Material Matters: Global Capex, Iron Ore, Steel

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– Global mining capex still softening in 2015
– Happy days almost over for iron ore juniors
– US scrap steel market still doing it tough
– Most Aus economic scenarios negative

By Andrew Nelson

Being negative on mining capex is no new thing. Citi points out its view soured back in March 2012 and since then, things have become increasingly worse. The broker is starting to see a little storm brewing, as while everyone knows how difficult it is in this sector, the bulk of earnings revisions had been meted out for this year.

Over the previous months, Citi says it has seen inarguable evidence that miners are continuing to cut future capex, that more ore mines are being mothballed, copper and gold projects are being slashed and mining equipment companies have more and more product sitting in their lots.

In the meantime, Citi reports that the majority of consensus downgrades after the end of the first quarter have been focused on 2013 estimates, more so than 2014 and out-years. This is troubling to Citi given the deteriorating fundamentals. This is especially so in Europe, where mining equipment providers saw a double-digit drop in the 1Q, further weakness in the 2Q, while all the while mining capex expectations for 2014 continue to be cut.

The broker sees this theme continuing to play out, not only over the course of 2014, but 2015 as well. The broker expects a cumulative 30% decline in mining capex over 2013-15, with more than half of it hitting in 2014. Thus, Citi sees increasing risks to 2014 consensus forecasts for the sector.

Making matters worse for Australian miners is that the Chinese have been getting better at the business. Citi notes a few recent contract wins indicate improving Chinese competitiveness, with companies winning business outside of China.

Macquarie notes a number of smaller iron ore plays have done well over the past few years, with their flexibility allowing them to pick up more than just crumbs from off the table. In fact, Macquarie reports that this year, around 25% of Chinese supply came from minor players in Australia, Brazil, India and South Africa.

However, Macquarie sees these days in the sun coming to an end now that a number of major projects are nearing production and now that finance for capex is becoming increasingly scarce. Macquarie points out that for every junior Australian project that made it to the market there was at least one that did not. There is no one taking these bets anymore.

Low capex, high operating cost, flexible business models, just like they have in China, is the way of the next few years. The projects leveraging off existing infrastructure and staged project growth to protect the balance sheet will be the ones favoured. In fact, Macquarie sees these types of projects outperforming well into the medium term.

The ones that won’t are the infrastructure heavy, high capital intensity projects, as there just isn’t any money or investor support for them in the current environment.

Analysts at CIMB took a poll of North American metal recyclers and the news was not good. Current conditions are dismal and respondents are almost universally of the belief that there are too many players in the market, meaning cost bases need to be kept uncomfortably lean.

Yet despite the incredibly difficult conditions, CIMB also saw a considerable amount of optimism about future prospects. Many surveyed believe conditions are near or at the bottom, although any sort of recovery is expected to be slow. What’s worse, the current levels of completion will serve to cap the potential upside for all players and may well be pointing to a more fragmented, lower profit market.

Lastly, analysts at BA-Merrill Lynch have put together a brief roadmap for the Australian economy post resource investment boom. The broker notes as the boom fades into the rear view mirror, the economic risks to the broader Australian economy are increasing.

This is especially so because the non-mining related sectors of the Australian economy are not really responding to lower interest rates, while the AUD is still high by historical standards. BA-ML's best case scenario, one to which it attaches a 75% probability, is that Australian real GDP growth slows from around 2.75% in 2013 and 2014 to just under 2% in 2015 and 1.5 % in 2016. Unemployment would peak at 6.75% by early 2016.

BA-ML sees a 25% chance that Australia drops into recession starting in the second half of 2015. Real GDP growth would average 1% in 2015 and negative 0.1% in 2016. Unemployment would reach 7.5% by mid-2016 if this case plays out.

There are, however, a few positive aspects. These are ongoing currency depreciation and subsequent falling costs. Both of which are positives, at least for the resource sector.

BA-ML expects the AUD will find it difficult to stay above US$0.90 over the long-term, especially if the weak growth expected in 2015-16 coincides with a deteriorating balance of payments, the end of Fed QE, less commodity-intensive growth in China and less speculative demand for the currency. In a recession scenario, BA-ML says the AUD will likely depreciate to the low 0.80’s

But if this does play out, there is some significant upside for a number of miners due to anticipated downward pressures on costs. The winners, of course, will be the big diversifieds, with BA-ML seeing considerable upside for both BHP Billiton ((BHP)) and Rio Tinto ((RIO)), although most domestic gold plays would also enjoy lower operating costs.

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