Weekly Broker Wrap: China, Steel And The Carbon Tax

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

By Andrew Nelson

Australian market watchers breathed a sigh of relief Friday afternoon after the last few horses crossed the reporting season finish line. There will be a few more stragglers in the days (and weeks) ahead, but for the most part broker focus will shift a little more back to the forest from the trees.

Last week’s sample of noteworthy broker reports includes commentary on the state of the big iron ore plays, a couple of snapshots on China’s stimulus efforts and some positive news on the carbon tax.

Iron ore prices fell around another 15% over last week alone, notes a report from Macquarie, who sees prices remaining volatile over the short term. While the broker, like most, is expecting a recovery in iron ore prices at some point, it also notes financial and valuation pressure will remain and increase the longer prices remain depressed.

On the other hand, the broker sees an equal, if not greater, iron ore spot price upside risk once the shorter-term pressure of current de-stocking ends.

Still, were iron price to remain flat for the next 12-18 months, the broker estimates that around 50% and 80% cuts to BHP Billiton’s ((BHP)) and Rio Tinto’s ((RIO)) 2013 earnings respectively, would ensue. BHP’s 1-year forward PE ratio would jump to 22x and Rio’s would rocket to 37x given more iron ore exposure. Based upon the above assumptions, Fortescue ((FMG)) would take an absolute beating, with earnings cuts in the neighbourhood of 85%-100% likely.

And while Macquarie sees such an outcome as being highly unlikely, it notes such conditions would also cause a bit of a balance sheet quandary for all three as well. Fortescue would require a further US$1.5-2b of external funding. Meanwhile, the broker also sees a cash flow shortfall of around U$10bn at BHP and U$13bn at RIO after dividends are paid and planned capex is spent. Thus, despite a reluctance to borrow in order to fund organic growth, management may be forced to borrow to maintain the dividend.

Also spurred on by the recent fall in iron ore prices, JP Morgan has dusted off its own abacus to factor for a longer run of weak prices. Firstly, the broker is a little less optimistic about a nearer term price recovery, noting the while steel prices are falling, the Chinese are continuing to pump out product. The broker belies that eventually the mills will pause to restock and the government may step in to slow iron ore production, but this will take some time.

In the meantime, JP Morgan sees little in the way of catalysts for iron ore prices.

On its numbers, Rio Tinto looks the best, with BHP next and Fortescue coming in last because of the aforementioned funding requirements. In mid-caps, Mt Gibson ((MGX)) would take the biggest hit given an inability to extract maximum value from its short mine lives. Both Grange Resources ((GRR)) and Atlas Iron ((AGO)) would fare better given stronger balance sheets, positive cash flow and lower development risk. Gindalbie ((GBG)) is the broker’s least preferred, given high leverage and potential commissioning risks at Karara.

Shifting our focus to China, economists at ANZ Bank ((ANZ)) note it is difficult to predict when a policy move may happen. However, the bank does notes that even despite the unpredictability, a bit of information can still be inferred from the timing of the PBoC’s past policy announcements.

ANZ notes that past policy announcements show that a change in the Reserve Requirement Ratio (RRR) is twice as likely to fall on Fridays as any other day, with interest rate moves pretty much spread evenly over the days of the week. The bank believes the PBoC will need to cut the RRR to encourage commercial banks to put more loans out in to the economy and thinks such a cut will happen at some point in September.

On a similar topic, analysts at BA-Merrill Lynch note news reports from the UK indicate China may be planning to spend a whopping 800bn pounds on stimulus in order to boost the flagging economy. However, the broker thinks the word “stimulus” was likely misused in the article. It’s been more than a week since the report and the broker notes there has been nothing on major stimulus packages thus far, and while BA-ML does expect more policy easing this month and next, it sees the chance of China announcing its biggest ever stimulus package is quite slim, at least in the near term, unless we see GFC-II.

Quite a few brokers took the chance last week to comment on and calculate the impact from news the Australian carbon pricing scheme will link to the European scheme, via a one-way link, from 1 July 2015.

The $15/t floor price for 3 years from 2015 will be abandoned, while the 3-year fixed price period from 2012 to 2015 remains at $23/t. After that, Citi notes from July 2015 onwards, companies may meet up to 50% of their liability permits, with a sub-limit of 12.5% imposed on use of "Kyoto units".

In short, this means the European carbon price will become a driver of the Australian carbon price from 2015. Right now, European carbon prices are at about $10/t and Kyoto units at are at around $4/t. The broker reports European price forecasts are for around $12-15/t in 2015, rising gradually to around $20/t in 2020. Don’t get too carried away with theses forecasts, warns Citi, as there is considerable uncertainty in predicting the carbon market right now, while talks are also underway to strengthen the European carbon price as you read this.

The broker sees a little bit of valuation upside for carbon trade-exposed companies such as those with commodity products priced on international markets, like steel, aluminium, coal etc… There is also minor upside for companies that are likely to receive a good number of free permits like steel and cement companies, as they might be able to buy cheap Kyoto units and sell some free permits, although this upside is capped given Kyoto unit restrictions.

BA-ML is of a very similar view, noting the new regime implies a potentially lower impact from July 2015 onwards. Although with Australian emissions reduction targets still unknown, the broker notes an aggressive baseline could still drive the price higher.

Analysts at Macquarie are on the same page, noting the news serves to water down the impact of the carbon tax, with the impact depending upon whether companies were winners or losers under the previous regime.

In theory, the broker notes Australian households will be better off, but the impact won't be material. The impact on electricity generators will depend on emission intensity, with Macquarie's Infrastructure analyst Ian Myles estimating that brown-coal fired power generators and gas-fired generators will actually be worse off, while green power generators will come out neutral and black-coal fired generators will be better off.

Macquarie also took a look at how the Government’s prediction of a 2012-13 budget surplus are coming along, given the recent falls in commodity prices.

In short, the broker estimates that if commodity prices do not recover, we’ll probably see budget cuts of around $10bn to keep the government’s surplus promise on track.  Such a cut would imply about 0.75 percentage points of GDP, with the impact concentrated in the first half of 2013. The good news is that it at least looks like the 2011-12 budget  will meet revised forecasts, meaning at least the government didn’t start from behind the eight-ball before the year even began.

Lastly, Morgan Stanley pours a bit of cold water on those hoping for an end of year share market rally like we saw at the end of 2010 and 2011. Firstly, because the global growth slowdown hasn’t really reversed, while the broker also sees potential for disappointment in US, Europe and China policy moves.

The downside risk is greatest for cyclical sectors, as that’s where the broker sees widespread earnings downgrades after the market is done with commodity-related sectors. The broker admits that cyclicals did start to outperform through August, but its sees that rally as pretty much done, with no expectations for it to re-start.

 
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