London Calling muses on the future of Mining's Giants

Published by MAC on 2012-05-08
Source: Business Spectator, Caixin

BHP and Rio's voice of caution

By Stephen Bartholomeusz

Business Spectator

4 May 2012

A year ago the major miners were boasting about the size of their capital expenditure pipelines. Suddenly, however, they have started talking about flexibility and prioritisation.

This week both Rio Tinto and BHP Billiton have given voice to that shift in tone. Rio's Tom Albanese, in the country ahead of next week's Australian annual meeting, has been making it clear to everyone from the prime minister down that Rio is re-thinking its investment program and is likely to stretch the timetable for its major new projects to lower risk.

BHP's chief executive for aluminium, nickel and corporate development, Alberto Calderon, expressed very similar sentiments at an investment conference this week, saying that while BHP remained confident about the long-term growth outlook and the fundamentals of key commodities it would now sequence its projects to reduce risk and balance short-term and long-term returns.

The factors influencing the relatively new-found caution within the two big miners are both global and local.

China has slowed its growth rate significantly and the composition of its growth is steadily shifting from investment to consumption, changing the nature of its demand for commodities.

At the same time a wave of new supply, which had been deferred by the financial crisis, is starting to enter a market that has been impacted by the continuing economic and financial instability in Europe and the anaemic state of the US economy.

Those factors have made the miners more cautious. They have also, moreover, had an impact on their investor bases.

In Europe and the US, superannuation is still largely dominated by defined benefit schemes and pensions, unlike our defined contribution regime. That means pension funds need long-term income streams and has traditionally seen them invest heavily in fixed interest securities.

The response of the European and US central banks to the crisis, flooding their debt markets with ultra-cheap liquidity, has pushed interest rates in those economies down to negligible levels, indeed into negative real rates territory.

That has in turn led to the pension funds searching for higher yields elsewhere and exerting pressure on the miners to divert more of the massive cash flows generated by the resources boom towards shareholders rather than capital investment. They want income today not investments that might produce returns in the long-term. For similar reasons BHP and Rio are facing similar calls from Australian institutions.

It is a coincidence, but a convenient one, that Albanese and Calderon have been expressing the evolution of their thinking just ahead of the federal budget, with Albanese illustrating the issues by raising a question mark over the planned $2 billion Mount Pleasant coal project in NSW.

If the big miners are now going to prioritise their project pipelines and spread their planned spending out over a much longer timeframe projects like Mount Pleasant are competing directly for capital against others, like the continuing expansion of Rio's Pilbara iron ore business, or the giant Simandou project in Guinea, or the Oyu Tolgoi copper-gold project in Mongolia or the Riversdale coal project in Mozambique.

Albanese has made it clear that costs, both capital and operating costs, are soaring in Australia. He hasn't been as explicit, at least in public, of warning of the threat to investment created by government action.

The miners, having negotiated it, can live with the Minerals Resource Rent Tax. Given that it was framed as commodity prices were peaking, and that they have fallen significantly since, it's not going to be much of an impost.

They are, however, really concerned about next week's budget and the informed speculation that the government is going to axe the diesel fuel excise rebate and is considering changing the tax treatment of overburden removal, now a deductible expense, to one where it is a capital item that would be depreciated over time.

Consider BHP's proposed Olympic Dam expansion, one of its mega projects whose cost will run into the tens of billions of dollars but which, if it goes ahead, will have a dilutive impact on BHP's returns for much of its first decade. The expansion involves digging perhaps the largest man-made hole on earth, shifting massive amounts of over-burden in the process and using enormous volumes of diesel in the process.

It has been apparent for some time that Marius Kloppers has been cooling on the idea of giving that project a go ahead this year and committing the group to such massive outlays even as the commodities markets have softened and the risks within the global economy have re-emerged. Abolition of the diesel fuel rebate and a change to the tax treatment of over-burden removal probably confirm his reservations.

It is probable that Rio's planned expansion of its Pilbara operations, from 230 million tonnes a year to 353 million tonnes, will go ahead at a cost of more than $US15 billion, although that expansion can be phased in smaller increments. BHP will also probably go ahead with the even more expensive expansion of its Pilbara business, which involves building new port facilities in the outer harbour at Port Hedland.

