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Morningstar | Bulk Commodities Get Another Short-Term Boost from China. Major Miners Remain Overvalued

Steel-making materials stocks, those exposed to iron ore and coking coal, have markedly outperformed our near-term expectations. The key reasons have been continued strong steel demand growth, particularly in China, and more recently, Vale’s tragic tailings dam failure and Cyclone Veronica. Iron ore supply losses this year are material, about 6% of global iron ore supply and some of that will bleed into 2020. Coking coal supply has also been impacted in the near-term through increased safety inspections, closures, and environmental regulation in China. Thermal coal supply has been added and was not as impacted by inspections.

Overall, we see the mining sector as overvalued. The Australian miners trade at an unweighted average 19% premium to our fair value estimates. We see the iron ore exposed stocks most overvalued. Current prices are elevated by what we think are short-term supply disruptions and current demand drivers are unlikely to persist. Fortescue’s recent decision to add 20 million tonnes of new supply from 2022 supports our view iron ore miners are overearning and new supply is a risk. The rational oligopoly argument for iron ore is unlikely to hold up, particularly if high prices persist.

All these mining firms are rated no-moat. Our fair value estimate for Independence Group rises 15% to AUD 4.60 per share with the higher spot nickel price and likely better smelter terms in future. South32 benefits from higher spot nickel and zinc prices, up 5% and 14% respectively, and higher near-term coking coal and manganese prices. Whitehaven also benefits from the latter, with our fair value estimate up 8%. Our fair value estimates for BHP, Iluka, Fortescue, Sandfire, Oz Minerals, Newcrest and Rio Tinto increase by between 2% and 5% to AUD 40, AUD 11, AUD 5.70, AUD 6.60, AUD 10.30, AUD 23.50 and AUD 60 per share respectively mainly due to higher iron ore and coking coal prices and in some cases a small increase in our 2019 copper price and time value of money.

Rio Tinto is the most expensive of the group trading 70% above our AUD 60 per share fair value estimate. BHP and Fortescue trade closer to 40% premiums. With the recent decline in the spot thermal coal price, and potential trade ructions for Australian thermal coal to China, New Hope is now cheapest of our coverage, trading at a 20% discount. Whitehaven is at a 3% discount. We continue to see Iluka as undervalued based on the outlook for constrained mineral sands supply. It’s also getting a boost from the near-term higher iron ore price. Newcrest, Oz Minerals, and Independence Group are all close to fairly valued, trading within 10% of our fair value estimates.

On the demand side, steel consumption has continued to grow more rapidly than expected. In 2018, steel production grew 4.6% globally and an even more rapid 6.6% in China. China accounted for 75% of the global growth in steel production in 2018. Iron production represents new steel made from iron ore and coking coal and is important for raw materials demand. Here in 2018, iron production grew more slowly at 2.2% a year, but still at a faster than expected rate. China’s iron production grew by 3% in 2018, accounting for 85% of the growth in global iron produced in 2018.

China is key to the global demand outlook for steel and, to an even greater degree, iron ore and coking coal. It accounted for 52% of global steel production in 2018. But, more importantly, 62% of iron--that is, virgin steel made from coking coal and iron ore. According to World Steel, China produced 928 million tonnes of steel in 2018 and 771 million tonnes of iron. In a country of 1.4 billion, this is more than a 500 kg per person annual addition to the total stock of steel in use, even after accounting for 67 million tonnes of steel exports. India is growing rapidly, with steel output up 4.9% in 2018, but that is from a low base. In 2018, India added just 5 million tonnes of new steel supply, versus 57.4 million tonnes for China. In addition, India has its own significant iron ore supply so is unlikely to be a major new driver of iron ore demand.

