Image Source: Peter Craven
By Kris Rosemann
Recent reports from the likes of BHP Billiton (BHP) have echoed our previous concerns with the iron ore market, “Iron Ore Market Stability Still A Ways Off.” A number of factors on both the supply and demand sides of things are expected to provide pressure to the price of iron as we move further into the back half of 2016. BHP, for one, anticipates economic uncertainty, political instability and well supplied markets to continue weighing on iron ore prices, among other commodities.
Seasonal factors will weigh on Chinese (FXI) demand–the nation is the world’s largest purchaser of seaborne iron–in the winter months when construction typically slows as a result of more inclement weather. The recent rally in iron prices has been partially attributed to a credit-driven surge in the Chinese property market. On the supply side, increased production is expected to come from Vale (VALE) beginning production in its S11D project before the end of the year, and output from the Roy Hill project in Australia’s Pilbara region is growing in 2016. The Roy Hill project is owned by a consortium that includes POSCO (PKX), China Steel Corporation (CISEF), and others.
BHP is fresh off reporting its worst annual loss ever of $6.4 billion largely due to one-time charges related to its US onshore energy assets and a major dam disaster at a joint venture with Vale in Brazil, “Developments in the Iron Ore Market.” However, even after excluding the $7.7 billion in writedowns and charges in the year, the firm reported an underlying profit drop of 81% from the year-ago period due to weak iron, copper, coal, and oil prices. Such material weakness came despite the firm setting a Western Australia Iron Ore production record; BHP’s production levels will continue to weigh on the global supply/demand dynamics in the iron ore market. The mining giant’s potash developments may provide a similarly disappointing feeling in the coming periods, as it is reportedly considering “mothballing” the shafts of its massive Jansen potash project, on which the company plans to spend $200 million in fiscal 2017. Timing its entry to the potash market will take precedent over simply getting the mine to production.
While many are expecting the most recently ended fiscal year to mark the bottom of the trough in BHP’s business cycle, CEO Andrew Mackenzie’s recent comments provided a bit of contradictory tone. Commodity prices are expected to remain low and volatile in the short to medium term, and though the firm is confident in the long-term outlook for the commodities it produces, oil and copper were singled out as the most attractive long-term opportunities, leaving the door open for questioning of the firm’s iron ore operations. The company also failed to deliver on its promise of reducing debt in a meaningful way as net debt remained relatively flat at ~$26 billion.
Investors may have been given a sense of false hope from BHP management in its quarterly conference call as it suggested that it will generate over $7 billion in free cash flow in fiscal 2017. However, such guidance assumes current spot prices and foreign exchange rates hold steady throughout the fiscal year, something that is unlikely to happen, given the aforementioned expectations for supply and demand pressures on iron ore, as well as the rebound in prices in early 2016. Such guidance seems to counter the notion of low and volatile commodity prices in the near and medium term.
Iron ore producers such as Glencore (GLCNF), Anglo American (AAUKY), and Vale are expected to increase asset sales to reduce debt in the back half of the year should prices fall again. The planned asset sales in the first half of the year did not meet original expectations due to the rally in commodity prices, which was fueled by China’s attempts at restoring economic growth. Anglo American and Vale both receive junk-grade credit ratings, and Vale has a good deal of work to do to reach its goal of $5 billion in asset sales in 2016 (it has completed less than $300 million in sales thus far). Glencore receives a credit rating one notch above junk status and has been the most successful in selling assets this year; the firm is well on its way to selling its targeted $4-$5 billion in assets.
Potential buyers of assets include industry giants BHP and Rio Tinto (RIO), but such purchases will likely wait until the recent bounce in commodity prices retreats and prices are more attractive for the acquiring firms. While BHP does not expect to begin growing capital expenditures until fiscal 2018, Rio Tinto will begin ramping up spending in the back half of 2016 as it works to hit its $4 billion annual target after spending just $1.3 billion in the first half of the year. The firm did not adjust its production guidance, as it still expects iron ore shipments of ~330 million tons in 2016 and 330-340 million tons in 2017.
Former Best Ideas Newsletter portfolio holding Rio Tinto remains our favorite operator in the iron ore space. Unlike rival BHP, the firm was able to reduce its debt load in the first six months of 2016, as its net debt position fell to $12.9 billion from $13.8 billion (good for about half of BHP’s net debt position). However, we cannot ignore the macroeconomic pressures that will continue to weigh on its business. The issue of stability in the iron ore market remains far from resolved, and major operators have shown little desire to slow down production.
While BHP may be able to put the worst of the worst behind it after its abysmal fiscal 2016 results, we certainly haven’t seen the end of the pain for metal producers. A reversion to prices seen in late 2015 could be the most likely scenario for iron ore as a result of material supply and demand pressures coming towards the tail end of 2016. The wave of dividend cuts we saw in early 2016 was a prime display of the difficulty even the best management teams have in navigating the cyclical nature of global commodity markets, and a perfect example of why we prefer to avoid relying on commodity producers for income.
Metals & Mining – Diversified: AG, BHP, CLF, FCX, RIO, SCCO, SLW, VALE