BHP and Rio have pricing power in iron ore but also a significant cost advantage over emerging producers and the marginal producers in China. They expect the iron ore price to fall over time and that their extra volumes will displace that marginal production, allowing them to offset their loss of margin with the extra volume.

Projects like Mount Pleasant, or BHP's planned Queensland coal expansion, or its massive Jansen potash project in Canada don't, however, have that same level of inherent protection against downturns in price and demand at a time of escalating costs, shifting energy mixes and shareholder demands for a greater share of the current cash flows.

The big miners are dialling down their risks and the pace of their previous dash for growth to adjust to the evolving near to medium-term environment and to focus their spending on the projects with the strongest medium-term returns.

The new reality means that there is now a global competition between the rafts of projects within their portfolios - and between the economies that host those projects. It is to be hoped that when Albanese spoke to Julia Gillard this week she understood the implications of his message.

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Sad Industry Mantra: Make Steel, Lose Money

By Zhang Bolin

Caixin

16 March 2012

From Baosteel to Angang, China's mighty steel companies are in a slump that shows no sign of easing.

China's steel manufacturers are holding back nothing while scouring for contracts in the worst business environment since the 2008 financial crisis.

The industry's tale of woe has been punctuated by financial reports from companies such as publicly listed Guangzhou Iron and Steel Enterprises Group, which said it lost 689 million yuan last year and nearly 98 million yuan in 2010.

Even the state-owned sector is struggling to make money. The country's largest steelworks Baosteel Group Corp., for example, said 2011 profits slid 21 percent year-on-year to 18.7 billion yuan.

And Shagang Group, a private steelmaker in Jiangsu Province, said last year's revenues fell 30 percent from 2010 to 207 billion yuan.

"No matter how we control costs, we can't stop the profit margin from declining," a Shagang manager told Caixin. "We've adjusted the product mix, expanded new product development and market expansion.

"Sales revenues increased, but profits slid anyway," he said. "This points to a problem: The entire industry has reached an operational state marked by high production capacity, high costs, and low economic benefit."

The China Steel Industry Association is trying to help its members get through the wintry business environment, said CSIA Vice President Zhang Changfu. But the task is formidable: The association said 77 large and medium-sized steel companies saw profits decline 4.5 percent last year, to a combined 87.5 billion yuan, compared with 2010. Eight companies posted a total 3.3 billion yuan in losses.

Losses were reported by four of the 16 steel companies listed on the Shanghai and Shenzhen stock markets that released 2011 financial results so far, according to industry tracker Wind Information Co. Another six companies said they expect to report weaker performance year-over-year.

Posting annual losses for the first time were Angang Steel Co. Ltd. in Liaoning Province, Chongqing Iron & Steel Group Co. Ltd. in the city of the same name, and SGIS Songshan Co. Ltd. in Guangdong Province.

Angang's red ink - an estimated 2.2 billion yuan - may have been the worst among all China's listed steel companies. Shougang said its 2011 profit was only 13 million yuan, as its net profit fell 96 percent from the year before.

Magang (Group) Holding Co. Ltd. in Anhui Province said its profits last year plummeted more than 50 percent, and its profit on sales dipped to "less than 1 percent," a company source told Caixin.

"We're under a lot of operating pressure right now," the source said. "Because it's related to employment, we cannot just cut production. We're now in a situation where we lose several hundred yuan on a ton of steel."

Get Out of Steel

Neither are steelmakers optimistic about near-term prospects for a turnaround. Many can only hope things don't get worse.

Executives were called to outline problems and map out solutions at a February 23 forum called by the Ministry of Industry and Information Technology (MIIT). The focus was "measures to be taken to promote the development of the steel industry and alleviate the present conditions in the steel industry," a ministry source said.

"The steel industry faces a future environment that will be even more difficult," said Zhu Jimin, chairman of Beijing Shougang Group.

Many industry insiders say they're convinced the doldrums will last for some time, prompting companies to look for new ways of doing business. Some that moved out of the steel industry have made money, while others lost their shirts.

Those that stick with steel will need to find new ways to do business, particularly if the enterprise is state-owned, said Liu Haimin, deputy director of the China Metallurgical Industry Economic Development Research Center.

Large and medium-sized steel companies owned by the state have a hard time suspending or reducing production even when they're not making money because shutting down blast furnaces is costly and they are obligated to maintain employment levels, Liu said.

