Thursday, January 31st, 2019
After sliding during the December quarter market selloff, BHP shares bottomed on 26 November and RIO shares on 10 December. The subsequent rally reflects:
- The freeze of US tariffs on China at the November G20 meeting and subsequent US-China trade talks, which if successful stand to limit further damage to China’s economy
- Expectations of Chinese stimulus met by monetary stimulus (interest rate cuts and reductions in banks’ required cash reserves), fiscal stimulus (tax cuts, support for consumption of cars and household goods, new railway infrastructure) and approval for local authorities to borrow to spend on local projects)
- Expectations of further share buybacks by RIO after it sold its interest in Indonesia’s Grasberg mine for US$3.5bn and its Dunkerque aluminium smelter for US$500m
- EPS accrual from BHP’s US$5.2bn off-market buyback, and the attraction of the A$1.41 fully franked special dividend payable on 30 January
- The more recent surge in iron ore prices due to the latest horrific tailings dam disaster in Brazil, which will see the operator Vale close 10 dams to prevent further safety risks. This will initially cut Vale’s iron ore output by 10% and reduce world seaborne supply by 2.6% before Vale offsets the lost supply by increasing output from other facilities.
Despite the US-China trade conflict, cuts to world growth forecasts and the many reasons for the December quarter volatility, both stocks significantly outperformed the ASX 200 in the December quarter and over calendar 2018. We think this was due to expectations of Chinese stimulus and a flight to large-cap ‘quality’ during widespread uncertainty and volatility. Investors liked both major miners’ strong balance sheets, divestments of non-core assets, intent to return surplus capital and transparent strategies to spend shareholders’ funds only on value-accretive projects. Unusually for one of the market’s most cyclical sectors, BHP and RIO were defensive stocks last year.
This year we expect a framework US-China trade agreement involving a further freeze of US tariffs and increased Chinese purchases of US exports. The best case would also include a timetable for mutual withdrawal of tariffs. Towards the end of 2018, we noticed lower thresholds for negotiating on both sides, reflecting their domestic interests. To retain the Republican nomination for the 2020 presidential election President Trump needs a trade deal to look successful and he also has to prevent the trade conflict doing any further damage to the US economy. Chinese President Xi was already trying to deleverage China’s economy and one outcome was a significant deceleration through 2018. He could not afford an external conflict which slowed the economy further.
The rollout of Chinese stimulus, admittedly not on the scale of the GFC era, makes major resource stocks a semi-defensive place to be in 2019 when consumer indebtedness, peaking dwelling construction activity and falling house prices pose risks to several housing and consumer-facing sectors. The trade de-escalation we expect between the US and China in coming months will coincide with stimulus working its way through China’s economy. We expect the market will see this conjunction of events as supportive of steelmaking raw material prices and earnings estimates for BHP and RIO.
This intention is despite the recent messy, somewhat disappointing December quarter production report from BHP, which will constrain the current consensus earnings upgrade cycle from strong iron ore prices:
Figure 1. BHP December quarter 2018 production
The outages at Spence (fire) and Western Australian Iron Ore (train derailment), and an unplanned production outage at Olympic Dam (acid plant failure), detracted ~US$600m from productivity and taint BHP’s reputation for smooth execution and operations. Previous guidance for US$1bn of productivity gains in FY19 will have to be downgraded at the 1H19 result, probably to ~US$500m. There will be a US$272m detraction from provisionally priced copper sales being marked to market lower.
Production guidance for FY19 remains unchanged for petroleum, iron ore, thermal coal and metallurgical coal. Copper production guidance was increased. FY unit costs for all major assets are expected to be in line with guidance but this will require stronger volumes in 2H, so BHP is now under more pressure to deliver. BHP will need to deliver 10-20% higher volumes in the 2H19 to hit the upper end of guidance ranges for most commodities.
All major development projects (North West Shelf, petroleum, copper, iron ore, potash) are tracking to plan and capex guidance was unchanged. In petroleum, the first appraisal well at Trion in Mexico found oil.
RIO’s December quarter production was more consistent and largely in line with market expectations:
Figure 2. RIO December quarter 2018 production
Iron ore was slightly weak with copper better. The 1H cost pressures in aluminium continued in 2H. Production guidance for FY19 has been released for the first time and is for incremental growth though with a wide range for iron ore.
RIO needs to re-establish a pipeline of growth projects after the balance sheet repair and multiple asset divestments (US$8.6bn in FY18 alone) and cash returns to shareholders of the last three years. The asset sale process is now almost at an end with proceeds from Grasberg (copper) and Rossing (uranium) expected this half.
Pilbara Iron Ore shipped 87.4Mt of iron ore (100% basis), up 5.5Mt from the weak September quarter, but down 3% from pcp. Annual production of 338Mt is up 2% on FY17. Guidance for FY19 is for an additional 0-12Mt of production.
Copper production bounced back strongly from the strikes at Escondida with FY18 production of 634kt up 31% on 2017. However, Escondida’s grade has slipped further to 0.87% copper, the lowest on record. Guidance for FY19 is for copper production to be 30-80kt lower.
Aluminium production of 3.5Mt fell 3% due to a lock-out at the Becancour smelter in Canada. Guidance for FY19 is for production to fall further to 3.2-3.4Mt now Dunkerque is sold. The average achieved aluminium price of US$2,470/t was up 11% on 2017 but aluminium prices are now back at two-year lows. Rising costs and falling prices will pressure margins in FY19.
TiO2 production of 1.1Mt was down 15% in the year due to industrial disputes at Richards Bay Minerals and production outages at Rio Tinto Fer et Titane. Production guidance for FY19 is for a return to normal levels of 1.2-1.4Mt.
Iron Ore Company of Canada production came in at the bottom of the revised guidance range at 9Mt due to industrial activity. The workforce went on strike on 17 Mar 2018 and did not return until 28 May 2018. Guidance for 2019 is 11.3-12.3Mt. We have seen media reports RIO is considering divesting IOCC via an IPO in 2019. The asset has long been considered non-core.
Clime Group owns shares in RIO and BHP.