Here Come The Iron Ore Price Downgrades

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By Greg Peel

The offer on the table from BHP Billiton ((BHP)) for rival Rio Tinto ((RIO)) stands at 3.4 BHP shares for one Rio, but in Tuesday’s rout that ratio had fallen to 2.7 to one. As the merger story has dragged on and on, market enthusiasm for a positive result has waned. Early jubilation was somewhat naive, however, as the process was always going to be a lengthy one.

But yesterday the Australian Competition & Consumer Commission granted approval, thus alleviating fears that the ACCC would find a merged entity just too monopolistically powerful in global commodities markets, particularly in iron ore. Rio investors can thank Andrew Forrest, as the emergence of Fortescue Metals ((FMG)) as a viable competitor helped sway the ACCC’s view.

It is now expected the equivalent European regulator will have trouble ruling in opposition to its Australian counterpart.

In response, Rio shares jumped sharply yesterday. BHP shares also jumped, but on a day featuring a strong upside reversal in the index it’s hard to extract just what proportion was down to the ruling. Rio clearly outperformed nevertheless, taking the implied ratio back up to 2.9 to one. BHP’s closing price yesterday of $32.75 implies a takeover price for Rio of $111.35, compared to Rio’s $95.00 close.

The news is also good for BHP, all things being equal, as a merged entity will gain that much more leverage in future iron ore contract price negotiations with major customers, particularly China. It’s a costly exercise, but at present BHP represents the equivalent one of the most stable economies in the world and has little in the way of funding problems.

The boost in excitement has come, however, amidst a global commodity price downturn. BHP and Rio have only just begun to reap the spoils of this year’s hefty price increase on annual iron ore contracts, but by the end of the year the protracted negotiations should begin for the following year’s price. The 85% jump enjoyed this year, finally set in June, was settled amidst the ongoing commodity price surge, and at the time analysts were already predicting another 20% increase for 2009. Now, however, the global economic scene is much more dour.

Macquarie analysts were among the first to reduce their expectations, deciding recently that iron ore prices would only “roll over” in 2009, meaning a 0% change. Today Merrill Lynch has joined the reassessment.

Merrill Lynch takes us back to 2005, the last time the iron ore price made a substantial jump (71%). In 2005 the global economy remained strong, unlike today.

After the increased price settlement, the spot iron ore price then fell 31% from March to June. The hot-rolled coil steel price fell 40% by October. This year the spot iron ore price has already fallen 44% from its peak above the contract price, but to date China’s HRC steel price has only fallen 22%.

Merrills expects Chinese steel production to reduce, thus stabilising prices into 2009 after a further fall, probably in time for the next iron ore contract price negotiation. However, while the analysts had previously assumed a 15% increase in the 2009 price over 2008, they have now pulled their expectation back to a 10% increase. Their further 10% increase expected in 2010 is now 0%, and their 0% expectation for FY11 is now a fall of 10%.

As a result, the analysts have downgraded their 2008 forecast earnings for Rio by 3%, 2009 by 2% and 2010 by 6%. They cannot, however, provide a target price and rating as they, like most leading brokers, are involved in merger negotiations and thus restricted from providing investor advice.

They can provide advice on other miners nevertheless, and as such Mount Gibson Iron ((MGX)) has copped a target downgrade from $5.00 to $3.50. But as MGX last closed at $1.80, the large premium still commands a Buy rating. The analysts note MGX represents the lowest risk iron ore “pure-play” among the miners they cover.

It’ not such a bright story for Murchison Metals ((MMX)) however. Merrills has downgraded MMX’s forecast FY09 earnings by 57% and FY10 by 31% noting the miner’s critical production commencement years will occur just as the iron ore price is falling (if the analysts’ assumptions are correct). Their target falls from $6.00 all the way to $2.00 and this results in a double-whammy downgrade from Buy to Underperform.

The only saving grace for MMX in the short term would be a takeover, and China’s Sino Steel has been granted approval to do so. But Merrills notes Sino has now secured its position in Midwest ((MIS)) and thus will likely wait for progress on MMX’s resource estimates and the bankable feasibility study before leaping in.

UBS is another broker restricted from passing judgment on Rio, but the analysts have taken the time, nevertheless, to point out Rio is trading at a significant discount to their net present value calculation of $171.97.

For any mining analyst, net present value is a calculation fraught with danger given the volatility of commodity prices and the impact of discounted long term commodity price assumptions. For a large diversified miner, it really becomes a minefield, UBS notes, given all the “moving parts”.

What the analysts do note, however, is that if you take Tuesday’s closing price for Rio of $84.50 and work backwards, the market is pricing in an expected 22.5% fall in net long term commodity prices. That means copper, gold, iron ore and coal would all have to fall 50-60% from current spot prices.

Once again, the analysts can say little more beyond pointing out the facts. But reading between the lines, 50-60% falls from here are rather substantial, and although commodity prices always overshoot on the downside, the Rio price pre-ACCC announcement seems to be assuming a prolonged global recession. Perhaps it is the Rio price which has overshot on the downside.

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