Bulk Buys: With iron ore prices taking a slight breather, are the majors a sell?
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Almost two weeks ago UBS slapped a sell label on Fortescue Metals Group (ASX:FMG) which, given its lack of diversity, is the most exposed major on the ASX to a fall in the iron price.
There are two aspects to this. Unlike Pilbara giants BHP (ASX:BHP) and Rio Tinto (ASX:RIO), which have world class assets in copper, nickel, alumina, met coal, oil and gas (for now), and lithium (for later), FMG remains solely reliant on its iron ore portfolio to generate income.
Secondly, FMG has weathered big discounts for the lower grade of its iron ore compared to the benchmark 62% fines index on which the price of the steelmaking commodity is measured.
While it is now cost competitive with Rio and BHP, those discounts mean downturns in the iron ore market hit FMG harder.
Prices have surprised in the week since they ducked for cover at US$92.98/t last Tuesday on steel output cuts in China.
They recovered to US$119.31/t on Monday on Fastmarkets MB, in moves price reporters say were related to restocking ahead of the weeklong National Day holiday in China with 58% discount fines going for $89.07/t.
Many market watchers believe prices will remain muted until at least February when restrictions designed to reduce pollution from steel factories ahead of the Beijing Winter Olympics could be relaxed.
However, exactly where they will fall remains a mystery.
In that context are the big iron ore miners a sell, as UBS suggests?
Kingsley Jones from boutique advisory firm Jevons Global told Stockhead the firm, which runs a model portfolio for investment advisors, is holding its iron ore exposure despite the recent negative sentiment.
Its largest single stock holding is BHP, which Jones said he likes due to its diversified revenue stream, although the sale of its oil and gas assets to Woodside will impact that.
Mineral Resources (ASX:MIN), which is diversified in mining services and lithium, is also in the Jevons Global model portfolio, some of which was traded out to buy Fortescue after the MinRes dividend payout and before the bumper FMG dividend.
Jones believes the conditions that resulted in iron ore’s charge above US$200/t earlier this year were not just a demand story, but also about supply discipline from the majors.
He said a strong reason for holding on iron ore stocks, which some analysts including UBS, the Federal and WA Governments and Commbank, have said could drop to US$65/t or less long term, was that despite a slowdown in China, the global steel market remains strong.
“What I think other people are not perhaps realising is that construction is actually pretty strong worldwide, too,” he said.
“So if you look at most of the building material companies, and if you look also at the train manufacturers outside of China, they’ve all been doing pretty well in the last year.
“So that speaks to a general pick up of construction demand ex-China. So that’s the main reason why we are a little bit hesitant with this, we’re a bit counter trend on that move.
“But you understand that if the move itself is to rotate within the sector, that’s not the same as increasing your exposure. So there we’re consistent with the general market view, we’re not adding new money into positions.”
Global steel production up to the end of August was up 10.6% on the year to date. Much of that was driven by China, which is now attempting to limit output to 2020 levels despite producing 12.2% more steel through the first half of 2021 than it did last year.
But markets outside of China are also improving, meaning global steel production and consumption could increase even if China succeeds in getting its output flat.
Coking coal prices, also part of the traditional blast furnace method of steel making, have also risen to record levels in recent weeks. While that has been driven by supply constraints, it shows steel mills remain buyers of raw materials.
One of the big reasons cited by analysts who are predicting a drop in iron ore prices has been the falling marginal cost of production for the major producers, who dominate the seaborne market.
Costs from companies like BHP, Rio and FMG are so low that with a bit of supply discipline they would still be making money at US$60/t.
However, not all of China’s iron ore comes from Australia and Brazil. In fact, China has a large domestic iron ore industry, which produces at higher costs and lower qualities than its trading partners.
Opportunities for China to become self-sufficient by increasing its use of scrap steel and wielding its global superpower influence to build large new mines in Africa are still some way off.
That means that in the short term it can only limit its reliance on the Aussie miners and Vale by boosting domestic production.
“I think what’s happening in the background is that it’s true, the Chinese steel markets are weak in terms of the import demand that we saw during that price collapse,” Jones said.
“But I also think that what’s happening is that China has recognised that they’ve got high steel prices domestically, because they’re purposefully trying to limit the growth of their industry, for whatever reason, whether it’s pollution, or carbon, or whatever.
“And they’re also encouraging rationalisation of the industry to make it easier for the steel mills to be price setters on buying inputs.
“But they also have a big domestic iron ore production sector. And there’s no way in the short term that they could substitute away from Australia and iron ore, without sustaining that domestically.”
While top Australian miners would be profitable at US$55-70/t, China’s iron ore miners would not be.
“So there’s another element to the clearing price, which is what prices make sense for Chinese iron ore producers within China,” Jones said.
“And we don’t think that’s $55-$70/t. It’s probably more like $80-90/t. And they can’t survive at that level if they don’t make a profit.
“So we think the prices are more like the $90-100 range that we saw tested last week.
“And that doesn’t mean we don’t go to $50 or $70/t in a circumstance over the next period which is obviously going to be weak, where the obvious catalysts for that would be Evergrande misses more than one bond payment, and we see a significant correction.
“And that can happen, but frankly we’d be buyers at that level.”
One area of the iron ore space that could be a growth area is the green iron space, one of the areas FMG is aiming to enter as it looks to become a green hydrogen leader.
One ASX-listed junior brandishing its green iron credentials is Magnum Mining (ASX:MGU), which wants to use biochar to process iron ore from its Buena Vista mine in the USA into hot briquetted iron and pig iron.
A production test of its green direct reduced iron is under way under the watch of steelmaker Shougang Group in China, the company reported yesterday.
It is conducting testing in a pilot rotary kiln facility to take iron ore, blend it with bio-char and produce green sponge iron and DRI products.
Magnum plans to use the test work to work out the optimal kiln size and feed grade of iron ore and bio-char and outline the the initial capital and operating costs for a commercial sized rotary kiln.
It is targeting the currently booming US steel market, where construction of new steel facilities, especially environmentally cleaner electric arc furnaces, is expected to ramp up in the coming years.
“The company is perfectly placed to supply the strong US domestic steel market,” Magnum MD Dano Chan said.
“There is a current and forecasted shortage of green pig iron supply in North America.
“With our own low-cost in-house iron ore and abundant local biomass supply, Magnum remains on track to achieve its vision to be a highly profitable producer of green iron and to achieve this in a relatively short timeframe serving rapidly growing markets.”
According to prices reported by Fastmarkets, premium hard coking coal out of Australia was fetching around US$406/t on Monday.
Shortages have fuelled high prices in China that have flowed into other markets like India, which are taking more Aussie coal since China locked our product out in October 2020.
The Global Times, the English language mouthpiece of the Chinese Communist Party, has taken umbrage to suggestions that the decision to lock Australian coal out of the country was spurring the price crunch.
It came as the paper said local officials were looking to ramp up imports of the energy source as winter approaches and power rationing appears to be taking hold.
“Amid the electricity shortage, some have claimed that the disruption of trade with Australia could be one of the reasons for the tightened supply, speculation that has been denied by industry insiders,” reporters for the Global Times wrote.
“Australian coal accounts for only 3 percent of total coal consumption in China, the Global Times learned from several industry insiders.”
Whatever the reason for the supply crunch, Aussie coal miners will for the time being be smiling all the way to the bank.