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Silver linings in the iron ore sell off

Lewis Jackson  |  26 Nov 2021Text size  Decrease  Increase  |  
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Several diversified Australian miners are fairly valued for the first time in years as a boom in copper and coal cushions the blow from a collapsing iron ore price.

Iron ore has fallen from heights above US$200 since August as a slowdown in Chinese real estate and an emissions crackdown in the steel industry crimps demand for Australia’s biggest export. In response, share prices for BHP, Rio Tinto and Fortescue Metals’ each fell by roughly a third.

That’s left Rio Tinto and BHP looking fairly valued. Morningstar director of equity research Mathew Hodge acknowledged the impact of lower iron ore prices with fair value cuts of 4% and 5%, respectively. But rising prices for aluminium, copper and coal partially insulate the diversified miners from the iron ore rout, he says.

“The blow from lower iron ore prices for Rio Tinto and BHP is partially offset by stronger near-term copper prices, and for BHP, higher metallurgical coal prices.”

“The general material sell-off in iron ore miner share prices sees the group of iron ore producers no longer materially overvalued, with the notable exception of still-expensive Fortescue.”

BHP (ASX: BHP) shares closed Friday at $38.03, just off Hodge’s updated fair value of $39. Rio Tinto (ASX: RIO) finished at $94.86, slightly above the updated fair value of $89.

Hodge warns there is little margin for safety in either miner, with the risk of a persistent downturn in Chinese economic activity.

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This changing of the guard in commodity prices is set to persist for several years, according to a set of new forecasts from Morningstar.

Hodge lowered his average iron ore price between 2021 to 2024 from US$133 to US$116. Meanwhile aluminium, copper and coal prepare for time in the sun, with the long-term price forecast up by 9%, 20% and 32%, respectively.

Iron ore prices are falling in tandem with Chinese demand, which accounts for roughly three quarters of the global total. Coal and copper prices are moving higher as demand from the post-covid economic reopening runs up against supply shortages.

The miners are also actively building out their portfolios with the minerals they claim a future world requires.

In July, Rio Tinto announced a US$2.4 billion investment in its Serbian lithium project, which it claims is one of the world’s largest greenfield lithium projects. Hodge says the impact of the Jadar mine is likely to be modest but does help offset the impact of lower iron ore prices.

“Jadar provides an important tilt towards battery minerals, with demand poised to benefit from the burgeoning growth in electric vehicles,” he says.

Meanwhile BHP announced in August it was investing US$5.7 in a Canadian potash mine. Potash is used to make fertilisers the miner claims are needed to maximise global food production.

Hodge thinks further investment is warranted but warns the project may fail to match the capital invested.

Despite these investments, there's no escaping iron ore. The metal accounts for roughly two thirds of earnings at Rio Tinto and just under half at BHP.

Fortescue still expensive

Fortescue Metals is the most exposed to iron ore of the big three local miners and bears the brunt of the fall in price.

Hodge slashed fair value for the miner by 30% to reflect his lower forecasts for iron ore prices. Where BHP and Rio Tinto spread iron ore’s poor performance across other minerals, all of Fortescue’s (ASX: FMG) earnings come from the ore.

Shares remain overvalued despite the cut, closing on Friday at $17.19, a 72% premium to the new fair value of $10. Hodge warns further share price declines could be on the way.

The world’s fourth largest iron ore miner is weighed by higher costs relative to its competitors, he says. Two thirds of Fortescue’s mines and equipment were built at the peak of the capital cycle, baking in higher costs for longer.

“This means returns are likely to lag those of the industry leaders, which benefit from building capacity at times when the capital cost per unit of output was, on average, much lower,” Hodge says.

That’s compounded by the discount Fortescue’s lower quality iron ore attracts relative to the other miners – one which has widening, says Hodge.

Over the past five years Fortescue’s lower grade iron ore sold at an average 26% discount compared to the benchmark grade.

For now, Hodge days the company’s plans to pivot to green energy don’t offset problems on the iron ore front.

“We also see potential risk from the company’s ventures into renewable energy, a hot space, but at this stage assume Fortescue’s investment will be value neutral,” says Hodge.

is a reporter and data journalist with Morningstar. Tweet him @lewjackk or get in touch via email

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