Metals & Mining: Uncertainty pushes our top pick toward RIO

About the author:

Adrian Prendergast
Author name:
By Adrian Prendergast
Job title:
Senior Analyst
Date posted:
06 March 2020, 3:50 PM
Sectors Covered:
Mining, Energy

  • No point believing we can pick the bottom, but we do now see value (and relative safety) on offer in both big miners RIO and BHP, we upgrade both to an Add rating.
  • Global macro uncertainties remain high, but we gain confidence in China’s ability to combat the coronavirus spread, or at the very least its impact on China’s economy.
  • A downside scenario we can’t rule out would see some iron ore miners unable to place all of their tonnes in the market (we prefer premium product producers).
  • New forecasts see a potential 13mt deficit in seaborne iron ore supply in 2020.
  • Current uncertain conditions have pushed our sector preference towards RIO, given its premium iron ore products and large stimulus exposure.

Iron ore steadier than previously expected 

Despite the coronavirus impact and typical seasonal demand weakness, we have not seen a further decline in iron ore prices unfold so far in Q1 2020. This is counter to what we previously expected, with steel activity proving more resilient (so far) to underlying demand conditions.

The hardest hit steel production has been in EAF (electric arc furnaces) which are operating at just ~20% utilisation (RIO estimate) and smaller infrastructure-constrained steel mills, while larger mills have mostly maintained production. This is seemingly confirmed by iron ore inventories at Chinese ports, which have actually declined in recent weeks (supported by rail).

Meanwhile, China’s domestic iron ore mine production has been impacted by recent suspensions, providing further support to seaborne prices.

Gaining conviction in China stimulus… 

At an analyst roundtable earlier this week, Rio Tinto CEO J-S Jacques confirmed that people are returning to work in China while truck activity (a vital logistical chain in China) is also showing positive signs.

This anecdotally would indicate demand conditions could start to stabilise, particularly when combined with reports on the slowing pace of new coronavirus infections in China. Either way the impact to China’s economy from the virus has been substantial and likely to continue generating weak data signals through at least H1.

In line with views from the major miners, we expect China’s government to respond to these conditions with an extensive and likely commodity-intensive stimulus package which could trigger a sharp recovery in commodities demand in the second half of 2020. 

…while the rest of the world is harder to call 

Our conviction on demand fundamentals outside China meanwhile has been impacted by the failure to contain the coronavirus within China.

The economic impact could prove more sustained in virus impacted countries outside China. This is likely to also attract stimulus measures in these regions, albeit we see other countries as potentially being less able to effectively stimulate real underlying economic activity compared to China.

This leaves us more cautious on energy resources in 2020 in particular.

Changes to 2020 steel/iron ore picture   

It is incredibly difficult to predict near-term demand activity, but underlying fundamentals appear stable in iron ore.

We now forecast a 13mt deficit in seaborne supply in 2020 (vs previous expectation of balance supply).

Specific changes made to our steel/iron ore model include:

  1. China domestic iron ore mine production to decline 4.9% yoy to 255mt (previous forecast 275mt)
  2. Chinese crude steel production growth in 2020 of 1.25% yoy to 990mt (weighted to H2)
  3. Cumulative reduction in forecast seaborne iron ore supply of 15mt (1.0%) to 1,353mt (post recent miners quarterlies).

A key area of demand we are monitoring closely is ore marketability, we do not believe a transition to low grade ores is certain and instead believe there is increased risk of market instability (that could make it hard for lower quality tonnes to be placed into the market in Q2).

We have upgraded our iron ore forecasts for CY20 to ~US$82/t (+7%) and CY21 to ~US$68/t (+5%).

Change in top sector preference  

We have little hope that we can pick the bottom, and remain cautious, but we do see value now on offer in both RIO and BHP.

While we see China supported by the prospect of heavy stimulus, we hold decreasing certainty on the broader global commodity demand picture ex-China (particularly energy). This has driven a change in our sector preference to RIO over BHP.

While pure producers like FMG hold larger leverage to a recovery scenario, we remain cautious given the small degree for error with a high implied iron ore price already priced in combined with a large earnings/valuation sensitivity to a single commodity.

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