BHP & Rio Profits Should Bottom Soon
September 8, 2009
by
Well, it's official. The negotiations for iron ore annual price contracts have concluded between Chinese steel mills and Australian miners. I highlighted this issue in my March article describing a drop of up to 40% in iron ore prices (and even larger cuts in coal prices) at a time when other commodities prices like copper and aluminum were on the mend.
Well, it's official. The negotiations for iron ore annual price contracts have concluded between Chinese steel mills and Australian miners. I highlighted this issue in my March article describing a drop of up to 40% in iron ore prices (and even larger cuts in coal prices) at a time when other commodities prices like copper and aluminum were on the mend.
The financial outcome was as predicted – a 33% cut in contract prices for iron ore and close to 60% drop in coal prices. The unusual path the negotiations took was anything but predictable. It speaks volume about the struggle for power between resource hungry Chinese manufacturers and global commodities producers. Rio Tinto (RTP) has called off the negotiations for the year, in part, because their negotiation team is now under arrest in China.
For those of you not following the drama that unfolded in Australia and China over the last six months let me summarize. Each year, mining giants BHP Billiton (BHP) and Rio Tinto have entered into pricing contracts with Asian steel mills setting the price from April 1st. The negotiations date back to the rise of Japanese industrial dominance when Japanese companies (whose fiscal years’ all begin in April) locked in prices of iron ore (raw input to steel production) and coal (used to fuel blast furnaces) for the following year. One or two companies on each side would establish a price in an annual contract that became the benchmark for most of the industry pricing. An exchange for spot price contract is developing in Singapore but remains a small part of the market.
While Chinese and Korean steel makers have overtaken Japanese mills in industry dominance, this annual tradition has continued. What started as a convenience for steel mills attempting to better forecast their primary costs for the coming fiscal year has come to benefit the mining companies. This shift in negotiation power was no more evident than the price greater than 80% price increase (from $50/ton to $90/ton) that BHP extracted from Chinese steel maker Baosteel at the height of the 2008 commodities bull market.
Today virtually all profits of the big miners are linked to these price negotiations. With the steep drop in global economy, steel mills sought steep reductions in 2009 discussions. Prices for commodities traded on exchanges (oil, copper, aluminum, etc.) corrected quickly from July 2008 just as iron ore and coal price hikes were going into effect.
As shown in the graph above, virtually all of BHP’s profits in the last year have been derived from these well-timed price increases. In June, Japanese and Korean steel makers settled for a 33% drop to the $60/ton level while Chinese makers held out for a 45% decline back to the $50/ton level on the logic that global demand for steel is nowhere near even 2007 levels.
Unfortunately for the Chinese companies, they had lost a key leverage point by June of this year. Thanks to Chinese government stimulus and a program of resource stockpiling, the price of iron ore on the spot market had been driven back up near the $90/ton level. While the spot market remains small, it is an important reference point for price. It seems in all the stimulus-led buying the Chinese mills had run up the prices on themselves. Talks broke down in July.
The most acrimonious discussions involved Rio Tinto, which had only months before abandoned a plan to raise $19.5 billion from the Chinese Aluminum Company, known as Chinalco (ACH). At the depths of the global economic collapse in early 2009, Chinalco’s increasing its stake in Rio through this further tie up seemed the only way for Rio to raise sufficient funds to pay down its debt load. As commodities prices rebounded throughout this year and political pressure against the investment mounted in Australia, Rio scrapped the plan in favor of a secondary public equity offering and an iron ore joint venture with BHP.
Little more than a month after Rio withdrew from the Chinalco investment plan, Rio’s price negotiation team, led by Stern Hu, was arrested in Shanghai on charges of bribery and stealing of state secrets. I will refrain from venturing an opinion on the validity of the charges as it would simply be speculation. However, the whole episode emphasizes the serious tug-of-war underway between Chinese industry and global resource producers.
What is the medium term implication? Shipments of raw materials from Australia to China continue. The halt in contract price negotiations simply leaves iron ore pricing at about $60/ton (the level agreed to by Japanese and Korean makers) through temporary contracts. So we should expect this 33% price drop for iron ore and 50-60% price drop for coal to remain in effect until next summer when Rio and BHP will be negotiating as one. The current half-year period (July – Dec 2009) will be the first full period at these lower levels. Thus profits still have further to fall.
