The ongoing debate over a China slowdown has shifted from will there be one to how bad will it be. The average investor has to be both bemused and confused by the array of opinions on this critical concern. On the one hand, a recent series of reports from Standard & Poor’s Ratings Services on the Chinese slowdown calls for a “soft landing” with GDP growth in 2012 at 8%; this despite the fact the Chinese government has lowered its own forecast to 7.5%.
S&P sees only a one-in ten chance of the dreaded hard landing of only 5% growth and a one-in-four chance of a medium landing of 7%. However, the chief strategist for J.P Morgan’s Asian and Emerging Market sector is of the opinion the Chinese are already in a hard landing. According to Adrian Mowat of Morgan, the data leaves no room for doubt – car sales, cement and steel production, and stocks of construction materials are all down.
Spend a little time on the Internet and you will find expert opinions to match multiple scenarios. Yet it is undeniable that the range of rosy forecasts for 2012 Chinese GDP as high as 8.5 and even 9% fall short of the 10% the growth the Chinese economy has averaged over the last decade.
An immediate impact of the slowdown was felt as comments by BHP Billiton that Chinese demand for iron ore is “flattening” sent the Australian dollar plunging downward, losing a full penny against the US Dollar overnight. Rio Tinto executives agree with the slower forecast, but they remain steadfast in their belief in a soft landing; as does rival iron ore producer Fortescue Metals. All three companies intend to proceed with current expansion plans and see the current iron ore price of $142 a tonne dropping no lower than $120 per tonne.
The strength of the Australian dollar has been like a two-edged sword on the Australian economy, resulting in what many call the two speed economy. The miners and other resource companies are in high gear while manufacturing, tourism, and retail are getting hit hard by Australia’s high dollar. If our dollar continues to fall, those industries will benefit but as always the question is will it continue its downward drift or stabilise?
Here again there is a wide disparity of opinion. There is no question our dollar has benefited from rising commodity prices and exploding resource demand from China, India, and other emerging markets. In addition, Australia is the only developed economy on the face of the planet with high interest rates. Rates in the United States are near zero and the Federal Reserve in that country says they will remain low through 2013 and beyond if needed. While the Reserve Bank of Australia continues to hint at the possibility of lowering the cash rate here to stimulate growth, no substantial reductions have been forthcoming.
What we have then are opposing forces on the Australian dollar – slackening resource demand exerting downward pressure and higher interest rates exerting upward pressure. The latest HSBC flash PMI (Purchasing Managers Index) for China was released during the ASX trading day. For the fifth straight month, the number shows economic contraction. The downward trend appears to be accelerating. Our market reacted with an immediate drop and then rebounded, closing in the green. However, the dollar reached yet another low against the US dollar. Forex technical analysts say it has broken resistance and may continue to fall.
If the dollar continues to fall, the mining sector will be adversely affected, twice over. The high dollar means lower profits for Australian companies that export goods and receive payment in a lower value currency, like the US dollar. The miners have been insulated from that negative effect due to the high prices they get for the commodities they export. If the price of the commodities drops substantially the miners will lose that price protection. However, our top three mining companies appear to be confident they can withstand the impact. There are other sectors of the Australian economy that stand to benefit from a deflating Australian dollar, most notably retail and tourism.
Australian retailers have been badly hurt by our strong dollar and the boom in online shopping. Why go to a local mall to buy an electronic gadget you can get on Amazon for far less, taking advantage not only of lower online prices, but also of the purchasing power of our stronger dollar? Similarly, why vacation in Australia when you can relax abroad for a lower cost?
While it might seem obvious that the next step would be to look for beaten down retailers and tourism shares, some skeptical thinking may be in order here. If the dollar falls, will not the confidence of the Australian consumer in our economy fall along with it? And will a precipitous drop in confidence result in the consumer vacationing in the back yard and cutting spending to the bare essentials?
There may be another play afoot here if one remembers that iron ore is not the only commodity with which Australia has been blessed. While demand for iron and copper from China and India has propped up commodity prices, there is another commodity boom on the horizon from which Australia stands to benefit handsomely and that commodity is gas; more specifically liquefied natural gas (LNG).
While China’s demand for iron ore may be flattening, their demand for clean energy is not. Even should they succeed in transitioning to an economy more dependent on domestic consumption and less dependent on infrastructure development and foreign exports, their burgeoning middle class will need more and more energy. In the eyes of many, natural gas is the fuel of the future, with a price tag to match. Look at the following graph:
The chart was part of an investor presentation from one of Australia’s leading energy companies, Santos (STO). Along with Woodside Petroleum (WPL) and Oil Search Limited (OSH) they are poised to capitalise fully on the anticipated rise in LNG demand in the near term future. What’s more, they and other experts predict that LNG will drive the price of gas to equal that of oil in the coming decades. The reason is simple – LNG is transportable while traditional natural gas is encumbered by the necessity of pipelines.
Those who believe in the promise of LNG believe the resource boom in Australia can continue with liquefied natural gas becoming the premier player over iron ore. Iron ore is not going away but if China continues to falter, the “smart money” may head for the exits with their mining shares.
Japan, the leading importer of LNG, has increased its LNG use to replace closed nuclear plants in the aftermath of the Tsunami last year. China and Korea are also major importers, with demand in China expected to increase as that nation shifts away from coal towards gas and renewables. Here is a chart of Chinese LNG imports through 2010:
Right now Australia’s big three all have major expansions in LNG mining and production capability underway to meet the growing demand. Australia is already China’s major supplier of LNG, as seen below:
Some experts claim LNG is about to spawn a new global industry. Even at this early stage, the shipping of LNG is the most profitable segment of the global shipping industry, with daily rates rising and every available ship filled to capacity. Already a major player, Australia is poised to replace Qatar as the world’s leading exporter of LNG. Here are some share price and valuation numbers on three of the companies that will lead us there:
|Company/Code||Mkt Cap||Share Price||52 Wk Hi||52 Wk Lo||2 Yr Earnings Forecast||P/E||P/EG|
|Oil Search Limited/OSH||$9,170M||$6.92||$5.43||$5.43||-16%||43.34||10|
Although we are looking at these companies primarily as pioneers in the anticipated LNG boom, all also have oil production revenues as well, a further cushion against a drop in the Aussie dollar as oil is priced in US dollars. Based on the above numbers, WPL is a clear winner in every category except share price performance. The Energy Sector P/E is 23.06 with a P/EG of 10. Taking those valuation ratios alone, WPL appears to be undervalued right now.
However, all three companies have had issues with their respective LNG ventures. Woodside has had construction delays and Oil Search’s joint venture in Papua New Guinea is on hold due to an accident and some land disputes, which may have adversely affected their forecasted earnings. Santos is also involved in the Papua New Guinea venture and has plans to build an LNG processing facility in Queensland using Coal Seam Gas (CSG) from another of its Australian operations. They anticipate shipping to commence in 2015.
The investing thesis for any of these companies is relatively simple. As a nation we have fallen in love with the miners and the mining boom of the last decade and now we are worried about what will happen should the boom lose some momentum. The strong Australian dollar that resulted in part because of this boom is under pressure and may again reach parity with the US dollar, and perhaps even fall below. The more market participants become convinced of that possibility, the more they will abandon the miners and look elsewhere. The liquification of natural gas has transformed that commodity from a regional one to a truly global one. The oil production of these three companies will benefit their shareholders should our dollar fall and they are on the ground floor of what many believe will be the next resource boom.
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