Material Matters: Miners, Engineering Services, Scrap And Gold

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-iron ore, coal costs to come down
-Chilean copper costs resilient
-Chinese scrap consumption to rise
-a new approach for goldminers
 

By Eva Brocklehurst

The difficult question has now been asked. Is there value in resources? CIMB has asked the question of the sector, particularly Australian iron ore and coal, as costs appear to rise inexorably. The broker thinks the market may be in for a surprise as to the extent of cost reductions over the next 12 months.

The analysis suggests most new supply has come from existing mines. This implies structurally higher operating costs as the miners go deeper as well as process lower grade material. Where CIMB thinks cost reductions will come from is through cyclical factors, and it should be enough to counter the structural cost increases. The key is productivity, pushing these existing assets harder.

Increasing coal production costs in Australia over the past ten years were heightened by reduced productivity. Productivity in the Australian coal sector declined in both Queensland and New South Wales. Saleable coal production in Queensland fell by 63% from 2003 to 2012, in the broker's calculations. Saleable coal production in NSW was similar, falling 41%. This is set to turn. As a result of increasing average strip ratios and pushing assets harder, CIMB estimates US$30/t, or 37%, of cost increases over the nine years to 2012 was cyclical. The broker suggests average coking coal cash costs could ultimately come down to within a band of US$65-85/t FOB including royalties. As a result of lowering longer-term cash cost forecasts for BHP Billiton ((BHP)) the broker thinks it's enough to upgrade its recommendation on the stock to Outperform.

In iron ore, structural cost increases for the big three producers, BHP, Rio Tinto ((RIO)) and Brazil's Vale have been relatively minor in absolute terms. By analysing the companies' ability to reduce cash costs, as well as estimating the structural component of the cost increases over the ten years to 2012, CIMB expects that Rio Tinto can bring its CFR cash costs down to within US$30-35/t, based on an AUD/USD rate of US87c. Given its position on the cash cost curve, the broker estimates Rio Tinto's earnings margins are 50% based on the low end of iron ore price forecasts.

Elsewhere, in copper, the broker estimates average Chilean cash costs are likely to increase above inflation on the back of lower grades, higher electricity charges and increased water requirements. Here, the structural costs will outweigh the cyclical. Capital intensity and increasing cash costs suggests copper prices will need to move towards US$3.60/lb to provide incentives for new Chilean production. Aluminium, the third of the world's three most consumed metals by volume, has been the orphan in the resources boom. Despite average Chinese aluminium production costs coming down over the past two years CIMB estimates, at current aluminium prices, the Chinese aluminium industry is losing cash at an unprecedented rate.

Recent share price strength across mining services and engineering sector appears to be driven by commodity prices and relatively stronger Chinese macro data and, in BA-Merrill Lynch's opinion, ignores the continuing decline in expenditure budgets from global miners. The broker suspects the market is still underestimating the depth of expenditure cuts and significant progress is still to be made on targeted cost reductions. Those stocks most exposed to this negative theme are Leighton Holdings ((LEI)), Monadelphous ((MND)) and Bradken ((BKN)), those at the building or capex stage of the mining cycle. At the next stage – operate and maintain – the exposed stocks include ALS ((ALQ)) and Ausdrill ((ASL)) as well as the former three.

Australian non-mining infrastructure investment has also peaked in Merrills' view, with forecast declines of 9% and 8% in 2014 and 2015 respectively. The federal government's recent announcement of a $4.6 billion increase in road spending, whilst incrementally positive, is not a game-changer. Amounts allocated to road funding at the state level are also expected to decline over FY14-17. The greater impact from this bearish view falls on Leighton. Merrills still has three Buy ratings in the sector. Downer EDI ((DOW)) is seen having a compelling valuation and diverse end-markets which provide many options. WorleyParsons ((WOR)) is buffered by a leadership position in global hydrocarbons markets. Seven Group ((SVW)) has strong value because of a leading brand portfolio and strong cash generation. The strong balance sheet at Seven means potential M&A too, when the opportunities arise.

Data from the China Association of Metal Scrap Utilisation shows that 2013 was the second year running where the country's scrap consumption per tonne of steel has contracted on a yearly basis. Recent reductions in scrap consumption are more cyclical than structural, according to Macquarie, as one of the key reasons to cut scrap consumption is to conserve cash at a time when productivity is not required. In this regard, it is similar to pellets or high grade ores, where price premiums eroded as capacity utilisation in China's blast furnaces fell after record capacity additions in 2012.

As blast furnace utilisation increases and steel industry profitability improves, Macquarie believes interest in more productive raw materials will also recover. This could happen sooner rather than later given the cyclical nature of Chinese steel production, as there can be times when mills need to ramp up output very quickly. Then, China should move to steadily increase scrap consumption as more supply becomes available.

UBS recently attended the Denver Gold Forum. What message did the broker find most interesting? Many presentations focused on obtaining quality ounces versus quantity. The broker was surprised that it has taken a significant correction in the gold price for this to become such a dominant theme and questions just how well the industry has been managing capital. The other theme was the M&A issue. The broker has called 2013 "Year of Impairment" as a number of companies clearly overpaid for assets in the rising gold market. Now, optimising acquired assets is the name of the game. The broker acknowledges growth is still fashionable and the current market will present opportunities for those able to do so.

The broker has combined the quotes of industry leaders from the conference and has come up with the mantra for success Firstly, don't rush. Efficiency and productivity lead to simplicity, while simplicity leads to low costs and low costs are the best hedge against the gold price. Thirdly, beware the lure of marginal ounces.
 

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