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Quarter-End Insights

Basic Materials: Iron Prices Swoon on Weaker China--Copper Is Next

The Chinese fixed-asset problem plaguing iron ore and soon copper will not be solved by cutting interest rates.

Jeffrey Stafford
  • Despite a recent rise in global equities, the basic materials sector continues to trade slightly below our fair value at a median price/fair value of 0.96 compared with a market price/fair value of 1.04.
  • Iron ore prices dropped off a cliff in 2014, and we don't expect a return to heady prices anytime soon.
  • Copper prices have held up relatively well, but we think Dr. Copper will be the next shoe to drop from China's inevitable slowdown in fixed-asset investment.
  • Markets cheered China's interest-rate cut as effective medicine for the country's slowing economy, and thus good news for commodities. We see this as nothing but a short-term fix--a shot of whiskey to cure a hangover.

 

China's slowdown in fixed-asset investment continues to reshape the outlook for many commodity markets compared with the boom times of the previous decade. It's been a painful year for iron ore. Prices started 2014 at $135 per metric ton and are now approximately $70, well below where most figured cost curve support would kick in. Many expect closures of higher-cost Chinese mines and moderate Chinese steel demand growth (3% annually) to help balance the now-oversupplied market and underpin a price recovery. By contrast, we believe Chinese steel demand has peaked and is likely to decline as excess real estate supply is absorbed and the economy rebalances away from investment toward consumption. In this climate, we strongly prefer low-cost diversified miners such as  BHP Billiton (BHP).

Although the price of iron ore has fallen to multiyear lows, copper has held up remarkably well in 2014, falling only 13% compared with a 50% decline in iron ore prices year to date. The performance gap has been particularly striking given the mounting weakness in China's real estate market, a key demand driver for both materials. Copper's tighter supply conditions explain much of the divergent price performance, as well as the consensus enthusiasm for copper prices and the stocks of copper companies. We think this optimism is misplaced, as it overlooks a demand-side quirk that portends trouble for copper in 2015. Although copper and iron ore consumption are each tied to Chinese real estate demand, copper is used much later in the construction process. As China's real estate starts have fallen this year, iron ore was first to feel the pain. Copper will be next. No copper-mining stocks under our coverage trade at a material discount to our fair value estimates, and most appear overvalued.

Cheap iron ore will have profound implications for the steel industry. Iron ore's new normal will mean lower steel prices and a flatter cost curve. At the company level, cheaper iron ore means different things for different players. We strongly prefer firms that compete on conversion costs rather than input costs. Favorable end-market exposures are a secondary consideration in surveying long-term investment opportunities in the steel industry, as this advantage tends to be fleeting.

Low iron ore prices will redefine how steelmakers compete. Input costs will remain a key driver of competitiveness but will diminish in relative importance. Conversion costs are increasingly critical. Firms with low conversion costs are poised to benefit in the new competitive landscape. Further, vertical integration should lose its strategic appeal. Upstream exposure has always meant higher earnings volatility (fixed costs/variable prices), but the downside wasn't apparent amid high iron ore prices.

All this paints a dim picture for global commodities leveraged to China's fixed-asset investment. China's surprise rate cut on Nov. 21 may restimulate fixed-asset investment, but it's likely to do more harm than good. China hardly suffers a lack of investment. In fact, China's problem is just the opposite: too much investment. Recharged investment outlays might boost headline gross domestic product, but it will also exacerbate excess capacity throughout the economy and add to the country's growing pile of bad debt. Long-term-focused investors should be concerned about Beijing's unwillingness to endure the short-term pain that it will take to put the economy onto a more sustainable growth trajectory. Another shot of whiskey will ultimately make this hangover worse.

Top Basic Materials Sector Picks

Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
Yamana Gold $9.50 None High $5.70
Newcrest Mining AUD 22 None High AUD 13.20
Cloud Peak Energy $19 Narrow High $11.40
Data as of 12-23-2014

 Yamana Gold 
Yamana Gold is a Canadian-based gold miner operating mines in Brazil, Chile, Argentina, Mexico, and Canada. Shares have traded off after Yamana impaired three recently opened noncore mines because of underwhelming performance. However, we believe the market is overlooking consistently solid performance from Yamana's low-cost cornerstone assets, a meaningful growth pipeline, and the benefit of lower expansionary capital expenditures in the coming years. We expect Yamana to continue to be one of the lowest-cost gold miners we cover.

 Newcrest Mining (NCM)(Australia)
Newcrest Mining is engaged in exploration, mining, and development of gold and gold-copper concentrate in Australia, Indonesia, and Papua New Guinea. Its projects include Cadia Valley, Telfer, and Lihir, among others. Newcrest's long reserve and resource life is a key differentiator and supports future growth. The market is disinterested in the large reserve base, but it provides valuable long-term options.

 Cloud Peak Energy
Cloud Peak Energy mines thermal coal out of the Powder River Basin in the western U.S. at low production costs. Although rail issues caused by severe winter weather in early 2014 have delayed contracted coal deliveries, we expect PRB coal prices to improve as rail service normalizes, allowing utilities to make spot purchases. Shares have also traded off as oil prices plunged. However, we believe the relationship to oil is largely overblown, as the two energy sources are not direct substitutes. In addition, any cancellation of U.S. shale projects because of low oil prices could benefit coal, as these projects often produce natural gas as a co-product.

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