Miners
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.
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 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.
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.