Commodity prices are an investment minefield. They are very difficult to forecast, and hindsight can embarrass a lot of experts. For example, in mid-2016, coking (steelmaking) coal was trading at US$80 a tonne, and thermal (electricity coal) was trading at US$40 a tonne, and even coal producers did not see much upside.
But the Chinese government came to the rescue, imposing production limits on many of its own producers in order to cut down on inefficient and polluting production, prompting electricity generators and steel mills to tap the imports market for higher volumes. Coking coal is now around US$190 a tonne and thermal coal – even with a significant ideological campaign against it in the developed world – changes hands at levels around $US115.
Iron ore was also defibrillated by the Chinese cuts, but not to the same extent as coal: after a long slide from the boom time (and irrational) peak of US$191 a tonne in February 2011 – which prompted the typical response, a huge boost in supply – the iron ore price fell as low as US$37 a tonne in December 2015. Since then it was moved back to the high-US$50s a tonne, as supply cuts have eaten into the surplus and demand has strengthened on the back of economic growth: the composite purchasing managers’ index (PMI) numbers – which are forward-looking indicators of economic activity – are firmly in growth territory in the key economies of China and the US, although there has been recent slippage as concerns of a trade war increase.
According to a recent ANZ report, the expected iron ore surplus in 2018 has all but disappeared: the bank says iron ore prices have limited downside and should rise toward US$69 a tonne over the next few months.
ANZ also sees analysts strong demand across Asia lifting thermal coal prices, with the Newcastle spot price recently pushing above US$115 a tonne. Coal-fired power demand in China has been supported by stronger economic data in 2018. In steelmaking coal, ANZ sees supply-side risks supporting price around current levels of US$200 a tonne.
The minerals analysts at National Australia Bank see coking coal prices averaging US$186 a tonne this year, down almost 15% from 2017, reflecting the impact of supply shortfalls last year. In its June budget, the Queensland government – the state is the world’s largest exporter of coking coal – raised its medium-term price forecasts by 13%.
Queensland produces close to half of the world’s seaborne coking coal, and the state government expects the commodity to fetch $US161 a tonne in the 2018-19 financial year, significantly higher than the $US123 it forecast just six months ago. Queensland’s Treasury predicts prices for premium hard coking coal will remain above $US130 a tonne until at least mid-2022, a lift on last year’s prediction that coking coal would gradually retreat towards $US115 a tonne in the medium term.
On the iron ore side, Fortescue Metals Group (FMG) is the largest pure-play exposure on the Australian market. In theory, Fortescue should not be doing as well as other iron ore producers, because it mines ore with lower iron ore content than its larger competitors – 58% iron, compared to 62%-plus. At present, Fortescue’s customers pay it a discount of about 40% to the price of 62% iron, as steel mills are incentivised to buy higher-grade ores.
However, Fortescue is selling all of the ore it can mine and has now become the lowest-cost producer selling into China. At present, FMG supplies 17% of China’s seaborne iron ore imports. The company is also expanding into other markets, including India, Indonesia and Vietnam: its sales of iron ore to countries other than China more than doubled in the March quarter, to 11%, from 5% last financial year.
At $4.38, FN Arena has a consensus target price of $5.44 on FMG – implying a rise of just over 24% if borne out. Thomson Reuters’ collation is even more bullish, at $5.50.
Analysts expect Fortescue to pay a dividend of 19.8 US cents a share in FY18 and 20.8 US cents in FY19, which places the stock, at current exchange rates, on a fully franked dividend yield of 6% (FY18) and 6.4% (FY19). Even selling its product at a price discount, Fortescue looks to be the standout bulk-commodity investment exposure.
Rio Tinto (RIO) is the next biggest iron ore play, with about 80% of earnings coming from iron ore, from Western Australia’s Pilbara region. Rio Tinto also offers exposure to aluminium, copper and diamonds, and energy and minerals (coking coal, uranium, salt and titanium dioxide), but iron ore is the main game. (Rio Tinto sold out of thermal coal in 2017, to Glencore and Yancoal, when the price was US$68 a tonne.)
