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.
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.
Coffina: At the same time, on the supply side, you expect China's domestic iron-ore supply to be a lot more resilient than a lot of people realize. Why is that?
Rohr: I'd say, generally, for a couple of reasons. First is that the state plays a large role on the production side for iron ore in China. So, while a private enterprise that's mainly focused on profit maximization may elect to shutter capacity if the price falls below their cash cost of production, for an iron-ore mine owned by the state, they are going to be thinking about other things as well. They are going to be thinking about employment within the prefecture or the county or the province. They are going to be thinking about the GDP figure that they can report to the central government at the end of the quarter or end of the year.
So, you're likely to see these state-owned mines producing at price levels below their cash cost of production. So, all else equal, that will weigh on iron-ore prices. The second reason why Chinese iron-ore miners are likely to remain in the game, perhaps at prices lower than most folks expect, would be their natural freight cost advantage. So, this is a simple fact of being located more proximate to the steel mills in China--such that the domestic iron-ore miners are earning a larger percentage of the benchmark price of iron ore that’s quoted on a landed Tianjin or Chengdu basis.
Coffina: How about supply from other major countries like Brazil or Australia? Will those miners pull back on production in light of weaker demand?
Rohr: Well, a lot of the higher-cost miners will. The problem is that a lot of the lower-cost miners won't, and the lower-cost miners also, in fact, will be expanding production. So, here we're talking about the likes of Vale (VALE), BHP Billiton (BHP), Rio Tinto (RIO). Their costs are low enough that, even at today's low prices, the incremental returns that they can generate on that additional capital that they can throw at a brownfield expansion are still sufficient enough to get a pretty good return on their investment.
Coffina: So, you've been talking mostly about iron ore and steel. What about other commodities like copper?
Rohr: Broadly, across the industrial commodity space, the story is the same--weaker demand and buoyant supply. Iron ore is exceptional only in that it's an extreme example of both of those and in that iron ore is the most quintessentially real-estate-oriented of commodities as far as China's demand is concerned and the supply response in iron ore is far stronger. But you mentioned copper--that's certainly a good example. We expect copper prices to fall quite a bit from where they are today.
Copper is a little bit different in terms of when it's consumed in the real estate development process. So, whereas iron ore and, therefore, steel is used early in the process of erecting, say, a residential high-rise, copper is used later in the game--fitting the pipes, throwing the cables and wiring in. So, the impact of weaker Chinese real estate activity is going to be a little bit lagged when it comes to medium-stage commodities like copper.
Coffina: So, mining stocks have also suffered in 2014 along with the decline in iron-ore prices and other commodity prices. What does all this mean for investors? Should they stay away from the mining sector altogether? Or if they do want to dip a toe into the sector, where should they look?
Rohr: We do think there is some value manifesting in the mining space, but we would caution investors to really focus on those names that have the cost position where they can weather a long and pretty arduous slump in prices. So, you can use our economic moat rating as shorthand for those companies that possess that unassailable cost position. One name that comes to mind would be BHP Billiton. It would be one of our top picks in mining at the moment.
Coffina: Thanks for joining me, Dan.
Rohr: My pleasure, Matt.
Coffina: So, in conclusion, our basic-materials team is relatively bearish on industrial commodity prices like iron ore and copper. We think investors should approach the mining sector with caution. But on the other hand, we think there are a few firms with sustainable low-cost positions that should be able to weather this storm better than most. One name that comes to mind would be BHP Billiton. For Morningstar StockInvestor, I'm Matt Coffina. Thanks for joining us.
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