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The Doctor is sick - but iron ore is worse

Worries over Chinese industrial demand were partly behind the equity sell-off at the start of 2016 - but are the industrial miners really faced by a pivotal decline from the People's Republic?
February 4, 2016

No one will be surprised to learn that the S&P GSCI Industrial Metals index has halved over the past five years. Bad news for miners, though things could be worse; you could make your living as a ship owner. The Baltic Dry index (BDI) - a measure of global seaborne trade - recently collapsed through the 500 point barrier to its lowest level ever. The BDI measures how much it costs to ship “dry” commodities around the world - raw materials like grain, metal ore, coal and steel. Though the index doesn't cover containerised exports, it is still held as a bellwether for the state of international trade; if the rating is contracting, it suggests trade is slowing. The BDI is now 85 per cent down on a recent peak of 2,330 in late 2013. But does this tell us anything about the state of industrial metals markets?

Industry overcapacity - a familiar refrain

The point about the BDI is that while it's a useful tool to examine export patterns, in isolation it's too blunt an instrument to dissect the state of global trade. Some reports have emerged in the media, at least in its more excitable quarters, suggesting that the collapse of the BDI will prefigure a commensurate slump in the global economy. But the index isn't actually a measure of the volume of world trade, but of the price you must pay to charter a ship to carry bulk goods. Nevertheless, if you were trying to gauge trends in industrial metals exports, you might be inclined to take a fairly negative view based on the recent performance of the BDI. But the fall-away in remits for bulk carriers is chiefly a reflection of industry overcapacity - a familiar refrain. The global fleet expanded rapidly as high shipping rates prompted a surge in commercial shipbuilding in the last decade.

 

 

Absolute imports versus growth rates

Any examination of the market in key industrial inputs will, by necessity, focus on import demand from China as it remains the world's chief importer across a range of commodities. As China's share of global trade increased, so did the world's dependence on Chinese demand. Unfortunately, as China transitions toward a more services- and consumption-based economy, we are witnessing a slowdown in global trade, coupled with a rise in inventory levels across the mining complex. But this shouldn't blind us to the reality that industrial demand in China continues to rise, albeit at reduced intensity. Take iron ore, for example; growth in China's seaborne imports slowed to 3 per cent last year, from an average 11 per cent a year increase through 2011-14. Likewise the example of copper, probably the most wisely viewed pointer to industrial demand; when quoted in tonnage rather than percentage terms, copper consumption in China actually increased last year by a similar amount to a decade ago, when producers were riding high on a cyclical upswing.

It would be foolish to deny that China's policymakers are grappling with structural issues, not least of which the extent of dollar-denominated assets held by the state treasury, but China's $10.3 trillion economy achieved 6.9 per cent annual growth in 2015 — the percentage increase, though slowing, is obviously set against a much larger base denominator than a decade ago. China's service sector grew by over 8 per cent in 2015 and now accounts for around half of GDP, but the nation continues to draw in huge imports of raw materials. We make this point merely to highlight that contrary to general assumptions, the current price weakness across the industrial metals complex has more to do with excess supply, rather than a marked decline in demand. It's a subtle distinction, but you would be forgiven for thinking that the latter dynamic holds sway, judging by the financial pages at any rate.

 

The last men standing?

Despite swollen inventories and a dramatic fall-away in iron ore prices; both Rio Tinto (RIO) and BHP Billiton (BLT) have sunk billions into the expansion of their producing assets in Australia's Pilbara region. After a surge through 2014/15, both miners have confirmed that supply growth will slow this year, and some industry watchers believe that both miners will benefit from increased rates of attrition as low-margin producers are forced to the wall - the so-called 'last man standing' argument.

Though both Anglo-Australian mining giants operate at the low end of the global cost curve, there's unlikely to be any near-term let-up in margin pressures. Another 266m tonnes of ore is scheduled to enter the global market over the next three years before additions are curbed from 2019. Put into perspective, that's equivalent to around three-quarters of Rio's planned output in 2016. So it's difficult to imagine that prices will ratchet-up significantly from the existing rate of $40 a tonne, all the more worrying given that iron ore was trading at $187 a tonne three years ago.

 

Diagnosis for Dr Copper more favourable

Spot prices for copper have pulled back by 56 per cent over the past five years, but the near-term outlook is certainly more favourable than that of iron ore. Copper has just come off a seven-year low, but analysts at Australian banking group ANZ recently called a market bottom, positing that a pick-up in demand from China is set to give prices a significant boost. As if to bear this out, December data from China showed that that copper imports had risen 30 per cent year-on-year to 480,000 tonnes. And the fact that inventory levels actually decreased slightly over the month suggests that there must have been an underlying increase in demand.

This call might seem fanciful to some, given the recent performance of the metal, but we've said for some time that copper's market balance is much tighter than prices suggest. Planned cutbacks in production from major multinational companies, together with improved stability in inventories in the second half of this year should help to stabilise the spot price, which at $4,534 a tonne is now just 3 per cent in advance of the level at which the GFMS team at Thomson Reuters estimates is the break-even point for around half the world's copper miners.

 

FAVOURITES: Any sustained recovery in copper prices would be good news for Antofagasta (ANTO), a Chile-focused 'pure play' that is majority-owned by Chile's Luksic family dynasty. The miner's share price has been on a downward leg since last April, though the decline accelerated during the third quarter when the group cut its interim dividend. This course of action never plays well with shareholders, but we think it reflects strategic clarity on the part of management, particularly as the group also acquired a 50 per cent stake in the Zalidar copper mine at the low point of the copper price cycle.

 

OUTSIDERS: It's been carnage across the sector over the past 12-months, with valuations across the FTSE 350 sector constituents falling by an average of 53 per cent. But the worst performers have undoubtedly been Anglo American (AAL) and Glencore (Glen). The latter group was forced to initiate a major debt reduction programme, incorporating an equity offering and the cessation of dividend payments, which actually played reasonably well with City analysts. Anglo American's share price has continued its downward path, raising speculation that it may be forced out of the UK benchmark index at the upcoming March reclassification, potentially triggering a broader sell-off amongst tracker funds. The group is currently revising its production strategy for its troubled Minas-Rio iron ore complex in Brazil, a source of delays and cost overruns since Anglo took control in 2008.

 

IC VIEW: With China's steelmaking output flat at best for 2016, seaborne volumes of iron ore will remain under pressure. Any recovery in prices will be largely dependent on how rapidly low-margin production is squeezed out of global markets, particularly - as some anticipate - that closures of domestic iron ore mines could increase China's reliance on imports. However, analysis from the World Bank suggests that iron ore prices are likely to record the largest drops among all industrial metals this year. Prospects for the copper market are certainly more favourable over the long-term, particularly if Chinese inventories levels stabilise, but it is clear that much of the collapse in prices has been driven by oversupply following years of investment by mining companies. We believe the frenzied equity sell-off at the start of this year is difficult to justify if it was primarily driven by worries over Chinese industrial demand, particularly if you view raw material imports in absolute terms. But we shouldn't get out hopes up given persistent US dollar strength and the fact that excess capacity won't dissipate overnight.