Longer term the Rio-BHP venture will only make a more concentrated oligopoly in iron ore. Previously, market dynamics were set by the pricing and production of these two companies and Brazil’s Vale S.A. (VALE). We may be looking at a duopoly trying to keep prices elevated.
BHP’s profits are down but benefited from favorable pricing. The above graph breaks down BHP Billiton’s half year earnings. BHP and Rio both report ‘underlying earnings’, a pro forma view of earnings strength independent of one time charges.
In general, I am skeptical of such measures as one-time charges seem to recur. For this exercise, I am giving the companies the benefit of the doubt, though, that this represents the core earnings power of the company in that time period. Both companies provide substantial detail on their operations, providing transparency to the investor.
I had forecasted back in March that half year earnings would decline to the $5 billion per half year level, which has already happened. BHP reached that level in half year ending June ’09. I stand by my forecast from back then that BHP would get down to an annual rate of around US$9 billion, lower with write downs. At that level, BHP now trades at a price about 20 times that level.
This might be seen as cheap if you believe global economic activity is now strengthening and prices will soon strengthen. Yet this is an expensive price if you believe economic activity will remain weak.
Rio’s profits are falling but its balance sheet is improved. While Rio Tinto may have extremely strained relations with the Beijing government and its customers in China, the company has gone a long way in improving its strategic position. It is now in the position to pay down its debt through cash raised from the capital markets and from a joint venture that should result in more pricing power over time.
In the short term, the Rio’s profits also have yet to bottom. More than 100% of its profits in the last year have come from the iron ore and energy (which includes coal) business units. It will not be until current half-year period (July – Dec 2009) that pricing will bottom for these two businesses.
Aluminum, copper, and diamond businesses may in fact stop loosing money on cost cutting but spot prices still remain well below the early 2008 prices when these businesses last made money and the trend since July has been downward. I think it is fair to assume a drop in iron ore profit by a third and a more sizable drop in coal (half) and breakeven for the rest. This would leave Rio at a $4 billion annual run rate on earnings. The question then becomes: What is the trend for 2010? The, of course, depends on an investors’ belief in the pace of economic recovery.
Management of both BHP and Rio are quick to credit the past half year as being strengthened by Chinese resource stockpiling, which they admit has concluded. From here, they expect demand for resources to reflect the output of Chinese and other factories around the world rather than the input. However, this is not a picture of strength. A good example is the Baltic Dry Index.
Global asset markets have rallied but economic activity measures still remains depressed. The Baltic Dry Index (graphed in gold above) is a measure of global freight prices and had surged above 10,000 in 2008. Today it stands at less than a quarter that level. After April, it rallied to a June peak above 4,000 based, in part, upon strong Chinese demand for bulk freight like iron ore and coal.
Overlaid on the graph above are equity market indices from China and the U.S. as well as the price of oil during the period. Since June this shipping index is trending the opposite direction from the others which are normalized to the beginning of this half year period.
Given the rebound in global asset markets like the Shanghai Composite Index or the S&P500 in America, one would think the measures of economic activity are surging. Unfortunately, this is not the case. Whether it is the Baltic Dry Index or global trade, the pattern is the same: a sharp drop in late 2008, a bottoming in early 2009, a bounce up and then trading sideways. This implies that asset markets reflect more an inflow of cheap stimulus money than a great increase in economic activity. As shown in the graph above, oil trades more like an asset market than a commodity being consumed.
Eventually, economic activity will set the price of metals, coal, and iron ore based on how rapidly these resources are being consumed. As it stands that consumption pace is no longer getting worse but is it recovering much either. This lack of a real recovery may explain the recent correction in Chinese stocks.
With China no longer in the buy-and-hold business there is more downside risk in the next six months than a chance of upside surprise for BHP and Rio. However, over multiyear horizon, pricing power and cost synergies in the joint venture ensure that prospects for the two companies look very good.
The only question in my mind is: Will there be a better entry point when it becomes clear that rebound in economic activity still remains weak? I continue to believe so.
Disclosure: No positions.