Yesterday we highlighted the supply constraints facing the global resource companies, particularly the major iron-ore and coking coal producers. The decades of massive infrastructure underinvestment, the chronic shortages of skilled labour and machinery, the lack of bulk cargo ships and the rapidly rising costs of brownfield expansions, and greenfield projects, have all combined to significantly delay the bulk commodity supply response.
However analysts continue to overestimate forecasts for new projects, and new commodity supply. Looking back over the duration of the current commodity bullmarket, I would guess that Fortescue's (FMG) Pilbara iron-ore project would be the only major global development commissioned on schedule. That is not to mention the seemingly never ending quarterly production disappointments from mining companies, both large and small. Importantly, every day the Chinese economy continues to grow at double digit rates, the arithmetic of new supply becomes more difficult.
In addition, just as the significant increase in Chinese commodity demand represents a structural change, so too are the capacity constraints which continue to slow the introduction of new production.There is simply no quick fix to ramping up new output, particularly bulk commodities. Just ask Tom Albanese, considering Rio Tinto (RIO )expects to increase iron-ore production by just 20mt a year to reach a target of 100mt in new capacity by 2013.
However today we are looking at the expansion plans of the major global steel companies, and never have the chronic supply constraints for the bulk commodites of iron-ore and coking coal, been more evident, than in the vertical integration strategies of the world steel industry.
Steel expansion ....equals bulk shortages.
Ironically, BHP supplied the base and precious metals for the manufacture of the Chinese Olympic medals. Considering the chronic shortages of bulk commodities, maybe iron-ore and coking coal medals might have proved more valuable to the athletes as our above cartoon shows.
Looking at the most recent presentations from the world`s top 10 steel makers in the list below, it is difficult to find a single company that is not intending to significantly increase steel production growth over the next 5 years. However Arcelor, Nippon Steel, JFE, POSCO, Baosteel, Tata Steel, Anshan , Tanshan and Wuhan all have one important factor in common at the moment, they lack primary production of the steel-making raw materials of iron-ore and coking coal. Consequently, given the supply constraints, and the intention to significantly expand steel production, we expect bulk commodities will remain in deficit, and prices will remain strong, for at least the next 4-5 years.
In the following chart from an Arcelor Mittal presentation, clearly global steel capacity utilisation is running at very high historic levels. In fact over the last 30 years to 2002, global capacity utilisation has averaged around 87%, however over the last 5 years the average has increased to 96%. As a result, just as the bulk commodity producers are facing capacity constraints, an interplay of factors are driving a similar dynamic in world steel production.
Incredibly, the world steel industry has been transformed from 30 years of overcapacity, to a current global shortgage as capacity utilisation rates have soared over the last 5 years. In this regard Bluescope (BSL) management recently stated that they are selling 100% of current production. The importance of this comment should not be underestimated.
The two main factors driving the positive change in steel fundamentals have been; Chinese urbanisation, and the consolidation of the global steel industry driven by ArcelorMittal.
We believe the change to a capacity-constrained environment, and higher steel-making raw material prices, have altered the long term fundamentals of the world steel industry supporting increased pricing power for steelmakers and a step change in profitability. We feel this important change is underappreciated by investors. As a result we remain very positive on the long term outlook for global steel producers.
Vertical integration....equals bulk shortages
Consequently the only way for the mega steel makers to achieve their volume growth aspirations is by significant investments in new brown field and green fields expansions. The traditional blast furnace powered with high grade hematite iron ore and high grade hard coking coal is still the most efficient way to make high quality steel. Clearly this is driving a global trend of vertical integration as steel makers are currently buying upstream iron-ore and coking coal producers to secure increasingly scarce raw material supplies and offset price increases. However we believe this trend is only in its infancy considering in most cases producers are still sub 30% self sufficient
This trend is very positive for Onesteel (OST) which is expected to produce 5mt of iron-ore by next year. We believe a combination of higher for longer steel prices, and iron-ore self sufficiency for OST is driving a long term multiple re-rating.
Mittal has probably been the most vocal and the most active in attempting to increase their own production of steel making raw materials. In this regard Mittal has a target of 62% bulk commodity self-sufficiency by 2012 from 45% currently. The clear example is Mittal's 20% stake in coking coal producer Macarthur Coal (MCC) recently.
However considering the easy locations have been exploited, the real issue for steel-makers like Mittal in seeking raw material self-sufficiency, is the high cost of new projects in remote locations. Currently Mittal have 2 major iron ore projects in Senegal and Liberia that will produce around 30 mpta. However the project costs may well be prohibitive considering the development difficulties like removing land mines, constructing hundreds of kilometres of new roads and rail lines, and ports. This is before the minefield of political risk in developing countries.
The prime example is the major political risk for RIO's Simandou iron-ore desposit in Guinea, and the increasingly problematic intervention by the Mongolian Govt in the Oyu Tolgoi copper/gold deposit. Despite the positive spin by RIO, major development risks remain. However it really underscores the undervalued nature of the BHP/RIO /FMG Tier 1 Pilbara iron-ore assets.
