Tail winds for Resources

11th January 2021: In managing our clients’ New Zealand and Australian investments, it is critically important to have a clear view on what is happening in China. China is not only the world’s second largest economy, it is also Australia’s and New Zealand’s largest trading partner (c. 30-40% of both countries’ exports) and its economic performance influences investor sentiment in both the New Zealand and Australian share markets. In recent times navigating the more fractious China/Australia trading relationship has also been an important focus for investors in Australian equities.

Portfolio Manager Tama Willis, who has researched China for over 20 years, is responsible for the analysis and stock selection of the Australian commodities sector at Devon. Normally this entails an annual on-the- ground research trip to gauge the macro environment and commodities backdrop first hand. However, due to COVID-19 restrictions, members of the Devon team will join the UBS Greater China Conference virtually in mid-January. In this brief summary we highlight the recent positive macro trends in China and the very supportive demand environment for commodities as we enter 2021, with a particular focus on the key steel-making raw material iron ore, which recently touched 10-year highs.

In terms of macro developments China has proved itself to be very effective at managing COVID-19, which allowed a strong recovery to develop throughout 2020. For example, Fixed Asset Investment (FAI) is an area the Chinese government has used to stimulate the economy and to meet growth targets. Overall FAI growth rose 9.7% year-on-year (yoy) in November, with manufacturing investment rebounding more than expected from 3.7% to 12.5% yoy. Property has also recovered with property investment growth of +10.9% yoy in November. There are also positive signs emerging from the consumer, with retail sales growth of +5% in November. Investment Bank UBS expects China’s GDP growth to rebound 8.2% in 2021, led by exports and domestic consumption. CITIC Securities in China is slightly more positive, forecasting +8-9% real GDP growth in 2021 and nominal growth of 10%. Notwithstanding a likely moderation in FAI and Property growth rates in 2021, from elevated levels on reduced policy support, this backdrop remains very supportive for commodity prices next year.

The chart below illustrates China’s demand as a percentage of world demand in 2020 for a number of key commodities. China’s share increased further last year given depressed levels of demand elsewhere in the world due to COVID-19 induced downturns. The old adage of being “long commodities where China is short” is still relevant for investors and applies particularly to both copper and iron ore where domestic resources in China are of low quality and local production represents only a fraction of domestic demand.

China as a percentage of world commodities demand, 2020e

Source – UBS    *seaborne supply

BHP Billiton, Rio Tinto and Fortescue Minerals are the largest mining companies on the ASX 200 and their aggregate weighting on the exchange is approximately 11%. The chart below shows our estimate of earnings by commodity in FY22. Iron ore is the dominant earnings driver, so a view on this key commodity is critical to the positions we take across this sector.

EBITDA split by commodity in FY22

More broadly, 2021 is shaping up as a strong year for commodities. Alpine Macro, an independent global macro strategy firm, recently pointed out in a research report that the three key factors determining commodity prices have turned decidedly bullish for this year. These factors include: the US Dollar, overall global demand conditions and supply side dynamics. They highlight that with effective vaccines now being rolled out, we should see a strong demand recovery for commodities, particularly outside of China, which is already growing strongly. On the supply side, COVID-19 has significantly impacted investment decisions across the industry resulting in relatively limited new supply additions over the next few years. Finally, contributing support will likely come from a weaker US currency due to elevated US budget deficits and open-ended quantitative easing by the Federal Reserve.  

The iron ore market is an excellent example of how strong demand and reduced supply can play out with the spot price for this commodity achieving a 10-year high during December.

Iron ore price (US$/t)

In terms of industry dynamics, China imports the majority of their iron ore requirement from Australia and Brazil which is then used to produce crude steel domestically. Over 80% of China’s steel output is produced using predominantly imported iron ore with the balance made up of scrap steel. On the current run-rate China is on track to produce approximately 1.05 billion tonnes of steel this year, an increase of 5.3% yoy, as it grows output to meet robust demand from the domestic infrastructure and property sectors. This is an incredible feat – it was only in 2015 that BHP predicted steel production in China would peak at less than 1 billion tonnes during the following decade. The trend of growth is expected to continue in 2021. CLSA recently conducted a survey of China’s 13 largest steel makers with eight of them expecting demand to rise by 2-4% in 2021 and five forecasting it to rise by 5-6%. This suggests strong confidence in the ongoing domestic economic recovery.

For iron ore another year of +3-5% China steel output growth in 2021 would keep the market very tight. We estimate that China’s iron ore imports increased 10.9% to 1.07 billion tonnes in November year-to-date, with Australia’s approximately 60% contribution to these imports highlighting the importance of this growth for Australian producers of iron ore. This is a key difference to other commodities such as coal, wine and certain agricultural products, which are currently subject to varying trade restrictions with China; China is simply unable to substitute Australian iron ore given few, if any, alternative sources, and their dependency on steel-intensive infrastructure for growth.

The iron ore supply side is also constrained at present. In Australia, supply growth is limited with BHP Billiton, Fortescue and Rio Tinto all facing some capacity constraints (predominantly port and rail). Meanwhile, Brazil’s Vale has consistently downgraded their supply estimates following the tragic Brumadinho dam failure in early 2019. In recent weeks Vale further reduced its output target for 2020 and 2021, adding to the upward iron ore price momentum. Overall Vale is tracking over 100 million tonnes per annum below the supply forecasts they outlined two to three years ago. The chart below highlights that the top four global seaborne iron ore suppliers (responsible for approximately 70% of supply) are only expected to return to 2018 levels of supply in 2022.

Seaborne supply – Top 4 global producers (million tonnes)

In summary, recent data is supportive for further growth in demand for commodities by China during 2021. With COVID-19 and other issues limiting supply growth, we see at least two more years of elevated prices. Macquarie research recently noted that free-cashflow yields for the sector are around approaching 20% in FY22, using current prices. Even using a more conservative iron ore price of US$115/t (current spot is at US$160/t) produces free-cash flow yields of close to 10%. Given the strong balance sheets of the major producers we anticipate bumper dividends to be paid across this sector over the next two years. At Devon Funds we are overweight the Resources sector with holdings in BHP Billiton, Fortescue Minerals and Rio Tinto, and we remain confident that these positions are likely to deliver solid returns for our investors.

Sector free -cash flow yields on spot iron prices in FY22