In early March Rio Tinto’s (RIO) chief economist spoke at an investor presentation and made a detailed case for a steep drop in the price of iron ore. From the current level of close to US$160 per tonne, Vivek Tulpule forecasts the price falling to US$100 per tonne by mid 2014.
Rio’s stock price took a beating after a lackluster earnings report and the dire forecast didn’t help. Here is its one-month chart showing market reaction to the 14 February Earnings Release and the 04 March investor presentation:
Rio’s chief economist is not alone in his bearish outlook for iron ore prices; other experts concur that iron ore prices will continue strongly first half of 2013 followed by declines in the second half and continuing into the foreseeable future.
• Analysts at Deutsche Bank forecast iron ore prices topping out at between US$150 and US$160 a tonne by the second quarter with limited upside thereafter. Bank analysts cite the improved economic forecast for Chinese GDP from 7.4% to 8.2%.
• Goldman Sachs sees another year of high iron ore prices with a 2013 forecast of $144 per tonne and a forecast of $126 per tonne for 2014. After that, Goldman forecasts the price dropping to US$95 per tonne in 2015.
• Morgan Stanley argues that iron ore has reached its peak and will end 2013 averaging $US133 per tonne.
The long-term bear case gained strength from the recent Chinese announcement that its government intends to control rapidly rising property prices. But wait a minute; does this scenario sound like déjà vu all over again?
• On 6 August 2012 CNBC published an article quoting independent analyst, Andy Xie, formerly of Morgan Stanley, who forecasted the iron ore price at $50 per tonne by mid 2013.
• In September 2012, a UBS analyst predicted $120 per tonne for iron ore by at the end of 2012, returning to $US85 to $US90 per tonne by 2015.
• In September the Australian Bureau of Resources and Energy Economics (BREE) predicted the average price over the entire year of 2012 would be $US126 per tonne, revised downward from a March prediction of $US140. The agency was forecasting $US106 per tonne for 2013 and still believes iron ore prices will end 2017 around $US109.
• In October 2012 Bloomberg News polled five major analysts and found the midpoint forecast for 2017 was $US96 per tonne. Bloomberg also quoted an analyst from HSBC stating “the equity market is already dismissing any recovery in the iron ore market.”
Here is how the price of iron ore closed out 2012:
The share price of our top two iron ore producers, BHP and RIO rallied at year end in conjunction with the rise in the price of iron ore. Here is a six month chart:
Investors liked these stocks when iron ore prices went up and headed for the exits once the sustainability of the price rally came under question. The rally surpassed the estimates of most forecasters.
Well known economist John Kenneth Galbraith supposedly once said “the only purpose of economic forecasting is to make astrology look respectable.”
If you focus your attention on the direction of the various prognostications rather than the variance in the actual price it is obvious no one is forecasting the price of iron ore returning to the boom days. The common thread is good times for a period of time followed by a decline. The question is how long will the price remain robust, and when will it decline. So what is an investor to do?
Demand for iron ore will never disappear altogether. The world will always need steel. However, only miners with high operating and profit margins – as well as the capacity to increase production – will continue to perform well in the face of lower prices. Additionally, miners with strong balance sheets (especially low gearing levels) can better withstand price fluctuations than those with high debt and low cash reserves. Finally, miners with revenue streams other than iron ore are safer plays than pure play iron ore producers.
Let’s look at five Australian miners and evaluate each against the criteria of diversification, margins, debt, and cash per share. Here is our table of companies:
52 Wk % Change
Cash per Share
Mt Gibson Iron
The first three miners are pure plays with Mt Gibson (MGX) and Atlas Iron (AGO) considered mid-cap miners with market caps of $762M and $1.2B respectively. Note that the three pure plays saw steep price falls year over year. The diversified miners, BHP Billiton (BHP) and Rio Tinto (RIO), are positive year over year, despite taking a bit of a beating over the last month or so.
Most miners report Full Year Results from June to June so we used trailing twelve month (TTM) numbers for margins and most recent quarter numbers (MRQ) for gearing, and total cash per share. As a general rule, in times of uncertainty many investors will stay clear of mid-cap and especially junior miners with a single commodity focus.
