The iron ore party can't last: Morningstar

-- | 10/08/2021 Text size Decrease

Read Mat Hodge's note: <a href="https://premium.morningstar.com.au/news/article/214110/miners-remain-somewhat-expensive-but-still-pockets-of-value-to-be-found">Miners remain somewhat expensive, but still pockets of value to be found</a> Emma Rapaport: Hello and welcome to Morningstar. I'm Emma Rapaport. Today joining me is Mathew Hodge, he's Morningstar's Director of Equity Research. Matt, thanks for joining us today. Mathew Hodge: Pleasure. Rapaport: Matt, we've seen a really strong spike in the price of commodities over the last year specifically looking at iron ore, thermal coal and copper. Can you explain quickly why we've seen such a super cycle in commodities? Hodge: Yeah, I think 2020 demand for iron ore in particular was very strong from China, post-COVID stimulus, and that carried on into 2021. Mostly demand on the China side, and also, supply has been really weak, particularly out of Vale from Brazil has not really recovered from the tailings dam failure that they had in 2019. Thermal coal is a bit of a different story. Really, if we go back a year, the market was in dire straits and very few thermal coal miners were making any money at all. So we've had supply come out of the market. A two-tier market emerges where low quality thermal coal has remained under the pump. But as demand has come back in Asia in particular, there's really, that tightness in supply has seen coal prices recover very strongly from what were pretty dire levels. Rapaport: And we've seen some really strong prices in our local ASX miners something about the result from Rio Tinto last week, and some of the prices have you been surprised to see these real boosts to the local market? Or was that very much expected because of the price of iron ore? Hodge: Well, it is interesting in that, you know, the half that's gone, is gone, right. Like what really matters is what's coming in future. And as we've seen in the last week or so, the iron ore prices sold off quite a bit, but it still remains at incredibly favourable levels I mean still not far off record levels, right. And I think it's just worth reflecting how favourable those prices are for Rio Tinto in the half that's just gone. They're earning over 100% return on invested capital annualised for their iron ore business. And at $200 in the second half, which is our forecast, it's 155% annualised so that is an amazing return. So for every dollar that Rio Tinto has invested in its iron ore division it's earning $1.55 a year after tax. So incredible returns for what is a commodity business with predominantly a pretty flat cost curve. Rapaport: Yeah, and I was kind of surprised to see <a href="https://premium.morningstar.com.au/news/article/214110/miners-remain-somewhat-expensive-but-still-pockets-of-value-to-be-found">in the report you just published on the ASX miners</a> that you don't expect this to continue for much longer. Can you explain why you don't think that the prices will stay at these elevated levels. Hodge: Timing is difficult, right. I think what you can say is that we are, basically at record levels for some of the key commodities like iron ore, copper, coal has been slower to come to the party, but it has improved recently. You also look at the China boom, and it is really China's demand that is fuelling this, and spending on infrastructure and housing. And if you look at their stock of housing, I mean, I think we've passed the peak of urbanisation. And their stock of infrastructure is basically on a par of Western world levels. Their spending as a portion of GDP remains way above developed world level. So it's really it has been an investment driven economy and investment driven economic growth. At some point that has to change. And timing is obviously difficult. But I think it's fair to say, with current prices where they're at we are closer to the top, than the bottom. Rapaport: Yeah, that was going to be my next question. Do you have a timeframe for when you think this demand might start to come off? Hodge: Yeah, well, I feel like we're in probably double overtime. So the boom has continued for longer than I would have already expected. China has talked about you know, changing the mix of its growth. Largely it's been unsuccessful, it's continued to increase debt and grow its pool of invested capital, and the returns on that pool of investment continues to decline. At some point, the buildings and the bridges just kind of to nowhere you know. Rapaport: So you have a look across your your coverage and across Morningstar's coverage of this sector more broadly. You do see that we consider most of the ASX miners to be overvalued, however you say there are a couple that are still in that sort of undervalued Four- or Five-star range? Can you go through some of those names and why you think they haven't come back as strongly? Hodge: Yes, I think we've got five that are undervalued. This is based on prices as of Friday last week, so the 30th of July. And those five are Whitehaven Coal, New Hope, South32, Newcrest and Alumina. Newcrest and Alumina are roughly kind of 10% undervalued. I like Newcrest as a business, its low on the cost curve. It seems like the market is not really pricing in the gold price that we have, which is unusual. Usually when you have the gold price spiking like it has, gold equities tend to be pretty expensive. That's not really the case this time around. For Newcrest I think it's partly a function of, you know, they've got a few projects, which we like, but they're a bit longer dated and the market tends to not like, the idea of spending money over a few years to get a benefit further down the track. So, I think there's a bit of time arbitrage in Newcrest. South32 some of its commodities have not performed anywhere near as strongly as some of the others. So, I think there's a bit more upside in that one. New Hope and Whitehaven I think coal is a really interesting space and thermal coal in particular, which sounds very funny, but I think it's true. What we're seeing is really kind of a two-tier market emerge where lower quality coal is trading at a discount. And that's keeping, supply relatively constrained, that's production coming from Indonesia or Colombia or places like this. And we've also seen demand recover as the global economy has recovered. And we're also seeing a preference towards higher quality coal as older, more carbon intensive, coal fired power stations get replaced by newer ones which demand higher quality coal. So the cheapest stocks are Whitehaven and New Hope, I think both trading in four-star territory and Whitehaven remains on our best ideas list. Rapaport: I think it's impossible at this point to talk about coal and not mention ESG. I know that the Morningstar team has started integrating ESG I guess ratings and principles into the underlying fair value. Can you give a sense of what impact that may have had on some of the coal miners under your coverage? And do you at all worry about investors not investing in this particular industry because of concerns around ESG? And what that might do to price and demand? Hodge: Yeah, inevitably some won't, right. And that's fine. Just as some investors aren't comfortable investing in casino stocks or cigarette companies, so too with coal. I don't think owning a coal stock is going to change the outcome or trajectory, right. Once the coal mines are built and developed, they're going to exist until they run out of reserves, right. The question is how this plays out, right. There's a couple of ways this can play out. And it could be either demand lead or supply lead. If the Australian government or Queensland New South Wales government decides that, hey, we don't really want to approve new coal mines. And if that happens elsewhere in the world as well, you can have a supply lead decline, right, it sets the clock on the whole industry. And in that scenario, you have mining companies who are no longer spending money on exploration and development. They're not developing new coal mines, which are quite expensive. This could be a little bit like the cigarettes of the the 90s and the 00s where, you know, the expenditure around advertising and marketing dropped away, and they enjoyed very strong cash flows as a result of that. So it's not clear to me particularly for the coal miners with long life and those that produce a higher quality input. I think those could potentially do quite quite well out of this which seems kind of counterintuitive. I think, if a coal miner is producing you know below Newcastle spec thermal coal, then I think the outlook for that is not good. And you know there's a lot of global export or production that is way lower quality than the Australian stuff and I'm talking about Indonesia and Colombia.