"Money-losing companies drag down average profit margins, and steel prices are pushed down when more products from money-losing companies are put to market, making it difficult for industry profits to rise," he said.

Some have opted to expand into energy ventures. On February 22, for example, Wuhan Iron and Steel Group (Wugang) in Hubei Province and China Resources Steel Trade Co. Ltd. formed a 50-50 joint venture natural gas business.

"The gas company will become a new profit point for the company," a Wugang executive said. "We initially expect annual profit contributions of around 700 million yuan."

Wugang's 2 billion yuan in profits from non-steel industries accounted for 70 percent of the company's total profit, eclipsing similar endeavors among other steelmakers. The company said its sales profit margin was 1.7 percent last year, while its profit margin from non-steel industries was 3.5 percent.

Baosteel, Wugang and Magang are accelerating expansions into non-steel industries, too. Over the next five years, Shagang plans to post an average 300 billion yuan in annual sales, with more than 30 percent coming from outside the steel sector.

"Steel companies are developing non-steel businesses because profits are too low," said Li Xinchuang, CSIA deputy secretary-general and president of the Metallurgy Industry Planning Research Institute. "Based on the funding and technical capacities of Chinese steel companies, coupled with the characteristics of a long and diversified industrial chain, the prerequisites for developing non-steel industries are there."

But Liu said expanding into non-steel industries comes with risks.

"After all," he said, "in downstream industries such as real estate and engineering machinery, development is slow and competition is becoming more fierce, while investment in upstream mining is very risky. The logistics industry is closely related to the steel industry, but it is also threatened by weak demand."

And some that tried to move out of steel have failed. One was the non-steel branch of a private Hebei steelmaker, Caixin has learned.

"We wanted to develop logistics, so we built two ships and rented more than a dozen others," a manager at the struggling steelmaker said. "But the shipping industry is also affected by weakness in the steel industry and burdened by the international economic situation.

"We didn't even have any cargo to ship."

Liu said for now "there is no sure-fire plan for profitability in the steel industry."

What might happen next is that the industry will see a phase of mergers and restructurings that create regional monopolies and reform the state-owned enterprise mechanism so that "Chinese steel companies are truly controlled by the market."

What Went Wrong?

Why the slump? CSIA blames high iron ore prices for steel company losses, Zhang said, and wants the issue resolved. This was one of the topics discussed February 24 at Magang's offices during a CSIA forum on improving steel company efficiency.

But a consensus deep inside the industry mainly points a finger at weak demand.

"The main reasons for the sharp fall in profits last year were, on the one hand, the release of production capacity at the year-end of 2011, and, on the other hand, the decline in steel demand growth from downstream steel-consuming companies, especially in the manufacturing industry, caused the steel price dropped," said Shougang's Zhu.

"Looking at our current orders, enthusiasm (for steel products) in the machinery industry is low," said a sales manager at Jianlong Group, in Hebei Province. Since last October, he said, some customers have cancelled the orders.

MIIT said in a February 29 forecast for the industry that the slowing global economy and cooling growth in China will combine to pinch steel demand further this year. And steelmakers should not expect a government stimulus program to come to their rescue.

"We don't think the government will invest huge funds to boost the economy again," the ministry source said. "The main part of consumption in steel is fixed-asset investment. We're not optimistic about future investment demand."

The European debt crisis may weaken overseas demand even more this year, the source said, while direct steel and steel product exports "will be affected. In terms of consumption, after several years of rapid growth, the main steel-consuming industries such as machinery, automobiles, ships and railways face declining growth."

High inventory levels and production capacity have also hurt the industry.

According to industry analyst Mysteel, nationwide inventories of rebar, wire rod and other steel products in 26 domestic markets totaled 18.9 million tons February, up 850,000 tons from the same date last year.

Meanwhile, nationwide production capacity continues to rise. CSIA said average daily crude steel capacity among the country's largest producers in early February was 1.6 million tons, up 5.6 percent from January.

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BHP Billiton's Chinese chill

Stephen Bartholomeusz

Business Spectator

16 May 2012

There wasn't anything especially new in Marius Kloppers' presentation to Bank of America Merrill Lynch's global metals, mining and steel conference in Florida overnight but the tone was slightly gloomier and the context in which the presentation was made is evolving in an equally gloomy direction.

