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By Matthew Coffina, CFA | 12-29-2014 02:00 PM

Approach the Mining Sector With Caution

A likely slowdown in Chinese real estate will mean weaker demand for commodities such as iron ore and copper, but a few firms with sustainable low-cost positions should weather the storm.

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by Dan Rohr, who is the director of our basic-materials team, and we are going to talk about iron ore and other commodities markets. Dan, thanks for joining me.

Dan Rohr: Thanks for having me, Matt.

Coffina: So, let's start with China because that's really where the trouble originates here. How important is China to global commodities demand?

Rohr: Matt, it's really, really hard to overstate how important China is to commodities demand, particularly industrial commodities. You take something like copper, for example. China is now 44% of global demand--up from 10% just a decade ago. And just as importantly, China has been nearly 100% of demand growth. It’s the same story across most industrial commodities--something like iron ore. China is two thirds of global seaborne demand and, again, nearly 100% of demand growth over the past decade. So, the world, absent that killer China growth, would look very, very different for commodities.

Coffina: So, let's focus in on the steel industry.

Rohr: Sure.

Coffina: You think Chinese steel demand has already peaked and is about to start declining. That’s a significantly more bearish view than the consensus. What's behind your thesis?

Rohr: It all comes down to real estate. So, just as China is the single most important source of demand globally, within China, it's real estate--that's the star of the show. So, for steel--and as a consequence, iron ore--real estate, you're talking about 50% of end demand. So, our negative call on steel is a function of a negative call on real estate. So, real estate in China is principally an urbanization story.

Over the past decade, China has urbanized roughly 20 million people annually. It's been a huge number, but it's been a relatively consistent number. So, if I were to draw you a graph, it would look something like this. If you take a look at Chinese residential floor space additions, it's been also a very large number, but it's been a growing number. So, something like that. [Rohr makes an inclining slope with his arm.] So, at present, we are adding to China's urban real estate stock roughly 1000 square feet per new urbanite each year. What that has resulted in is significant overcapacity in many, many cities throughout China.

What we think that's likely to mean is real estate starts are going to have to come back down to equilibrate with a natural level of activity commensurate with urbanization. As I said before, real estate accounts are half of steel demand, so that's naturally going to mean weaker steel demand going forward and weaker demand, therefore, for iron ore.

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