Any investor who set aside a place in their 2018 individual savings account (Isa) for BHP (BHP) can look back on a strong year. A dip in coal prices in recent months has neatly coincided with a rally in iron ore and crude oil, helping the diversified commodity group’s share price outperform its peers over the past 12 months. Of the 20 largest stocks in the FTSE 100, only Diageo’s (DGE) shares have risen by more during the same period.
But with the group’s margins buttressed by stronger prices, shareholders might be asking whether this month’s 1,955p-a-share high point – a price not seen since the summer of 2014 – could prove a mirage.
That’s one reading of a decidedly bearish turn in analyst commentary in recent months. This week, UBS became the latest in a series of banks to downgrade the miner on what it characterised as an unsustainable rise in iron ore prices to more than $90 (£69) a tonne. Prior to UBS’s recommendation change, JP Morgan cut its rating on BHP to ‘underperform’ shortly before analysts at Societe Generale lowered their rating from ‘buy’ to ‘hold’.
It’s easy to see why analysts think current market valuations are overblown. Since January, when the collapse of Vale’s Brucutu tailings dam led to a sharp cut in the Brazilian iron ore major’s output, major peers have been riding high on short-term supply fears. BHP, along with rival Rio Tinto (RIO) and pure-play Ferrexpo (FXPO), all saw their shares jump despite signs of steel mills taking stock, and marginal production returning in China.
However, just as prices started to settle – and with BMO Capital Markets predicting market efficiencies would see iron ore trend “back towards normality in short order” – tropical cyclone Veronica hit Western Australia. Rio Tinto was first to quantify the storms’ impact, confirming that damage to its port facilities would reduce Pilbara iron ore shipments to the lower end of the 338m-350m tonne forecast for 2019. BHP followed suit, dropped its mid-point production guidance from 278m to 267.5m tonnes of iron ore, and pushed up its divisional cash costs forecast from “less than $14 per tonne” to “below $15 per tonne”, after operations were hampered by localised flooding and the processing of wet material.
As such, BHP’s iron ore production will need to step up by 5 per cent in the final three months of the year to June 2019, relative to the first nine months’ output, if the miner is to hit its revised targets. But with prices back above $93 a tonne, investors may be less concerned with production targets than the maintenance of current market conditions.
In the first half of the current financial year, margins averaged 59 per cent and iron ore contributed to 41 per cent of group cash profits, despite the impact of planned maintenance and November’s train derailment in the Pilbara region.
Margins now probably sit above 70 per cent, which could in turn help to explain analyst nerves. Last week, Vale was meant to restart the Brucutu mine, which has an annual production capacity of 30m tonnes, thereby enabling the world’s largest iron ore miner to maintain its sales guidance of 307m-332m tonnes. BMO Capital Markets thinks this should ease some of the pressures on iron ore availability, and herald “the start of the potential shift of iron ore back towards an equilibrium level of $75-$80 per tonne".
