Bulk Buys: Here’s why BHP is confident US$100/t is the right price for iron ore
Iron ore prices have, it could be argued, flattered to deceive.
As the Chinese property sector conks out and the zombie-like husk that was Evergrande looks finally ready to call it quits, you may be wondering when steel demand is going to kick the bucket and consume iron ore miners’ hopes and dreams on the way down.
Since that bearish property news hit our iPhone screens the picture for iron ore only seems to have, somehow, got rosier.
Singapore futures were back above US$110/t yesterday, with hopes for stimulus measures to come and China’s apparent reluctance to enforce wide scale production curbs on steelmakers coming to the fore.
While some analysts think cost support from marginal producers will be found around US$75/t, BHP’s (ASX:BHP) top brass are now more confident that in the short and medium term it’s more like US$80-100/t.
That could mean iron ore prices remain at attractive levels for longer — remember BHP produces it all at around US$17/t — protecting for some time to come BHP’s golden goose, responsible for 60% of its US$28 billion EBITDA haul in FY23.
Asked whether he was scared iron ore prices could fall as Chinese production curbs set in, BHP’s CEO Mike Henry was bullish on a conference call yesterday on the back of its full year financials.
“I think there’s actually two factors at play. One is overall what happens with steel and therefore overall impact on iron ore demand, but we also have to keep in mind that inflation has been running at pretty high levels,” he said.
“We’ve contained inflation at our iron ore cost of 5% in terms of the unit cost but we know others that run at higher levels.
“Hence my point earlier that we’ve kind of doubled our lead. The implication of that, because that inflation has been global, is that the marginal cost of production for iron ore as well as other commodities, has gone up.
“All other things being equal, that means a cushion kind of arises for iron ore at higher levels and other commodities at higher levels than it would in the past.
“I think in the case of iron ore we’ve spoken about at US$80-100 is kind of the window where we see that cushion kick in. Obviously very difficult to predict the specifics and it will come back to how sharp is the pullback in demand and so on.”
But it’s not just about the nature of inflation.
BHP chief economist Huw McKay’s economic and commodity outlook is always essential reading. To him, there are plenty of fundamental reasons iron ore has found cost support at US$100/t, only breaking lower on a handful of occasions since the pandemic.
“Using Wood Mackenzie’s forecasts published in the September quarter of 2018 for the state of the industry in 2021 as a proxy for market consensus, we note that actual contestable demand was +125 Mt higher than expected in 2021,” McKay said.
“Major seaborne producers collectively exported –79Mt less that year than was expected three years earlier. And rather than being squeezed out, higher–cost producers increased total production by an enormous +183Mt – essentially enough to constitute another ‘major’.
“Fast forward to calendar 2023, and the major seaborne producers have collectively increased supply by only +25Mt over the calendar 2021 level, while contestable demand has been relatively flat.
“Chinese domestic production has been relatively stable too.
“Ergo, there has been little change in the aggregate call on higher–cost supply, and hence we return to the original observation that the wedges of supply that currently underpin the $80–100/t cost support range feel like they are firmly in place while the current constellation of fundamentals persists.”
BHP continues to see China’s steel production in a plateau state at between 1-1.1Bt, a notably more optimistic outlook than Rio’s (ASX:RIO) Jakob Stausholm a few weeks ago, who said Chinese steel had already peaked.
Its performance has dropped year on year since 2020 (1.065Bt) as China’s economy attempts to shift from a reliance on infrastructure and construction and towards a focus on retail and services.
But McKay sees the stretch of 1Bt+ years continuing for a 5-6 year spell, until 2024 or 2025, while India is emerging as a major growth centre for iron ore and commodity demand.
It is planning to grow its steel industry to 300Mt by the end of the decade and 400Mt at some point beyond that.
“I’ve mentioned strong growth in India, I was there about a month back and the energy in the country is palpable,” BHP CEO Mike Henry noted on the earnings call, reinforcing his positive outlook on BHP’s iron ore and metallurgical coal divisions.
Looking out longer term however, the prospect of large sources of new high grade iron ore from the Simandou project in Guinea, part owned by Rio Tinto, is now becoming more likely, McKay said.
“Looking out a few years we consider the entry of new, higher–grade supply from the Simandou project in Guinea to be a near certainty, with first tonnes likely to come no later than the final third of the decade,” McKay said.
“Additional tonnes are likely to come out of the major basins as well, including the plans and studies that BHP has outlined.
“We also note the ambitions of the Chinese domestic iron ore industry to increase production materially, while the scrap–to–steel in China is also assumed to be heading consistently higher – notwithstanding the struggles that the scrap industry has endured in the zero–COVID era and its immediate aftermath.”
This could see an environment with lower prices emerge, eventually.
“Our analysis indicates that the long run price will likely be determined by the all–in 62% equivalent cost base of the least competitive seaborne exporters (higher operating cost and/or lower value–in–use) in either Australia or Brazil,” McKay said.
“That assessment is robust to the prospective entry of new supply from West Africa, and China prioritising the accelerated development of its domestic resources. This implies that it will be even more important to create competitive advantage and to grow value through driving exceptional operational performance.”
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OK, that’s iron ore. What about BHP’s coal division?
Much has been said about the sale of the Daunia and Blackwater mines in Queensland, which BHP is likely to flog for billions to some lucky (or perhaps unlucky) suitor.
BHP is likely in no major rush. It’s six months into a process it initially gave itself two years to complete.
It views the mines up for grabs as less attractive than the rest of its BHP-Mitsubishi Alliance assets. Those produce premium hard coking coal, the benchmark steelmaking coal product traded on the open seas.
Daunia and Blackwater are semi-soft coking coal producers, which typically trade at a discount to PHCC.
BHP also thinks given the large proportion of steel made via the high polluting blast furnace route in China and India, higher quality coals will be desired to reduce emissions as the world transitions towards green steel.
Front month thermal coal futures were trading at US$162/t yesterday, with premium hard coking coal at a premium at US$255/t.
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