Iron ore prices won’t stay high for long, warns Morningstar

-- | 24/07/2019

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Glenn Freeman: I'm joined today by our Head of Equities Research covering the commodity stocks. I'm joined here by Matt Hodge.

Matt, thanks for your time today.

Mathew Hodge: No worries, Glenn.

Freeman: Now, we're talking about the miners and one of the key points you've made in this report is that our view on the iron ore price is that it's not going to stay higher for longer.

Hodge: Yeah, that's been our view for a while, but the prices continued to defy that reality. So, there's been a couple of reasons for it. The Vale tailings dam incident, pretty well-known, the cyclones in WA. So, we think there's at least 100 million tons of productions come out of the market which was 1.8 billion tons. But arguably a bigger driver has been China. So, we've seen unexpected secondary impact of the trade war with the U.S. So, China has gone back to the old playbook of borrowing more money, investing in assets, doesn't really need to build and that's consuming steel. So, steel production year-to-date is up 10%, which is huge, right? The rest of the world is down. Production from Vale will come back. It's just a question of when and it might not be in two to three years. It might take a little bit longer than that, but it will come back and that's pretty meaningful. The price is so far ahead of the marginal cost. I mean, you look at the production costs of BHP Rio and Fortescue, it's close to $20; the price is $120. Iron ore is not rare. So, there is a risk that new production will be incentivized as well. We've seen a little bit of that with Fortescue adding.

Freeman: And also, in addition to the iron ore price being high, the share prices of the producers as well have been pretty staggering, really, I guess you could say, over the last – I mean, Fortescue, I think, has returned a huge amount in the last 12 months when you look at the – again, do we have the same view that that's – I guess, that's predicated on the fact that iron ore price is higher…

Hodge: Yeah. So, Fortescue has got the most leverage and exposure. So, it's pure iron ore. It's also, when you include the discounts, it's higher cost. So, we've seen Fortescue is getting a discount on the price, and I think at one stage, it was probably $40 a ton now realizing the index price was around $60. And now, they're getting something closer to $100. So, the price for BHP and Rio is double, but for Fortescue, it's 2.5 times, so their margin has improved dramatically, and they weren't making great margins before. So, that's where the leverage is. It is meaningful to the valuation. For them, I guess, our quibble is, we just don't think this level of earnings is any way sustainable, or the dividends. The last time people were looking at resource plays as dividend-yielding stocks, you have to go back to pre-GFC and that kind of heaty period '10, '11, '12, '13 when these stocks were making really good money. So, I think seeing resource stocks on low P/Es and high yields is generally a signal that they're expensive, not the other way around.

Freeman: Another point that you've discussed, I know you've said this in relation to Fortescue, but there's this distinction between the higher grade producers and the lower grade producers. Can you explain for us a bit about how that dynamic works across some of these different miners you've discussed in this report?

Hodge: Yeah, I'll try and give you the short version. So, when steel maker margins are high, they want to produce more tons of steel, because that's how they make the most money. They're less sensitive about the price of the inputs. When steel maker margins are low, the steel makers care about the price of the inputs, and they trying to reduce that unit cost of raw materials. What that means is, for Fortescue, when steel maker margins are high, the discount for their lower grade product is high. And when steel maker margins are low, the discount for the low grade product is low. So, it's kind of counterintuitive. If the steel mills are making less money, Fortescue gets a better price. It's kind of (odd) that way. Yeah. But it's not the biggest driver. The biggest driver is the general market balance, and that's been the primary mover of the price.

Freeman: By market balance there do you mean the balance of the iron ore?

Hodge: Supply and demand. Yeah.

Freeman: And the distinction there, does this just come back to why people or how people can be selective in terms of which miners might be doing better than others and beyond just looking at the market cap?

Hodge: Yeah, I think more importantly is the commodity exposure in this case. And we've seen base metals have sold off a bit. We've seen some – we don't see a lot of overvaluation at all amongst the base metal miners and even some pockets of value like OZ Minerals is undervalued. We've seen Iluka – that was on our best ideas list in May – return 27% when the time was taken off at the end of last month. So, that's done well. We think the market was mispricing a few things there and that's kind of played out. And now, it's kind of the coal stocks where value is emerging.

So, there are a couple of reasons for that. So, on the demand side, it was a pretty mild northern hemisphere winter. So, demand was a bit soft. We've also seen more production of energy from other sources in China. And China has increased its own production of coal as well. And China is a huge producer of coal and the export market by comparison is a drop in the ocean. Newcrest was another stock that we've been positive on for a long time and that's well and truly played out now and we've seen a lot of concern about geopolitical risk, economic risk and the stock itself has actually had a really good run in terms of improving the reliability and production and cost at its operation. So, that's been a good story, but it's played out now. We think it's relatively overvalued. That's not to say it won't get more expensive.

Freeman: And of course, people can look at this full report that's available if you are Premium subscriber.

Hodge: Yeah. Or if they're on (indiscernible) as well.

Freeman: That's right. Yeah. Great. Thanks for your time today, Matt.

Hodge: No problem. Thanks, Glenn.

This report appeared on 2022 Morningstar Australasia Pty Limited

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