A silver lining to iron ore’s big tumble
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The 40 per cent fall in the iron ore price isn’t exactly good news. But a glass-half-full view on supply and Chinese demand suggests things might not be as bad as they seem.Can you put a positive spin on the 44 per cent tumble in the price of Australia’s most important export commodity? The fresh 4.2 per cent fall to US132.19 a tonne on Wednesday night certainly doesn’t make it easy, but Citi’s veteran mining analyst Paul McTaggart makes the case that lower prices might provide investors with much greater confidence in earnings forecasts for the next few years.
Xi Jinping has put the brakes on Chinese steel production. David Rowe
The reasons for iron ore’s slide since it hit a record in May of $US237.57 have been well canvassed. China’s determination to reduce carbon emissions has seen the government force production curbs on steel makers, and seasonal factors (production is typically cut back in winter) and the fact China will host the Olympics next February have led analysts to assume these curbs will not be reversed in the near term.
On top of that, China has sought to put the brakes on its property sector after Chinese President Xi Jinping said housing was for living in, not for speculating. New property starts in August fell 21 per cent year-on-year and 34 per cent month-on-month. Industrial production is also slipping and iron ore inventories are building at ports.
All of this is bad news for Australia’s iron ore giants, which are feeling no shortage of share price pressure despite delivering monster dividends for investors during the August reporting season.
Rio Tinto is down 21 per cent from its August peak, BHP has dropped 24 per cent and Fortescue Metals Group lost 32 per cent from July 31. Not exactly a rosy picture, although Rio and BHP remain up 6 per cent and 11 per cent on a 12-month view.
So what exactly is there to be positive about?
First, McTaggart makes the point that falling iron ore prices will reduce the competition facing Australian miners, as higher cost producers from countries outside Australia, Brazil and to a lesser extent India are forced out of the market. Citi estimates that if iron ore falls below $US100 a tonne, China’s import from outside the major producing nations would fall from 200 million tonnes a year to 120 million tonnes.
In addition to these tonnes being forced out of the market, the potential entry of production from the African nation of Guinea appears to be far less certain than it was last week, after a coup led by a group of army special forces officers deposed president Alpha Conde.
Coup de grace?
The Simandou project in Guinea, whose development is being led by Chinese groups, has long been seen as the great threat to Australian iron ore. But while the situation in Guinea is clearly fluid, it would appear that an already complicated and expensive project – which among other things requires the construction of a 650-kilometre railway line across the nation to get ore to port – has just got harder.
It was notable that China, which hates foreign nations interfering in its domestic politics and generally has a policy of staying silent on international affairs, issued a statement saying it “opposes coup attempts to seize power and calls for the immediate release of President Conde”.
This was seen by some commentators not as a sudden embrace of democracy, but rather as a sign China is unsure of what its Plan B looks like in Guinea.
(Incidentally, the one policy that Australian iron ore miners won’t want to see coup leader Mamady Doumbouya change is Conde’s insistence that ore from Simandou leave the country via a Guinean port, rather than via a cheaper, quicker route through neighbouring Liberia. Then again, coups aren’t exactly famous for suddenly reversing nationalistic policies.)
So with less ore coming from non-traditional producing nations, and the Guinea threat fading, McTaggart says iron ore could hold above $US100 a tonne for longer than the market thinks.
This is especially the case if Chinese demand can improve and McTaggart sees some positive signs. Citi’s measure of Chinese monetary conditions has lifted off recent lows, which McTaggart says has traditionally been a good leading indicator of what will happen to property starts six months later and steel consumption.
Several commentators have also argued that China might need to make tweaks to keep economic growth around the 5.5 per cent mark.
McTaggart wonders if the steel cuts have gone too far, given Citi’s measure of China’s apparent steel consumption (production plus imports, less exports) has fallen well below where its historic relationship to industrial production says it should be.
Further, while steel production is down, steel prices have remained high, suggesting the weakness in consumption does not reflect great weakness in underlying demand. That should help buttress the profitability of Chinese steel mills and demand for Australia’s higher grade iron ore, which helps to make steel production both cleaner and more efficient.
Might the Chinese also need to gently back away from its crackdown on property?
Don’t forget the yield
As Bank of America Miao Ouyang said this week, property accounts for more than 28 per cent of Chinese GDP, so putting the brakes on the sector will inevitably hurt economic growth in the second half of the calendar year. Ouyang, who describes the crackdown as “overly aggressive” also points out restricting housing supply will ultimately push property prices up – exactly what the government doesn’t want to happen.
At any rate, McTaggart argues the big miners would still be attractive with iron sitting just below $US100 a tonne.
Using an iron ore price of $US98 a tonne for calendar 2022 and $US80 a tonne for 2023, McTaggart says Fortescue can still deliver a dividend yield of about 9 per cent in the 2023 financial year, falling to 5 per cent in the 2024 financial year.
Similarly, Rio can produce a dividend yield of about 9 per cent in calendar 2023. While that is well below the 17.2 per cent yield he’s tipping for 2021 and the 14.2 per cent yield forecast for 2022, it is still well above the 3.3 per cent dividend yield Citi expects from the ASX 200 in 2023.
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