The macro theme of the presentation was consistent with recent commentary from both BHP Billiton and Rio Tinto's senior executives: China's growth rate is slowing and the composition of that growth is shifting from investment to consumption, which will change the nature of its demand for commodities even as a wave of supply, delayed by the global financial crisis, enters the market.

Both of the major Anglo-Australian resource groups, however, while acknowledging that steel intensity would peak first as China's economy matures, have remained confident that China's demand for steelmaking commodities will remain strong for at least another decade.

Kloppers, however, painted a less optimistic picture of the shorter term outlook yesterday, saying that the cash flows for most miners were going to be lower now than they would have been a year ago, with lower commodity prices and higher project costs squeezing them.

Both BHP and Rio have spoken about changes to the "sequencing" of their planned major new projects - being more discriminating about where and when they invest and stretching out the timing of the pipeline of new projects.

The big end of the resource sector had already factored in some softening of commodity prices this year as China had made it very clear it wanted to slow the growth rate in its economy to deflate a property-centred investment bubble. It is officially targeting 7.5 per cent growth this year, from 9.2 per cent last year and 10.4 per cent in 2010.

Recent economic numbers out of China - and China's response to them - however, have sent some disturbing signals.

On Monday China reduced the amount of cash its banks have to hold in reserve for the third time in six months, in an attempt to encourage the banks to lend and stimulate activity. That followed April economic statistics that showed a sharp slowdown in both exports and imports.

The new European crisis and the continuing weakness of the US economy help explain the drop-off in export growth, which fell back from 8.9 per cent in March to 4.9 per cent, or 1.5 per cent seasonally adjusted. The potential for a eurozone implosion and new global financial and economic crisis has strengthened in recent weeks as the backlash against austerity measures has developed, making it most unlikely there will be a significant rebound in exports in the near term.

Virtually flat imports (up 0.3 per cent year-on-year), however, were probably the bigger surprise. Among the declines in import volumes were iron ore (minus 8.2 per cent from the March numbers) and steel products (minus 11 per cent).

That signals a sharp reduction in domestic demand and suggests the measures taken so far by the Chinese authorities to stimulate demand have failed to gain any real traction, a view supported by the fact that China's bigger lenders are disclosing significant reductions in their rates of new lending.

In the near term commodity prices have fallen back - as have the stock prices of miners big and small this month, with a particularly sharp sell-off this morning - but they remain at historically high levels. If China can't stimulate domestic consumption, however, the pricing environment could change quite rapidly.

With a leadership change due later this year the Communist Party will presumably do whatever it can to ignite some meaningful growth. So far, however, its actions haven't had the desired effect.

The long-term picture of continued increases in demand for steelmaking materials from China, India and other developing countries probably remains intact, but the new crisis in Europe and the subdued medium-term outlook for the US has clouded the near- to medium-term outlook for commodities.

The other complicating and adverse factors are the extent and pace of the escalation in project costs, both capital and operating, that have been occurring and the amount of new supply entering and nearing the market.

Higher costs and lower prices aren't good for project economics, although at least the Australian miners have (so far) dodged the bullet of changes to the tax treatment of over burden removal and the abolition of the diesel fuel rebate that were widely speculated about in the lead-up to the federal budget.

There used to be a consensus that the market for iron ore would move towards a balanced supply-demand equation around the middle of this decade as the crisis-deferred production started flowing into the market.

The unexpected acceleration of the slowdown occurring within China and the new financial and economic fissures that have opened within the eurozone, however, have the potential to bring that moment where supply meets demand forward.

BHP is fortunate that it has yet to make final investment decisions on a cluster of mega-projects - the Outer Harbour expansion at Port Hedland, the Olympic Dam open-cut expansion and the Jansen potash project in Canada are the big ones - that are scheduled to be made later this year.

It is pretty obvious that at least one and probably two of the projects will be deferred unless conditions turn around quickly, and that Rio and other miners will be adopting the same defensive approach until the environment stabilises.

There will still be a continuing boom in resource sector investment - there are hundreds of billions of dollars' worth of projects already underway that will have to be completed - but a big dent is now emerging in the pipeline of future projects. The prospective returns from those projects underway or recently completed may not be quite as lucrative as was once envisaged and the odds on the minerals resource rent tax raising anything material have lengthened even further.