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These 3 miners may be over-exposed to China

Glenn Freeman  |  19 Apr 2017Text size  Decrease  Increase  |  

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Australia's ongoing economic performance--and that of some of our biggest companies--hinges on China's consumption of our commodities exports.

 

The outlook for the Australian economy over the next two quarters may be strong, but the sustainability of the commodities rally is a key question.

"If the commodity sector has been driven by Chinese fiscal expansion, this momentum could begin to run out during the second half of the year," says Chris Rands, a fixed-income portfolio manager at Nikko AM.

"As commodity prices have risen, the Australian economy is set to benefit from these continuing gains ... this should provide positive economic outcomes, with the important question now being--can this last?"

Rands points to Australia's improving terms of trade as having led to a big increase in nominal GDP, which is now growing at 6.1 per cent year on year.

"As commodity prices have moved higher in the first half of 2017, this will aid the strongest expansion in nominal GDP since early 2011."

Rands believes most of the improvement in Australia's terms of trade has been due to Chinese demand.

"Over the past few months, the trade-weighted yuan has stopped devaluing against its major trading partners, and this could slow the improvement in Australia's terms of trade," he says.

"If the US Federal Reserve continues to tighten interest rates and the US dollar rises, then China may need to continue devaluing the Chinese yuan renminbi and US dollar, to avoid tighter financial conditions," he says.

Mining company outlook

On a more micro-economic level, some Australian companies have been huge beneficiaries of ongoing commodity price strength. Fortescue Metals Group (ASX: FMG)--the world's fourth-largest iron ore exporter--is one of these.

"Incredibly favourable iron ore prices" is one of the main reasons for its rapid growth, says Mat Hodge, Morningstar's senior equities analyst covering mined commodities.

"Fortescue is a China fixed-asset investment play, with practically all iron ore sold there.

"Fortescue could again benefit if China supports further high levels of fixed-asset investment, as it did in 2016, but in the long term, we see demand growth for steel in China evaporating."

Many of the same factors will affect another Western Australian iron ore company, Mineral Resources (ASX: MIN).

Morningstar's forecast of dampened Chinese demand for iron ore "bodes poorly for the company's mining business, as it is a high-cost producer" that only broke even in fiscal 2015, when the iron ore price averaged $86 per tonne.

Hodge tips falling margins for Mineral Resources, as larger miners that contract out their crushing and screening pull back their outsourcing of this business.

"Our expectation of less-favourable external conditions, a weaker mining sector, and a smaller pool of work is likely to see increased competition among mining services companies and more competitive tendering," he says.

"Mining companies will probably look to share margin pressure with contractors, which could include insourcing crushing activities to drive down contractor rates."

Rio Tinto (ASX: RIO) is one of the world's biggest mining companies. Though most of its revenue comes from its Australian, North American, and European operations, its presence spans six continents.

"Given our expectation for significantly lower iron ore prices from 2016 onwards, we no longer think Rio Tinto is likely to generate returns on invested capital above its cost of capital in midcycle conditions," Hodge says.

"While the company still enjoys low operating cots relative to its peers, particularly in iron ore, Rio Tinto lacks a sufficient cost advantage to sustain excess returns and to justify an economic moat."

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Glenn Freeman is Morningstar's senior editor.

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