However, with a P/E of 9.25 Mt Gibson is worth researching further. Considering the steep decline in share price and its modest gearing levels, MGX might be suitable for momentum traders looking for short-term gains, should the price of iron ore remain strong into the second half of 2013. However, the company’s low margins cast doubt on its ability to withstand steep dips in the price of iron ore.
Mt Gibson has three operating mines producing lower quality ore. Still, some major analysts like the stock, with Deutsche Bank, CIMB Securities, and Citi with BUY or OUTPERFORM recommendations as of 20 February 2013. A key reason to think twice before buying this stock can be found in the opinion of one of the bullish major analysts, who said “with iron ore approaching $160/t, the broker sees considerable upside potential to its forecasts.” Ask yourself what happens if the price falls well below forecasts.
Atlas Iron reported a bleak first half for FY 2013 with a net loss approaching $A9 million after one-off items. Operating and profit margins fell – yet despite the results, analysts at BA-Merrill Lynch and UBS have BUY ratings. UBS upgraded the shares to BUY on 27 February. Both cited the company’s aggressive expansion projects as reasons to buy the stock. Yet the company’s big play, the Horizon 2 mine, will not begin producing iron ore until FY 2016, right about the time some experts predict the price of iron ore will be substantially lower than current levels.
Here is a one-year price chart for the two mid-cap miners in our table:
Fortescue Metals (FMG) pulled a rabbit out of its hat to fend off the short sellers with improved debt financing last year. Yet the company still has an astounding gearing level over 300% as of the most recent quarter. Fortescue has invested heavily in expansion projects and the anticipated tripling of production could pay off handsomely as long as the price of iron ore remains near current levels. The company’s share price saw substantial gains in the six month iron ore price rally, despite being down year over year. Here is a six month chart for FMG:
Along with Australia’s top two iron ore producers, Rio and BHP, Fortescue has had ambitious expansion plans underway for some time. While RIO and BHP slowed down their efforts, Fortescue plunged ahead at a time when capital expenditures for expansion were increasing. At the recent Interim Earnings release, management announced its intention to raise between $US3 and 4 Billion from asset sales to pay down debt and reduce gearing. However, on 21 February an analyst at Citi noted the asset sales could increase the company’s operating costs. Along with CIMB Securities and BA-Merrill Lynch, Citi has a BUY recommendation for Fortescue.
Of the three major iron ore producers here, FMG is the riskiest. If demand and prices remain at or near current levels, Fortescue will come out a big winner.
While both Rio Tinto and BHP Billiton are considered diversified miners, BHP refers to itself as a diversified natural resources company. In short, if it is in the ground and it has profit potential, chances are BHP mines it. BHP is increasing its presence in the oil and gas space, most notably with its 2011 acquisition of US shale gas producer Petrohawk Energy in a $US12 Billion dollar deal. BHP management said the acquisition would double BHP’s oil and gas assets leading to production increases expected to average 10% through 2020.
Rio sees itself as a global mining and metals company. The company reported Full Year Results in mid February and for the first time ever posted a loss. Major analysts are largely bullish on RIO with only Macquarie with a NEUTRAL rating. While analysts at JP Morgan, BA-Merrill Lynch, Credit Suisse, UBS, Deutsche Bank, and Citi praised BHP’s cost cutting efforts and potential asset sales, the Macquarie analyst noted the lack of specificity in those plans.
There are some commonalities between the two companies. Both are entering a new era of increased cost control and reduced expansion and both have newly appointed CEO’s. For investors, the most significant difference would seem to be BHP’s move into oil and gas. Despite its diversified metals portfolio, RIO derives so much of its revenue from iron ore some analysts refer to the company as basically a “one trick pony”, too heavily dependent on iron ore.
Oil and gas are consumables while steel from iron ore is not. BHP right now looks like a better longer term bet based on its exposure to oil and gas. Rio has enough cash on hand to follow suit.
While past history is no guarantee of future performance, you might find it interesting to check out at the ten-year share price history of these two Australian giants:
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