More Iron Ore Upside, Plus The Return Of M&A

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By Greg Peel

The spot iron ore price in China this week has hit US$148/t for the sort of high-grade fines produced by BHP Billtion ((BHP)) and Rio Tinto ((RIO)) and Brazil's Vale, note the analysts at Citi. This equates to a 120-130% increase over last year's annual contract price as settled with the Japanese and Koreans. China never did settle a 2009 contract price, given it was belligerently holding out for better than the 44% reduction over 2008 prices the Japanese negotiated.

This meant China spent most of the year paying not agreed to-contract prices. Throwing Rio executives in gaol made no difference. Up until last week, resources analysts were still conservatively assuming a 60% increase in the annual price while admitting 80% might be achieved. Then reports came out this week that Vale – not the aggressor in recent years – was seeking a 114% increase. And on a quarterly basis rather than an annual basis, allowing for even more upside the way things are going.

Chinese imports of iron ore hit 96mt in January-February this year – up 21% from the same period last year to the highest levels ever. For all its recent muscle-flexing, China really hasn't got this capitalist haggling game down at all. If you don't want to pay too much for your iron ore than best not to go buying record amounts of the stuff just before negotiations begin.

As soon as the Vale news hit the wires, the forecast upgrade floodgates opened. Analysts suddenly realised they were all going to look a bit silly with their paltry 60% increase assumptions, and so they're all now moving to 80-100% assumptions.

Morgan Stanley has moved to 90%. Morgan Stanley has also assumed that the traditional annual benchmark contract system has reached its twilight years, given the greater importance of the spot market and determination by the major producers to use spot as the price indicator. The analysts are now assuming spot pricing will replace benchmark pricing within five years, which is faster than they previously had assumed.

This is all well and good for producers when prices are on the rise, but the shoes will be on the other feet if prices start to fall again. However, while across the globe, and particularly in Australia, large amounts of new supply are set to come on stream, they won't be making any impact until at least 2013. Ergo, the global iron ore market will be in deficit over that period if China doesn't stop buying the stuff.

Yet global steel production hit 108mt in February notes Citi – up 30% year-on-year, and back to the previous high level in February 2008. Of that, China produced 50mt – up 25% from January. Non-Chinese production is running at only 75-85% of peak. If China keeps it up, there is little to stop iron ore spot prices. Steel-makers believe there's sufficient scope to pass both iron ore and coal price forecasts onto customers for the time being.

Looking at the shorter-term horizon, Citi's Global Macro Strategy team sees a sustained but uneven global economic recovery in 2010, with the Fed holding its cash rate steady until late in the year and the European Central Bank until early 2011. Developed markets won't be doing much spending, but the “infrastructure deficit” in emerging markets will more than compensate. The team sees further upside in iron ore and coal prices in the next 6-12 months, which will prove important if producers successfully negotiate quarterly contracts only.

The sweeping cost reduction programs initiated by global mining companies as a result of the GFC will only start to pay off this year, Citi has learned from miners, suggesting positive cashflows. Mining companies are eager to increase capex on new projects but are running into feasibility delays while balance sheets remain inflexible. This will lead to a constrained supply-side response to higher prices in the medium-term.

Morgan Stanley has upgraded its FY10-12 earnings forecasts for BHP, Rio and Fortescue Metals ((FMG)) by varying amounts as a result of its iron ore price increase. In FY10, BHP earnings rise 1%, Rio 14% and Fortescue 38%. The difference lies in FMG being far more leveraged to iron ore than the big diversifieds, and Rio's iron ore business representing a greater proportion of its stable than BHP's.

MS rates FMG only Equal-weight given recent share price moves, while the analysts are restricted on ratings for the other two given what one assumes is a corporate advisory role on the Pilbara merger (which is being stalled by regulatory concerns).

GSJB Were has run an exercise in base metal miner modelling, specifically in the copper and nickel markets, and published its results this morning. It's a confusing exercise, so I won't go into the detail.

Suffice to say, Weres believes copper enjoys the best fundamentals of all the base metals. Supply disruptions are suggesting the market must surely return to deficit within two years, say the analysts, although they are “uncomfortable with the extent to which the [spot copper] price is running ahead of the fundmentals”.

That said, the exercise has thrown up Pan Australian Resources ((PNA)) as the preferred junior copper exposure in the near-term with the larger Equinox Minerals ((EQN)) most appealing on a 3-5 year view. Weres has Buy ratings on both.

Weres has no Buy ratings on nickel names, given a bearish view on the metal. But amongst its Hold ratings in the space, Independence Group ((IGO)) has the advantages of gold exposure and Minara Resources ((MRE)) has the greatest nickel price leverage.

Returning to the theme of mining capex, Citi believes those companies with cashed-up balance sheets but limited growth options are now in the hunt for those companies with the growth opportunities but not the funding. The analysts believe another wave of M&A activity is just beginning in the resources sector.

[Incidentally, Woodside ((WPL)) is rumoured to bid for Santos ((STO)). If accurate, it would seem like Woodside has been pierced by an Arrow. If it pays a 30% premium for the already re-rated Santos to snaffle its CSM and PNG assets this late in the game, while already struggling to fund its own WA LNG projects, will it be ringing the bell on Australian LNG?]

Citi has drawn up a list of those companies it deems potential “hunters” and those the potentially “hunted”.

Local hunters include BHP, OZ Minerals ((OZL)), Aquarius Platinum ((AQP)), and Lihir Gold ((LGL)).

Local prey includes Medusa Mining ((MML)), Riversdale Mining ((RIV)), Whitehaven Coal ((WHC)), PanAust, Kingsgate Consolidated ((KCN)), and Equinox Minerals.

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