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Australia’s mining boom is faltering, with market watchers forecasting a continuing slowdown in response to weaker Chinese demand, soaring plant costs, questionable decision making, stumbling Europe and overseas competition.

Mark Lennox, of Halifax Investment Services, is particularly bearish, forecasting the mining boom is drawing to a close on the back of thinner export margins. In response, Lennox expects share prices of the big miners to continue tumbling, while explorers and debt-laden companies will struggle to survive. He says investors have voted with their feet and headed for the exit.

Rio Tinto has fallen from $82.21 on April 30, 2011 to trade at $57.76 on May 17, 2012. BHP Billiton has slumped from $45.83 on April 30, 2011 to an intra day price of $32.54 on May 17, 2012. Fortescue Metals has retreated from $6.15 on April 30, 2011 to trade at $4.86 on May 17, 2012, while Woodside Petroleum has nosedived from $46.80 on April 30, 2011 to $31.59 during trading on May 17, 2012.

“Mining volumes may be rising, but so are the costs of doing business in Australia,” Lennox says. “Labour costs are so much higher here than, say, Africa and rising energy costs are also an impediment. Miners simply won’t be able to generate the very high level of returns on capital of past years.”

Lennox says Rio Tinto shareholders are paying the price for the company’s $US8.9 billion impairment charge related to its aluminium businesses for the 12 months to December 31, 2011. Consequently, company net earnings of $US5.8 billion in 2011 were 59 per cent down on 2010. Capital expenditure of $US4.6 billion in 2010 rose to $US12.3 billion in 2011. Total capital expenditure on approved projects and sustaining capital is expected to be $US16 billion in 2012. Lennox says Rio’s decision to expand Pilbara iron ore production to 283 million tonnes by the end of 2013 may backfire, particularly if the price drops. “Iron ore supply is one thing, but will the demand continue to be there?” Lennox says. “With companies expanding their projects, iron ore supply is likely to exceed demand in a few years.”   

He argues Fortescue Metals, as a single commodity stock and almost totally dependent on future Chinese demand, is particularly vulnerable to the demand and supply equilibrium. Fortescue plans to triple production to 155 million tonnes in 2013 after recently approving an $8.4 billion expansion of its Pilbara operations. According to the company, productions costs rose from $US46.43 a tonne in the 2011 December quarter to US$52.56 in the 2012 March quarter. The company says lower shipped volumes caused by cyclones, flooding and a higher Australian dollar against the US greenback were behind the higher costs.

Prominent US hedge funder manager Jim Chanos was recently reported to be shorting Fortescue Metals stock, claiming it was a “value trap and a highly leveraged bet on continued fixed asset investment growth in China”. Chanos, speculating about the iron ore price falling to $US100 a tonne, argued that major iron ore producers were significantly expanding operations at a time when Chinese growth is flattening. This, he says, increases the risk to Fortescue’s multi-billion dollar debt-financed expansion. Fortescue rejected Chanos’ views, claiming it was in the interests of short sellers to predict price falls. Fortescue says there’s tremendous support for an iron price at $US140 a tonne in May 2012. Iron ore was fetching about $US180 a tonne in 2011.

Value investor Roger Montgomery, of Montgomery Investment Management, is also forecasting a mining downturn and has reduced his fund’s exposure to companies in the resource and related sectors. Montgomery says BHP Billiton, Rio Tinto and Fortescue Metals are ramping up iron ore production, and an additional 700 million tonnes of global supply will be available by 2015. “That’s two Pilbara regions of additional supply,” he says. Montgomery says China has historically taken about 60 per cent of global production to feed steel mills, but it doesn’t have the capacity to take 60 per cent of additional supply. So Montgomery is forecasting price falls in iron ore and other commodities in response to weaker demand and greater supply. Montgomery says additional available supply is a typical industry response to the cyclical nature of the commodities business. High commodity prices generate more investment in projects to meet the supply response. But falling commodity prices, as a result of excess supply, cuts investment. “It’s a cyclical business,” Montgomery says.

Movements in commodity prices can have a tremendous impact on profits – positive and negative. A $US1 a tonne increase or decrease in the iron ore price can impact full year 2012 net profit after tax by about $95 million, according to a BHP Billiton table presented at its interim results in February, 2012. The impact on the bottom line for a $US1 increase or decrease for a barrel of crude oil is about $US40 million. A US 1 cent movement for a pound of copper or aluminium translates to about $US20 million. A $US1 a tonne movement in metallurgical coal works out to about $US20 million. Mark Lennox expects commodity prices to fall in line with weaker Chinese and Asian growth. He says China’s growth rate recently slowed to 8.1 per cent in the latest quarter as policymakers unwind the credit boom to bring housing prices under control.

Richard Batt, of Shadforth Financial Group, says BHP Billiton recently closing its Norwich Park coal mine in Queensland is perhaps a sign of things to come for the broader mining industry. Lower coal prices, higher costs and softer production due to flooding were cited as reasons for closing the mine – a joint venture between BHP and Japan’s Mitsubishi. Batt says Australian miners may have to reconsider future projects in line with potentially softer commodity prices influenced by weaker demand in a world of falling, subdued or negative growth. He says mining projects in Australia are going to require far greater scrutiny in terms of viability. Miners will have to work much harder for reduced returns on capital compared to several years ago. “There’s much more competition around the world,” he says.       

In terms of investing, brokers point to high yielding dividend stocks and exchange traded funds. Telstra is on most radar screens, with the share price surging to a three-year high of $3.75 on May 15, 2012. Telstra has announced that it intends to retain its dividend of 28 cents a year for full year 2013. In mid May, the stock was yielding more than 7.5 per cent fully franked. Telstra expects to generate billions of dollars in free cash flow from the NBN deal and it posted mobile revenue growth of 10.9 per cent to $4.393 billon in its first half. Brokers say the major banks appeal in a falling interest rate environment, as their yields are far more attractive than term deposits.

John Rawicki, of Ord Minnett, says exchange traded funds, consisting of Australian government bonds, provide solid returns and an effective hedge for equity portfolios. He says the Russell Australian Government Bond ETF invests in fixed income securities of between five and 10 years. He says the ETF was issued at $20 and listed on the ASX in early March 2012. On May 16, the ETF was priced at $21.10. Rawicki says at this early stage, quarterly coupon distributions are averaging 5.24 per cent. He says investors can use the Russell ETF as a hedge because the price of government bonds rise as equity indices fall. “If you’re concerned equity markets will fall in the next 12 months, then ETFs consisting of Australian Government bonds can smooth out annual returns,” he says.

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