Rio currently has a production target in the Pilbara of 360 million tonnes a year by the end of 2019: through productivity gains and investment in mine development, analysts believe Rio could push this as high as 400 million tonnes a year. Rio says that over the last five years it has been able to replace ore reserves at or near the rate of mine production: currently the company has 3.7 billion tonnes of ore reserves sustaining its mining operations and development projects.
The focus for Rio Tinto is underpinning the supply of the company’s high-grade “Pilbara blend” iron ore. Rio expects to spend US$2.2 billion ($3 billion) on replacement mines and US$3 billion ($4.1 billion) maintaining existing mines in Western Australia over the next three years. The next cab off the rank will be the US$2.2 billion ($3 billion) Koodaideri iron ore deposit in Western Australia, which the company reckons could produce more than 70 million tonnes. Construction work on Koodaideri is expected to start in 2019: further out, Rio has confirmed that it is looking closely at the substantial Western Range deposit (near Paraburdoo) to become its next new mine in the Pilbara.
BHP Billiton (BHP) is the third big iron ore player: iron ore accounts for 38% of the company’s EBITDA (earnings before interest, tax, depreciation and amortisation), with Copper 28%, Petroleum 18%, and Coal 16%. The biggest sensitivity factor for BHP is the iron ore price – an extra $US 1 a tonne boosts the company’s underlying EBITDA by US$221 million.
In April, BHP cut its full-year production guidance, as unexpected maintenance problems forced it to reduce iron ore production guidance for 2017-18 to between 272 million tonnes and 274 million tonnes, down from its previous guidance of 275 million tonnes and 280 million tonnes.
The BHP share price is influenced by other things than iron ore. For example, during the March quarter, its copper division more than doubled its annual output, on the back of surging production at its Escondida mine in Chile. More recently, reports at the weekend indicate that the company is poised to exit its costly US shale gas and oil problem, with global major, BP emerging as the front-runner to buy the unwanted assets. Reports have suggested that BP will pay just over $US10 billion ($13 billion) for BHP’s onshore oil and gas operations in the US.
BHP is trading at $33.15, with an analysts’ consensus target price of $34.478, according to FN Arena – offering 4% upside. (Thomson Reuters posits an analysts’ consensus target price of $32.98, implying the stock is over-valued.) At current exchange rates, the US$1.145 expected in dividend in FY19 represents a yield of 4.6%, fully franked. The most bullish brokers, Ord Minnett and Macquarie, both see BHP reaching $38.
Analysts think Rio Tinto looks better. RIO is trading at $79.76, with an analysts’ consensus target price of $89.314, or 12% above the current price. (Thomson Reuters has an analysts’ consensus target price of $89.95.) The most bullish broker, Ord Minnett, has a price target on RIO of $96.00.
In 2018 (RIO uses the calendar year as its financial year) the US$3.143 expected dividend represents a dividend yield of 5.3%, fully franked, on current exchange rates. In FY19 the dividend is expected to come down to US$2.87, for a yield of 4.9%.
Another stock offering Australian investors diversified bulk-commodity exposure is South 32 Limited (S32), which was spun off by BHP Billiton in May 2015, at $2.13. Initially viewed as a grab-bag of unwanted assets – it was created to hold BHP’s non-core aluminium, manganese, nickel and zinc mines – South 32 has been a revelation on the ASX, well and truly outperforming its parent and rising to $3.64, with a peak of $4.01 in May 2018. Since 2015, South32’s main commodities, most notably manganese and alumina, have enjoyed a strong revival: the South32 manganese assets (in South Africa) are regarded as the best in the world.
South32’s strong performance since spin-off has removed much of the value proposition going forward: FN Arena puts the analysts’ consensus target price at $3.824, implying 5.1% upside, while Thomson Reuters’ collation is lower, at $3.77 (the most bullish broker, Macquarie, sees the stock at $4.20). Analysts expect the stock to pay a dividend of 14.4 US cents for FY18 – up from 6.4 US cents in FY17 – but for this to come down to 13.7 US cents in the current financial year. At current exchange rates, that prices South32 on a 5% fully franked dividend yield in FY19, which gives medium-term investors a look at a total return of 10%.
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