China’s total steel stock now sits at about 7.5 tonnes per person, versus Western world levels of around 12 to 13 tonnes per person. At this level, developed nations tend to reach an equilibrium point where very little new steel from iron ore and coking coal is required. Steel demand tends to be met by scrap--for example,the steel in new cars or buildings is made from old cars or buildings. If China continues to add to its stock of steel at the 2018 run-rate rate of around 0.5 tonnes per person a year, then it will rapidly reach this equilibrium point in about a decade. The maturity of China’s existing infrastructure and housing stock, coupled with falling population growth, a declining working age population and future urbanisation rates are key headwinds to future demand. To be more positive, we would have to conclude that China will be an outlier on steel stocks. That fundamentally the economy just requires more steel stocks per person than the likes of the U.S., the U.K., Japan, Canada, Australia, and South Korea which all cluster around 12 to 13 tonnes per person.

On iron ore supply, Vale’s tragic incident, has cut our estimates by approximately 80 million tonnes from the global iron ore market in 2019. Coupled with the recent cyclone in Western Australia, which saw about 20 million tonnes taken out, 100 million tonnes of supply has been lost in 2019. This is a short-term shock loss of about 6% from the contestable iron ore market--seaborne production plus China domestic supply--of about 1.8 billion tonnes.
The iron ore situation is still fluid. Since our update in late March, Vale’s volume guidance was downgraded again to 307 to 332 million tonnes in 2019, down from our prior forecast of 350 million tonnes. While BHP and Rio Tinto were impacted by a further 10 million tonnes more than we expected by Cyclone Veronica. Collectively, a further 28 to 43 million tonnes of production has been lost since our March update. In addition, there's considerable uncertainty around the speed of Vale’s recovery, and its impact could see iron ore prices remain elevated for longer than expected. Vale expects the remediation of all of its dams to be a three-year process.

The Brazilian government has understandably lifted the standard around tailings dams. Vale is still figuring out how to meet the new standard for all of its dams. Currently around 90 million tonnes of annual of capacity is suspended at Vale--about 5% of global supply. Some of the suspended capacity should restart relatively quickly, notably the 30 million tonne Brucutu mine. Initially, Vale expected to suspend 40 million tonnes of capacity post the tailings dam failure, and for some of those losses to be made up through the return of mothballed mines. But negative outcomes from further dam inspections have extended the temporary cuts. It turns out much of the mothballed capacity Vale thought could come back has been caught in the net of increased government scrutiny and regulation.

The key changes to our commodity price forecasts are an iron ore price of USD 78 per tonne in 2019, and USD 65 per tonne in 2020 versus USD 72 and USD 60 per tonne previously. We’ve extended the time we expect coking coal to decline to our long-term price for a year to 2022. We now expect the price to average USD 150 per tonne to 2021, versus USD 120 per tonne previously. Spot sits around USD 200 per tonne. The spot price for nickel increased 5% to USD 5.90 per pound and zinc by 14% to USD 1.34 per pound. We also raised our copper price assumption for 2019 only by 10c to USD 2.80 per pound with prices to date tracking modestly ahead of our prior forecast.

There were no major changes elsewhere. Thermal coal supply has been added in China and supply was not as impacted by inspections as coking coal was. The thermal coal price has fallen to the point where the coal miners New Hope and Whitehaven both look reasonable value. Here, China is a relatively high cost producer, so we don’t the thermal coal price to sustainably fall significantly from these levels.

The rise of nickel demand for batteries is likely to favour nickel sulphide producers such as Independence Group, and lead to better terms with smelters. We estimate Independence currently gets paid by the smelters for approximately 70% of the nickel contained in concentrate it produces. We expect this to grow to 75% within the next two years with Independence working on alternative technology to produce its own, higher-value nickel sulphate product. This would be suitable for direct sale to battery manufacturers, cutting out the traditional smelters. We think the smelters will have to step up to retain the supply of concentrate feedstock by paying a higher proportion of the value of the nickel to the miners. This dynamic should be to Independence's benefit. The firms existing contracts with smelters expire in June 2019 and December 2020. The expectation of improved smelter terms accounts for half of this increase in our fair value estimate to AUD 4.60 per share.