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Morningstar | Vale’s Misfortune Priced into the Iron Ore Miners but Value Emerging in Base Metals and Coal

Iron ore and gold prices are flying but we don’t think either will last. Iron ore is benefiting from unusually strong demand and supply disruptions while gold is rising with negative interest rates. The global miners remain overvalued. The sector trades at an average 10% premium to our fair value estimates, versus a 20% premium three months ago. The iron ore miners--BHP, Rio Tinto, Fortescue and Vale, on average are at a 30% premium, while the rest of our coverage is only at a 4% premium. The coal miners have been soft and New Hope and Whitehaven now stand out as being relatively undervalued. New Hope is the cheapest of our mining coverage and trades at a 26% discount to our fair value estimate.

We’ve raised our near-term iron ore forecasts meaningfully given higher spot prices, stronger near-term demand from China and potential for Vale’s supply issues to persist, but our long-term price is unchanged. We now forecast USD 41 per tonne iron ore from 2023 with our long-term price kicking in from 2023 versus 2022 previously. The Feijao dam failure has yet to play out and  a slower return to normal production from Vale means elevated iron ore prices can persist for longer. Our metallurgical coal price forecasts also benefit from higher near-term steel production. On the negative side, spot prices for nickel and zinc have fallen with lower industrial production.

We raise some of our miner fair value estimates, particularly for the iron ore producers. Fortescue is the primary beneficiary, rising 25% to AUD 7.10 per share. For iron ore and metallurgical coal exposed miners Rio Tinto, BHP, Anglo American and Vale, our fair value estimates rise by 8% to 16%. We’ve raised our Teck, Whitehaven, Independence Group, Iluka, Sandfire, Newcrest and Regis Resources fair value estimates by 2% to 7% with the higher gold, iron ore and metallurgical coal price forecasts, and the lower Australian dollar. Glencore, Oz Minerals, New Hope and South32 are unchanged.

Softening global economic growth has seen base metals generally sell off. Thermal coal also softened with additional supply from China and a relatively mild Northern Hemisphere winter. Price rises for iron ore and gold have been the exceptions, both rallying of late. Iron ore has risen further, principally from Vale’s misfortune, but also with strong demand from China. Here, softening economic growth and the U.S. trade war has led to a second order benefit for iron ore. China is again pushing infrastructure investment to stabilise soft economic growth, to the benefit of steel and iron ore demand. Steel production in China grew 10% for the year to date ended May 2019 but the rest of the world was flat.

Iron ore continues to be an outlier in terms of commodity performance. Against a backdrop of weakening global industrial production and generally softer coal base metals prices, the iron ore price rose more than 30% in the June quarter and now sits above USD 120 per tonne, five-year highs. With production costs less than USD 20 per tonne for BHP, Rio Tinto and Fortescue, iron ore miners are printing money at current prices. There’s potential for special dividends and buybacks for the three Australian based iron ore majors. We will explore this potential for returns to shareholders with the quarterly reports this month.

On the supply side, we estimate more than 100 million tonnes of iron ore production, or 6% of the 1.8 billion tonne market, has been lost in 2019. For demand, China has continued to defy headwinds in property, demographics and debt to grow steel output by 10% in the first five months of 2019. There may be some seasonality to production though with the Chinese government implementing cuts to steel production during peak periods for pollution.
Iron ore now trades well ahead of the cost curve with about 80% of global supply from Rio Tinto, BHP, Vale and Fortescue, which are all low cost. The tail of the cost curve is steep though with supply coming from high cost sources such as domestic China and non-traditional suppliers such as India and Iran. It’s highly likely lost supply from Vale will return to the market. The company expects to produce at 400 million tonnes a year in 2-3 years, from an estimated 320 million tonnes in 2019.

However, it’s increasingly likely there will be delays to the return of full production at Vale. Samarco provides an example. The tailings dam failed in 2015, and production has still not returned despite the strong price incentive. It’s unlikely Samarco will restart in 2019 and if a return comes in 2020, it will have been five years since the accident. And it’s likely to take a couple of years for production to return to the 30 million tonne a year rate prior to the tailings dam failure. The likely delay to production restarts at Vale, coupled with stronger steel production in China and higher spot price sees our average price forecasts rise by USD 17 per tonne to average USD 76 per tonne for the four years to end 2022. This is broadly in line with the average for consensus and the futures curve to 2022. Our long-term forecast is USD 41 per tonne from 2023 onwards. Our forecast for 2023 is unchanged, but our long-term assumption now kicks in from 2023 versus 2022 previously.

