The Australian Production Phase And Resultant Currency Impact

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– Production phase now upon us
– Current account deficit declining
– Capex reduction offsets increases in opex, dividends and taxes
– Upward pressure on AUD not material

By Greg Peel

Australia’s mining investment boom is over and the industry has now shifted into the production phase, with expansion particularly notable for iron ore. New mines coming on line from BHP Billiton ((BHP)), Rio Tinto ((RIO)), Fortescue Metals ((FMG)) and Gina Rinehart’s Roy Hill have already begun to shrink Australia’s current account deficit, and trade surpluses will further improve from 2015-16 as Australia’s new LNG export facilities come on line.

A lower current account deficit should by rights place upward pressure on the Australian dollar. The current account includes the trade balance, being the balance of exports and imports, and all other funds flows into and out the country. These include interest payments on foreign loans, dividends paid on foreign investments and taxes paid locally by foreign-owned companies, among other elements. The current account deficit/surplus should not be confused with the federal budget deficit/surplus which is purely domestic.

Over the past twelve months, Australia’s iron ore exports have risen by $4.4bn and have proven the key driver of a $6.7bn improvement in the trade balance. As Australia is a major global commodities exporter but has only a small consumer base, increased exports should by rights increase GDP which in turn would lead to RBA rate increases and thus an increase in Australia’s interest rate differential with major economies. This, in turn, leads to an increase in the Australian dollar, although markets make that adjustment pre-emptively.

A rise in currency is counterproductive not only for the net Australian economy – witness the death of local manufacturing – but also for the resource sector itself, as US dollar receipts fall in Aussie dollar terms.

So should the rest of Australia be concerned about the next few years of iron ore/LNG export boom and its indirect impact on the entire economy? Not necessarily, say the economists at ANZ. It’s not quite that simple.

The structure of Australia’s current account is somewhat unusual, ANZ suggests, given trade is/will be dominated by only two products that are sold in US dollars by Australian-based companies that are predominantly foreign-owned. This means not every transaction recorded will actually create demand for Aussie dollars.

Ownership structures of resource companies, and that fact the USD remains the global trading currency, means retained earnings are typically held in USD. Resource companies have three primary reasons to require AUD, being to meet domestic costs (eg labour), for payments of profits/dividends to Australian shareholders, and to pay taxes and royalties to federal and state governments. We note that BHP and Rio, for example, are dual-listed and thus pay dividends in both Australia and the UK while the first two big Australian-based LNG projects set to begin exporting in 2015-16, Gorgon and Queensland Curtis LNG, are both 100% foreign-owned.

In terms of costs, resource companies have to finance capital expenditure (the cost of constructing a facility), operating expenditure (the ongoing cost of production at the facility) and any loans.

The recent “mining boom”, now winding down (with LNG lagging), was all about capex. ANZ estimates net capex will decline to $80bn in 2015 from $100bn in 2014 and keep declining until 2018. Given a lot of equipment and parts are imported, only around 50% of that reduction will actually equate to fewer Aussie dollars being spent, or $10bn less in 2015. While some of this cost is/was financed from offshore debt markets (Fortescue being an obvious example), the vast bulk of capex was financed out of retained earnings or, in the case of the big LNG projects, equity farm-downs and customer offtake agreements. In other words, close enough to $10m of AUD demand will be lost in 2015.

The flipside is the rise in opex that comes with the production phase. ANZ estimates opex will average around US$55/t for iron ore production in 2015 and will rise by less than 4% per annum thereafter. Once again, around 50% of this expense reflects imported inputs. And opex increases may actually be less than ANZ is currently estimating, the economists note, given resource companies are all on efficiency drives. But throw it altogether and ANZ suggests opex will rise by $2bn per annum between 2014 and 2018 – far less than the offsetting fall in capex.

Opex increases in the gas industry will be more expansive, given the cost of actual natural gas extraction is dwarfed by the cost of the liquefaction process required to convert that gas into LNG for seaborne export. Currently Australia produces 20mtpa of LNG from the North West Shelf and Pluto. In 2014, 2.5mtpa will be added, followed by another 7mtpa by 2015 and around 15mtpa over the next three years. Opex will rise, on estimate, $1.3bn to $2.7bn in 2015 and an additional $900mpa until 2018, after which costs begin to taper. These numbers are still too low to put a dent in the offsetting capex decline.

Despite Australia’s LNG projects being designed with export to Asia as the primary goal, they will still supply a small amount of gas for domestic consumption which acts as a draw on AUD demand as well.

As exports of iron ore and LNG convert to earnings in USD, the bulk of those earnings will be retained as USD and , as noted earlier, only a proportion will be converted to AUD to pay distributions and taxes. Fortescue is locally owned, but will pay down foreign-sourced debt before increasing dividend payments. Iron ore producers are highly beholden to iron ore prices (LNG is sold on long-dated, oil price-indexed contracts). Resource sector analysts have long forecast lower long term iron ore prices in response to increased supply.

The domestic ownership ratios of Australia’s LNG projects are quite low. Santos’ ((STO)) Gladstone LNG and Origin Energy’s ((ORG)) Australia Pacific LNG will together account for around a third of the country’s LNG production increase from 2016 but only 35% of the production is Australian owned, equating to only a 4% profit share in 2016. By 2018 these projects will represent 20% of production for only a 7% local profit share.

LNG will see increased AUD demand of around $600m in 2015, rising to around $2bn by 2017 and plateauing thereafter.

Beyond dividends, taxes will need to be paid. ANZ cites estimates suggesting overall royalty/tax collection from the iron ore industry will remain within $1bn of current levels going forward, while the state and federal governments will together raise an extra $4bn from LNG beginning in 2018. This will rise in later years but ANZ is not yet forecasting out that far.

The bottom line to all of ANZ’s above research is that while the growth of Australian iron ore and LNG production over the next several years will serve to reduce the country’s current account deficit, there is no direct implication for upward pressure on the Aussie dollar of any great concern until at least 2017, by which time the decline in resource sector capex should have run its course. Thereafter, opex and taxes will provide increased demand for AUD.
 

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