The chart above shows both Arcelor Mittal`s 5-year steel growth target from 110mtpa currently, to 130mtpa by 2012, but also an additional internal growth target to 150mtpa. Importantly, even if Mittal is successful in bringing on the expected new iron-ore production (a big ask), the forecast increase in steel production will erode the current self-sufficiency, let alone an increase to 62%. As a result we believe the risks for the iron-ore producers like BHP,RIO and FMG are minimal. However it also means steel prices will remain strong.
M&A activity
Clearly Arcelor Mittal is the 600 pound gorilla of the global steel industry, but there are plenty of other mega steel mills also intending to expand steel production. As a result we think the competition for raw materials will be fierce and the price action strong. In this light the Japanese Govt has just recently allocated Nippon Steel an acquisition war chest of hundreds of millions of dollars to secure iron-ore and coal assets.
This raises a very important issue which we believe investors are not appreciating. Currently we are urging investors to buy resource stocks driven down to significantly undervalued levels by the short-term, and short-sighted actions of hedge funds. We believe the recent approval to go to 14.9% of RIO for Chinalco, which is an arm of the Chinese Govt, and Nippon's donation from the Jap Govt,will drive a sovereign wealth fund frenzy for global resources that will make the private equity grabfest for industrials look like petty cash.
It is worth noting that when Tata Steel bought the Anglo Dutch steel giant Corus for $12.9bn, and suddenly became a top 10 global steel producer, Tata fell from 80 % bulk commodity self sufficient to just 22%. In addition, it is unlikely that Tata would have foreseen a 300% increase for the coking coal price following an 85% rise for iron ore.
Although endowed with significant iron-ore resources (albeit lower grade), India is nude coking coal. Last year Tata bought 35% of a coking coal project in Mozambique with Australian listed Riversdale Mining (RIV). In addition, Tata is strongly rumoured to be aggressively seeking further coking coal producing and development assets in Australia. Further, it was very interesting to note that Xstrata belatedly settled coking coal contracts at US$362t, a significant premium to the benchmark, and it all went to Indian customers (around 12mt of hard coking coal) including no doubt Tata. We believe a violent round of bulk commodity acquisitions by steelmakers is imminent.
POSCO is the other good barometer of global steel making raw materials pricing. They are viewed as a very conservative long term investor, and interestingly the only major basic materials holding for Warren Buffet. However even POSCO has publicly set a target for 40% raw materials self sufficiency over the longer term. It is worth noting that POSCO followed Mittal into MMC with a 10% stake at $20. We expect this will not be the last raw material acquisition for the Korean steel giant.
The recent auctions that appear to be occurring in domestic steel making raw material producers such as Aquila (AQA) and Felix (FLX) indicate the end game is some time away. We believe there is a significant amount of end customer interest in the data rooms from well known steel producers. However our other small cap bulk commodity recommendations are Gindalbie (GBG), Mount Gibson (MGX) and Brockman Resources (BRM).
In addition, it is equally interesting to note the Russian steel giant Evraz`s interest in Australian iron ore minnow Cape Lambert. After a failed attempt at a late takeover to block the sale to Chinese interests, the Russians eventually did a deal to buy 75% of the project from the Chinese. The transaction is intriguing considering Evraz is virtually 100% self sufficient in iron ore. We believe this indicates the corporates remain very bullish on the long term fundamentals for bulk commodities despite the current investor negativity.
From Russia with love
The global commodity capacity constraints are not just confined to Aust. We hear from a Russian steel contact that it was now quicker and cheaper to ship iron ore from the Pilbara to the steel making areas near the Ukraine, than to source raw materials from Siberia. After 30+ years of underinvestment in infrastructure, the rail and port bottlenecks (sound familiar?) within Russia are horrendous.
It is amazing to think that a ship carrying iron ore from the Pilbara, all the way up the Suez Canal and then to the Black and Caspian Seas, can be quicker and cheaper than ore from the other side of Russia. This highlights not only the chronic global supply-side constraints, but also the expected longevity of the global infrastructure investment cycle for the "de-bottleneckers".
Listen to Lakshmi.
There is no doubt that steel production is absolutely critical to the multi-decade Chinese urbanisation process. However it is not just China, India is next with the rest of the developing world following close behind. In this regard steel production is the central driver of the commodity cycle supporting the consumption of both nickel for steel plating and zinc for galvanisation.
As a result global steel production has soared, which is driving significantly higher capacity utilisation rates and creating global supply-side shortages in steel itself, in addition to the production constraints for the steel-making raw materials of iron-ore and coking coal.
Iron-ore contract prices have just risen 85% while coking coal prices are up 300%. How can the commodity bull market be over? I know one thing for sure it will not end through the actions of some Manhattan desk jockey.
We strongly recommend investors follow the actions of global steel producers into upstream raw materials and commodity producers in general. It is hard to believe that BHP,RIO, and FMG are trading on single digit foward multiples with 50% earnings growth locked in. In addition, real long term value has emerged in small caps like GBG,MGX and BRM. The day Lakshmi Mittal stops pulling out the chequebook it's time to go lukewarm on iron-ore, coking coal and base metals but I suspect that will not be anytime soon.
Go Australia
Charlie Aitken Director Head of Institutional Dealing Southern Cross Equities
(20min delay)