Higher near-term iron ore price forecasts are the main change to our commodity price assumptions. Elsewhere, we’ve raised our medium-term metallurgical coal price forecasts by USD 14 on average to USD 149 per tonne to 2022 due to the stronger steel production in China. Our gold price forecast is also 4% higher for 2019 at USD 1,320 per ounce but unchanged thereafter. Gold is benefiting from investor risk aversion, heightened geopolitical risk and fears of a global economic slowdown. Central bank and investor demand have been strong in 2019. We’re still positive on the long-term outlook for gold demand from China and India, however, the current price is somewhat inflated by broader near-term investor concerns. As a result, we’ve generally viewed Newcrest as being undervalued for years but now think it’s overvalued. We’ve thought Regis Resources a well-run but overvalued firm for some time, and that view remains.

Elsewhere, nickel and zinc prices have softened with slowing global industrial production growth. Our price assumptions fall in line with the lower spot prices of USD 5.70 and 1.15 per pound respectively. We’ve also lowered our forecasts for alumina and thermal coal to USD 370 and USD 85 per tonne respectively for 2019. Our forecasts for 2020 onwards are unchanged. We expect alumina prices of USD 326 per tonne in 2020, USD 317 per tonne in 2021 and USD 302 per tonne long term from 2022 onwards. We forecast thermal coal of USD 80 per tonne in 2020 and USD 73 per tonne long term from 2021 onwards.

Aluminium consumption growth has slowed with lower global economic growth and the trade tensions. Auto sales globally have taken a hit this year and this has slowed demand for aluminium. The alumina price has fallen on the addition of 3.0 million tonnes of supply from Alunorte. The refinery had been operating at just 50% capacity after its owner, Norske Hydro made unlicensed water emissions. But the issue has resolved and the government restrictions preventing a return to full production have lifted. Thermal coal was impacted by a relatively mild Northern Hemisphere winter and some additional supply from China. But with prices starting to eat into the cost curve, and additional supply from China being relatively high cost, we think there is longer-term support for the thermal coal price and emerging value among the coal miners we cover.

We continue to see the global miners as overvalued, with the sector trading at an average 10% premium to our fair value estimates, versus a 20% premium three months ago. There’s a broad separation between the iron ore miners and the remainder of our coverage. The iron ore miners – BHP, Rio Tinto, Fortescue and Vale, on average trade at a 30% premium to our fair value estimates, while the rest of our coverage is at a slimmer 3.8% premium.

Share prices for the coal miners have been soft and New Hope and Whitehaven now stand out as being relatively undervalued. New Hope is the cheapest of our mining coverage and trades at a 26% discount to our AUD 3.50 per share fair value estimate. It’s not without risk, being exposed only to thermal coal and the long-awaited approvals for Acland Stage 3 still yet to be confirmed. Nonetheless, it seems highly likely the project will be approved, particularly following the latest Federal election results in Queensland. It’s just an extension to an existing mine and continuity of employment in regional Australia is important. However, if approvals are delayed by a couple of years, our fair value estimate could take a AUD 0.50 per share hit.

Iluka has benefited from the renewed market attention on iron ore, but we also think the market was too pessimistic on the outlook for zircon and titanium dioxide minerals. We were positive on the stock after it sold off substantially and it was added to our best ideas list in May 2019. After appreciating more than 25% since, we’ve removed it from our best ideas list with the shares only trading at a modest discount to our fair value estimate now.

Of the global diversified miners, Rio Tinto is the most expensive of the group trading 50% above our new fair value estimate. BHP and Fortescue trade close to 30% premiums. The London listed plc shares of Rio Tinto and BHP trade at lesser premiums of 26% and 15% respectively. The difference is largely accounted for by the implied value of the franking credits to some Australian shareholders. Anglo American is less exposed to iron ore but has a sizable coking coal business as well. Those shares are at close to a 20% premium to our fair value estimate.