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China's prodigious appetite for steel tipped to ease

Lex Hall  |  16 Apr 2019Text size  Decrease  Increase  |  
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China’s strong demand for steel has been a boon for Australian iron ore miners such as Fortescue Metals Group but doubts persist over the long-term outlook as the Middle Kingdom transitions from investment-led to consumption-led growth.

The Australian mining sector is overvalued, in the eyes of Morningstar analyst Mathew Hodge, who expects lower volume growth and prices for iron compared to the “heady years” between 2010 and 2013.

“Overall, we see the mining sector as overvalued,” Hodge said in a note published last Friday. “The Australian miners trade at an unweighted average 19 per cent premium to our fair value estimates.

“We see the iron ore-exposed stocks as most overvalued. Current prices are elevated by what we think are short-term supply disruptions and current demand drivers are unlikely to persist.”

And yet steel-making materials stocks – those exposed to iron ore and coking coal – have done well recently and beaten expectations.

Part of the reason is the strong demand from China but also supply disruptions such as Vale’s tailings dam failure in Brazil in January, and the shutdown of operations in the Pilbara because of Cyclone Veronica in March. These incidents have boosted the iron ore price, which hit a five-year high in February of US$90.99.

This has given a slight boost to the fair value estimates of mining firms, the bulk of which nevertheless remain overvalued – the exception being New Hope (ASX: NHC).

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Rio Tinto (ASX: RIO) is the most expensive of the group, trading 70 per cent above our $60 per share fair value estimate. BHP (ASX: BHP) and Fortescue trade closer to 40 per cent premiums,” Hodge says.

“With the recent decline in the spot thermal coal price, and potential trade ructions for Australian thermal coal to China, New Hope is now the cheapest in our coverage, trading at a 20 per cent discount.”

The key to demand is China, which accounted for 75 per cent of the global growth in steel production in 2018.

However, while steel consumption continues to grow more rapidly than expected, the country is on track to reach an “equilibrium point” where very little new steel from iron ore and coking coal is required.

If the country continues to add to its stock of steel at the 2018 rate of about 0.5 tonnes per person a year, it will swiftly reach equilibrium point in about a decade, Hodge says.

“The maturity of China’s existing infrastructure and housing stock, coupled with falling population growth, a declining working-age population and future urbanisation rates are key headwinds to future demand,” Hodge says.

“To be more positive, we would have to conclude that China will be an outlier on steel stocks. That fundamentally the economy just requires more steel stocks per person than the likes of the US, the UK, Japan, Canada, Australia and South Korea.”

On the commodity pricing front, Hodge has increased his forecast iron ore price to US$78 per tonne in 2019 and US$65 per tonne in 2020 versus US$72 and US$60 per tonne previously. 

is senior editor for Morningstar Australia

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