Monday, September 8, 2014

Iron Ore Warning: High Spending Days Are Over

One of the world's largest investors in mining stocks, BlackRock, has been out and about over the past week issuing warnings to the major resource companies. 

The iron ore price has hit a five-year record low and BlackRock wants to push a message to management - avoid reverting to the high spending expansionary ways and stay focused on cutting costs and rewarding shareholders.

Evy Hambro, whose team manages more than $20 billion across multiple funds for BlackRock, doesn't seem to explicitly mention whether he includes big iron ore producers chasing increased production among the list of management's bad habits - or whether he thinks the likes of BHP and Rio are ultimately shooting themselves in the foot, given that massively increased supply is a significant factor on the weakening price of the metal.

There is plenty of unconfirmed talk that this is the message that BlackRock has conveyed to the likes of BHP Billiton (in which it is the largest shareholder) and Rio Tinto.

One of the larger culprits in a supply-flooding sense is Fortescue which, percentage wise, has grown much faster than its larger competitors. However the genesis of its expansion plans dates back many years and its target production level has now been reached. 

Fortescue's shareholders are unlikely to see any further volume expansion beyond sweating the existing assets a bit harder.

The ripple effect of the continuing fall of the iron ore price is an issue that is now becoming mainstream. It has major ramifications for the country's exports and governments' tax revenue and thus the broader economy.

To date the large mining companies in Australia have been able to offset last year's lower commodity prices for iron ore and coal by undertaking major cost cutting drives and efficiency initiatives.

But if prices continue to fall and much of the low hanging fruit has been harvested, revenues and profits will be under pressure.

While we can't blame everything on oversupply, given there are seasonal demand factors from the Chinese customers that come into play - the latest of which is that country's weak property market - the fact remains that the Australian producers in particular have been pumping out enormous volumes of iron ore into the seaborn market.

The immediate focus for the Australian iron ore industry has been the health of the smaller mining companies with cash costs close or in excess of the current iron ore prices. How much longer can they last and is this the start of a wave of consolidation?

Western Desert Resources, a company unknown to most, became the canary in the coal mine last week when it had receivers appointed to it. It was the iron ore plaything of hotel billionaire Bruce Mathieson, and had plenty of high-profile directors on the board - with loads of experience across business. Sadly not much in mining.

How the industry shakes out from here depends on which of the smaller players are attractive to those looking for a cheap entry and the agenda of the buyers.

There may be some consolidation between the smaller players - and how this pans out depends on which have cash. BC Iron recently made a $250 million bid for Kerry Stokes' iron ore play, Iron Ore Holdings.

Earlier in the year the Chinese group Baosteel moved into the market in a joint bid with rail infrastructure group, Aurizon for Aquila Resources.

New York-based financier Edward Sugar - a man who helped Fortescue find finance in its early days and who was in Australia last week - suggested there were billions of dollars waiting in the wings looking for resources projects.

He says that private equity players that have traditionally not stepped into the mineral resources space are now assessing whether there are opportunities stemming from the fallout from the financially wounded or the asset sales from the bigger mining stocks that are looking to focus their core portfolios. BHP Billition and Rio are clear examples.

The interest from these private equity groups and other funds set up to invest in mining assets generally - like that formed up by former Xstrata boss Mick Davis - are scouring Australia, the UK and Canada in particular.

UBS' Glyn Lawcock has just released a useful update on the price iron ore (62 per cent Fe which is the one traditionally used) needs to be for companies to hit cash break-even.

For Rio (best in show) it is US$45, BHP needs an iron ore price of US$50 and Fortescue needs a price of US$74. The first two are looking pretty comfortable at this price and FMG will hope to further reduce its costs in order to make a decent return at current price levels.

But the next layer down the smaller iron ore producers hit break even above where the iron ore price is today. The exception in Mount Gibson and BC Iron which have a bit of additional head room.

These producers can not afford to ride out a protracted period of weak prices. 

And there is enormous disparity among those in the industry, the investment banks commodities experts and even the Australian state and federal treasuries about the outlook.

Lawcock for example thinks the price might pick up a bit in November and December (as it usually does).
But not even the most optimistic are suggesting that the days of super profits from this industry are set to return. It's a business that can generate good returns if costs are low but the days  of justifying the massive capital costs of building rail and port infrastructure from scratch appear to be a thing of the past.

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