End of commodity super cycle spells higher prices

The end of commodity super cycle and metals and minerals now likely condemned to long periods of low prices will mean many high-cost operations, where cash flows are not paying for operational costs and debt servicing, will fall by the wayside. Such assets will come cheap in the market, ripe for takeover. But wiser by their bitter experiences of high-cost acquisitions in the two years preceding the 2008 global financial crisis, the still resilient groups will be exercising a lot of discretion in any future attempts at mergers and acquisitions (M&As). Under pressure from shrinking margins and tepid demand growth, industry in general has lost the appetite for big bang M&As. In a presentation at a recent conference, chief executive of copper and coal of Rio Tinto Jean-Sebastian has explained why companies will look at acquisition opportunities with caution to avoid value destruction. He says,“we will not see significant consolidation. This is because there is now greater scrutiny of real value creation of big bang M&As and the potential value destructive premium needed to secure tier one asset.”

So instead of headline-grabbing consolidation moves of the kind of Rio buying Alcan,Tata Steel buying Corus and Glencore acquiring Xstrata, groups, according to Jean-Sebastian, are to seek partnerships for projects for risk sharing. Big metal producers and miners are coming under shareholder scrutiny more than ever before as their profits keep on tumbling. BHP Billiton found its attributable profit (excluding exceptional) for the year ended June 2015 down 47% to $7.1bn from a year earlier. Rio’s first half of the year to June profit at $806m was down by as much as 82% year-on-year due to low copper, aluminium and iron ore prices and asset impairments. As for Anglo American, the first half earnings before interest, taxes, depreciation and amortization were lower by 24% to $3.2bn from a year earlier. These are the companies with some excellent assets, particularly iron ore and strong balance sheets with low leverage. They, therefore, are not to be scathed as much by the present crisis unlike hundreds of companies with many weaknesses, including their quality of assets. The universe of metals and minerals has come to depend so very heavily on China that the world’s second largest economy’s growth slowing down is having a negative impact on the fortunes of all companies engaged in production and trading of iron ore to coal and steel to copper.

But not only are opinions among the world’s big miners divided over the future growth in demand for steel and its principal ingredient iron ore in China, the country’s own trade bodies don’t have a consensus on the subject. For example, the China Iron and Steel Association (CISA) believes the country has arrived ata tipping point. Not all China agencies, however, agree. CISA has forecast a 2% fall in Chinese steel production in 2015, the first contraction since 1990. Unarguably China’s economic woes contributing to the fall in local demand for all metals is leading to a piling up of negative factors for global steel. The World Steel Association (WSA) says Chinese steel demand, which for the first time since 1995 saw a negative growth in 2014, will see further demand fall of “0.5% in both 2015 and 2016.” WSA’s ‘short- range outlook for steel’ was released in third week of April and if anything China has found itself in greater difficulties since. Chinese imports falling 13.8% in August from a year earlier and exports down 5.5% are seen as pointers to the world’s second largest economy growing at a lesser speed than earlier thought.

Concern for the European Union, the US and India is that pressure will be further mounting on China to sell growing quantities of its surplus steel in the world market. In the first seven months of 2015, China exported 62.13mt (million tonnes), which is more than Japanese production of 61.438mt in the same period. Slowing local demand will prompt China to export over a record 100 mt in the current year. Such volumes of steel leaving Chinese shores for overseas destinations will keep a lid on prices to the dismay of struggling mills in all continents. Such high exports will heighten China’s trade tensions with India, the US and the European Union. When every stakeholder in steel is braced for a struggle not to end too soon, Rio’s iron ore chief Andrew Harding believes China’s steel production will rise to 1 billion tonnes (bt) by 2030 from 822.7mt in 2014. This will be driven by exports of steel-based higher value added finished goods resulting from more and more Chinese factories moving up the value chain. Another demand booster will be the construction of new homes that are taller and more steel intensive in place of nearly 25% of the present stock to be pulled down by 2030. Steel demand in China will also get a leg up from the building of infrastructure, particularly as urbanization gets a push and car ownership rises.

But Harding’s thinking about Chinese steel and iron ore has expectedly left no impact on the market. Caixin’s China general manufacturing purchasing managers’ index (PMI) for August was down to a near six-and-a-half year low of 47.1. This is a pointer to persistent sluggishness in Chinese manufacturing as the economy remains in the process of bottoming out. To be fair to Harding, he is saying that Chinese steel production will be rising only “modestly” to 1bt by 2030 while emerging nations will henceforward figure more prominently in annual global steel demand growth of 2.5% in the next 15 years. The “ongoing volatility” in commodities has not stopped Rio saying that high quality ore will still meet with “growing demand.” An average 2% rise in demand will expand global ore consumption to 3 bt by 2030, says Rio whose investments in the past few years will lift ore production in Western Australia’s Pilbara region to 335 mt next year and then to 350 mt in 2017.

What, however, must have given Rio and the world’s other three leading ore producers a shock was fall in the mineral price to $44.59 a tonne on July 4 from the record just above $190 a tonne in early 2011. Ore with 62% iron content has since recovered to $57.42 a tonne for delivery at Qingdao in China. But the outlook remains dispiriting since China, which accounts for over 70% of seaborne trade in the mineral, received 14% less ore in August at 74.12mt. Quite a few agencies believe that prices at the current level will not be held. Goldman Sachs sees possibility of prices drifting 30% over the next 18 months. Rio’s response to price collapse is by way of bringing down ore cash costs to $16.20 a tonne in this year’s first half from $20.40 a tonne in same period last year.