore. The AUD has declined by almost
15% over the course of the past year. The declining AUD is helping to insulate
Australia miners for the fall in the iron ore price.
Oil is a significant production cost in the process of producing iron ore for miners.
With crude oil now at a 12 year low, it will further aid the efficiency of miners.
Outlook
The median, as compiled by Bloomberg, is for $50 per ton for 4Q15 and $55.50 per
ton for 2016. After that, the market expects China’s demand to stabilize amid the
high-cost miners’ exit, leading to an upside and prices settling at $63 per ton.
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Accordingly, although there are some negatives that surround the mining industry,
mainly the fall in the iron ore price, there are also a number of positives that
appeared to have been ignored. Currently the industry is being purged of inefficient
producers which is far more positive for the industry longer term. In particular the
Australian producers are already the lowest cost producers and as inefficient
producers exit the market there is likely to be some cheap assets that they may
acquire.
In addition, the falling AUD and oil price are helping to insulate the profitability
Australian miners. BHP and Rio both hold strong balance sheets and on current share
price, are offering investors an attractive divided yield.
Although global demand may be slowly transitioning away from hard commodities,
this is certainly not the case for soft commodities and agriculture. A growing middle
class, particularly through Asia, is putting significant demand pressure on agricultural
resources. With demand growth out stripping current supply, prices are likely to
significantly increase leading to larger profit margins for producers.
believes this sector is set to take the place as the growth engine of Australian
and New Zealand going forward. This thematic features heavily in our model
portfolios – “Mining Boom to Dining Boom”. We believe this is set to be a multi-year
investment theme and Australasia will directly benefit from this dynamic given their
favourable trading arrangements and close proximity with China and the rest of Asia.
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