Weekly Reports | Sep 29 2021
This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO
By Tim Boreham, Editor, The New Criterion
Have the iron ore miners been oversold or should investors steel for more ferrous pain?
The pundits were right, for once: the laws of market gravity were always going to catch up with the price of iron ore, which in a matter of weeks has tumbled more than -50% from its nosebleed territory of $US220 a tonne.
Still, no one quite predicted the extent of the rout which stems from the sickly Chinese construction sector coupled with Beijing’s steely intent (excuse the pun) to taper the nation’s steel output for the sake of the long-suffering environment.
According to Goldman Sachs, global crude steel output is already -7% below its May 2021 peak, while Chinese production is -20% off its April zenith.
As always in a market meltdown, the (guessing) game is about when the commodity becomes oversold – as it inevitably does. Last year’s dramatic oil and gas price swoon – followed by a dramatic recovery – highlights what can happen.
On the negative side, there doesn’t seem to be much to support the iron ore price in the short term.
Veteran broker Richard Morrow describes iron ore as “ridiculous” at $US220/t and “ludicrous” at $US100/t.
Ludicrously low? High, actually: the Pilbara producers are digging the stuff out at an average ‘all in’ cost of A$40 a tonne so even $US100/t represents a stonking – and unsustainable — margin.
Meanwhile, Bank of America's global research cheerily cut its 2022 forecast for iron ore fines from $US165/t to $US91/t and conceded that a $US70/t price was "possible".
On the positive side, Beijing is not about to padlock China’s vast factory altogether: the official dictate is to maintain the current year’s steel production at last year’s levels (having grown a surprising 11% in the June half).
For the foreseeable future, the Pilbara remains the best and nearest source of reliable supply for the Chinese, who account for more than 90% of the seaborne iron ore trade.
On an annualised basis Australia accounts for 686 million tonnes of seaborne supply, with Brazil (mainly Vale) supplying a further 357mt.
In the longer term, new iron ore threatens to exacerbate oversupply, notably the 2.4 billion tonne, high grade Simandou mine in Guinea which could add as much as 200mtpa to available supply.
Then again, the country’s recent coup highlights the constant sovereign risk of doing business in Africa.
Predictably, the iron ore sell-off has punished the valuations of our big three producers. Since the iron ore price began tumbling in late July, Rio Tinto ((RIO)) and BHP Group ((BHP)) shares have fallen by up to -30%.
The pure-play Fortescue Metals ((FMG)) has been routed by up to -40%, slashing more than -$10bn from the value of founder Andrew Forrest’s 36% shareholding.
But don’t send care parcels – he’ll be OK.
Are the Big Three now decent value? Broker Evans & Partners tentatively mounts the case for the affirmative, at least in the case of BHP and Rio.
Assuming a negative iron ore pricing scenario of $US100/t in the current 2021-22 year and the only $US75/t between 2023-25, the firm extrapolates 23% returns for BHP holders and 27% for Rio investors over the next 12 months.
This estimate factors in forecast dividends, With BHP yielding well over 5% and Rio close to 8%.
(At the time of these calculations, BHP and Rio shares traded at $41 and $106 respectively, but as of [this morning] are at $36.02 and $96.79. So the forecast returns are better than stated, if anything).
“We continue to believe that both BHP’s and Rio’s iron ore operations are fantastic businesses that produce strong returns,” the firm opines.
“But we do think that risks are now more balanced relative to the past 18 months of positive momentum.”
While BHP and Rio are diversified – notably with copper exposures – their Pilbara operations remain responsible for the fat dividend cheques. The red dust accounted for 70% of BHP’s underlying earnings in the 2020-21 year, while for Rio it was more like 77%.
The proposed merger of Woodside Petroleum ((WPL)) with BHP’s oil and gas assets muddies the picture somewhat. BHP is also the world’s biggest producer of coking coal, which this week hit record levels in direct contrast to the fortunes of its steel-making cousin, iron ore.
Rio also owns 45% of the Simandou project, so stands to benefit if the complex and oft-delayed venture gets into production.
And Fortescue? As the pure-play exponent the Pilbara upstart is most susceptible to further deteriorating conditions, especially given its produce is lower grade.
But everything has a price.
On Credit Suisse numbers Rio Tinto looks the cheapest of the Big Three, trading at a multiple of five times expected current-year earnings and a yield of 14%.
BHP and Fortescue trade on multiples of 7-8 times forecast current-year earnings, with yields of 6% and 11%.
Crucially this is based on the spot price of circa $US100/t and what happens from here is pretty much guesswork – at least for those not full bottle on the inner policy workings of the Middle Kingdom.
At the junior end
The phalanx of junior ASX-listed iron ore miners and developers haven’t been spared the price pain, especially given their per-tonne operating costs are higher.
Hardest-hit is Mt Gibson Iron ((MGX)), which last year sold 3mt for a handy net profit of $6m.
Mt Gibson’s flagship Koolan Island project in the Buccaneer Archipelago is claimed to have WA’s highest grade hematite reserves, averaging 65.5%.
Management forecasts sales of 3-3.2mt for the current year, but with operating costs of $75-80/t (free on board), the days of easy money look to be over.
Mt Gibson shares have halved in value since the iron ore price peaked.
At Grange Resources ((GRR)) focus has been on producing high-quality low purity magnetite from its Savage River operation in Tasmania.
In the June half made a $205m net profit on sales of 1.21mt.
The pellets fetch $U260/t, with direct costs of $100/t. So while the Grange is still flowing, the stock looks more like Koonunga Hill territory if conditions deteriorate.
Midwest WA producer Fenix Resources ((FEX)) has not escaped the sell-off, having dispatched its maiden shipment of direct shipping ore from its Iron Ridge mine in February.
Fenix produced just over 500,000t between then and June 30, for a handy profit of $49m.
Sagely, the company has hedged 50,000t of annual production for the next 12 months – 45% of planned output — at a heady $230/t. But this partial protection hasn’t stopped Fenix shares from falling -40%.
Further afield, Champion Iron ((CIA)) is banking on increasing demand for high-grade ore from its Bloom Lake operation in Canada’s ferrous-rich Labrador Trough.
Champion produced 1.93mt in the June quarter at a grade of around 68%, compared with 58-62% for the Pilbara producers.
Champion thus taps into the carbon abatement theme at a time when steel makers are under the pump to lower emissions: the richer the grade of the ore poured into the blast furnaces, the less energy required. Richer ore also means fewer slag heaps.
Finally, the heroism award goes to Pearl Gull Iron ((PLG)), which listed on the ASX in the eye of the storm of the sell-off.
Pearl Gull is looking to mine on Cockatoo Island off the Kimberley coast, where BHP first mined the stuff in the 1950s.
The company is unfazed about the short term pricing, arguing it’s a play on long term demand for its high-grade direct shipping products.
In other words: if you don’t laugh, you cry.
Disclaimer: Under no circumstances have there been any inducements or like made by the company mentioned to either IIR or the author. The views here are independent and have no nexus to IIR’s core research offering. The views here are not recommendations and should not be considered as general advice in terms of stock recommendations in the ordinary sense.
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