Rising Costs Undermine Iron Ore Growth

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– Citi has increased its 2014-2020 iron ore price forecasts
– Demand is expected to grow from emerging markets
– But price increases reflect increased costs and risks
– Little change in listed producer forecasts as a result
 

By Greg Peel

We only have to cast our minds back to 2007-08 to the last time commodity prices were going ballistic (copper crossed US$4, uranium hit US$138, oil was on its way to US$147, iron ore prices jumped 100%) to recall that not everything about commodity prices is a function of demand and supply for the product. It's also about demand and supply for the inputs required to produce.

Commodity prices at the time were supported by a weakening US dollar, kicked along by greater market access to speculative investment, and underpinned by a belief the Chinese economy (and other emerging economies) would simply grow forever at a break-neck pace. Fast forward to 2011 and not much has changed, other than this time Beijing is a bit more experienced in keeping its economic growth in check.

What was also driving up prices back then was the simple reality that commodities were becoming increasingly more expensive to produce. The runaway oil price was a stand-out on the cost side, but shortages in everything from mining professionals to truck tyres meant cost blow-outs both in terms of price and in terms of delays as well. Years of underinvestment in the resources sector meant infrastructure could not keep up with demand for product, and everything filtered back to China, for example, having to pay a lot more for its iron ore.

Which was all well and good for iron ore producers, but the fact of the matter is any price inflation on the cost-side simply undermined revenue inflation on the sell-side. And the stronger Aussie dollar was also acting as a dampener.

We may have had a GFC in between, but in 2011 the China (and friends) story has not changed. “Developing Asia” (which includes China and India) and Africa will be the fast-growing regions in the view of the Citi metals and mining analysts, driven by population and per capita income growth. Assuming no change to steel usage intensity, iron ore demand from these regions should see 8% compound annual growth out to 2020, suggests Citi.

(Note that “Developing Asia” does not include Japan, but Japan will suddenly now need a lot more steel as well.)

Citi has upgraded its iron ore price forecasts for the period 2014-2020 by 11-38% in each year. Were those upgrades simply a function of expected demand growth, then the forecast earnings and discounted valuations of listed iron ore producers should also rise accordingly. But this is not the case. Citi attributes the price increases to “the challenges of bringing new projects into production, operating cost pressures and rising capex”.

In response to expected developing world growth in iron ore demand, major iron ore producers across the globe are planning substantial production increases through new project developments, and juniors are popping up left right and centre with loads of reserves but little in the way of infrastructure. New projects take time to develop, and Citi sees a “pipeline bulge” beyond 2014.

“But the challenges remain immense,” warns Citi. Logistics are one problem, and country risk another (new projects are planned in, for example, African countries of tenuous sovereignty).

A third problem is grade.

Companies like BHP Billiton ((BHP)) and Rio Tinto ((RIO)) have made their fortunes from spending decades pulling high-grade hematite ore out of the Pilbara, for example, while Vale has been doing the same in Brazil. But those high grade glory days are now passed and ore quality is quietly diminishing. Most of Fortescue Metal's ((FMG)) ore is a lower grade, for example.

The higher the grade, the less processing is required between mine and steel mill. High grade ore can almost be thrown into a furnace as is after being crushed down to transport size. Lower grade ores need to be refined. The “other” form of iron ore is magnetite, which typically is found in much lower grades than hematite, and as such typically refined into pellets before use in steel-making.

All of which costs more and more money.

One must not forget that China produces its own iron ore as well as importing it and China, too, has massive plans for production increases. Most Chinese ore is magnetite, grades are falling, labour and electricity costs are rising, and the renminbi is in an appreciation phase. In other words, while Chinese production balances global seaborne ore supply the same problems of cost increases apply, Citi notes.

In terms of projects planned to come on line after 2014 to meet rising global seaborne iron ore demand, Citi believes “barely half” of those projects will make it by 2020. That's why Citi has increased its longer date price forecasts.

So how do these forecast price rises impact on Australia's listed iron ore producers?

Citi has increased its Rio price target to $110 from $100 on a discounted cashflow basis (counting back those latter years). However, the analysts have actually reduced forecast earnings in 2011-12 by 1-2% at the same time, which largely reflects production lost to the weather. Citi rates Rio Buy.

Citi has nevertheless not changed its BHP target of $56. Forecast price rises are simply offset by rising capital intensity for both iron ore and coal production, and oil production has suffered from the moratorium in the Gulf of Mexico (post oil spill). Looking ahead on the energy side, Citi sees field decline in the Gulf as offsetting the growth offered to BHP by its recent shale gas acquisition. Citi rates BHP Buy.

On a comparative basis, BHP has higher margins, offers higher growth and dividend yield, notes Citi, but Rio is preferred due to its lower price/earnings multiple (8x 2011 compared to BHP's 11x) and greater discount to the analysts' net present value on current share price.

Fortescue, which is Citi's top pick in the iron ore pure-play space, remains with an $8 target but with a caveat that capacity limitations at Port Hedland still need to be resolved if production expansion plans are to be exploited. By contrast, Citi expects Atlas Iron ((AGO)) to resolve its infrastructure challenges this year and as such the forecast price increase does translate into a target price increase – to $4.70 from $3.90.

Citi has upgraded Atlas to Buy from Hold.

Among the magnetite producers, Citi prefers Gindalbie Metals ((GBG)) assuming its funding issues are resolved one capex requirements are confirmed, and sees pellet producer Grange Resources ((GRR)) as most leveraged to higher iron ore prices. Citi has a Buy on both.

Citi has a Hold on Mt Gibson Iron ((MGX)) and has lowered its target to $2.30 from $2.60. The analysts see MGX as too risky given a short mine life and the “debacle” of major shareholders and customers controlling the board.

Citi sees Murchison Metals ((MMX)) as an even riskier proposition given the analysts don't believe enough cashflow can be generated even on new price forecasts to carry MMX through its construction phase. A third party investor will probably be needed, and the broker rates MMX Hold.

All of which is why investors have to be wary in assuming that increased commodity price forecasts must automatically imply higher share prices for listed miners.

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