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Tuesday, May 17, 2022

Gold rout could turn into stampede out of commodity investment

World’s largest mining companies are running out of options as commodities slump tipped to deepen

It all started with a bullion sell-off on the Shanghai Gold Exchange , when 4.7 tonnes of the precious metal was unceremoniously dumped on to the market. The trade sent gold tumbling 4.3pc to less than $ 1,100 per ounce and played to fears that China’s demand for all commodities, precious or otherwise, was imploding.

During the boom years of the commodities super-cycle, when iron ore traded at $ 180 per tonne, gold topped out at more than $ 1,900 per ounce and oil looked cheap at $ 100 per barrel, no bet on resources was too risky to take. China’s demand for raw materials, energy and food was expected to drive growth in the entire commodities sector uninterrupted for at least the next 25 years.

However, those days are over ; and despite glimmers of hope that the current slowdown in Chinese economic growth may be short-lived, the crash in resource-based asset prices has turned from an orderly exit into a stampede. This sense of nervous panic is partly why gold prices tumbled so fast on Monday, only for them to recover their losses in the following days.

The sense of foreboding hanging over resources was made worse by the big global mining giants, which are running out of options if they want to maintain their commitment to progressive dividends while boosting production against the backdrop of a falling market. In valuation terms, mining companies trading on the FTSE are now back where they started just before the onset of the global financial crisis.

BHP Billiton the world’s largest integrated mining giant set the tone when it revealed that only its iron ore division will see production gains. Copper output this year will fall 12pc, thermal coal by 2pc, metallurgical coal by 6pc and petroleum liquids by 7pc. By comparison, iron ore which many analysts view as the ultimate barometer for the strength of the overall Chinese economy will grow to 270m tonnes in the current year.

Lower production across its entire business will put even more pressure on BHP Billiton to find cost savings, in a process that its management describes as “squeezing the lemon”. Clearly, iron ore remains the last bastion that BHP Billiton plans to defend, on the principle that China’s demand will mop up any additional supply.

Broker Jefferies, which expects earnings season to bring greater cost-cutting, writedowns and potential restructuring, expects iron ore to potentially outperform in the second half. The broker wrote this week: “Recent improvements in Chinese property markets may lead to some recovery in construction, which would be a relative positive for iron ore demand. A restock of depleted iron ore inventory in China is also possible if construction picks up.”

BHP Billiton (NYSE: BBL – news) continues to ramp up iron ore output despite headwinds

BHP Billiton’s intention to persist with its strategy of ramping up iron ore production was matched by the other heavyweight in the sector Vale.

But there is a significant lack of consensus on the trajectory of iron ore despite Jefferies’ prediction and the actions of BHP Billiton in maintaining its commitment to boost output. In its latest commodities report, the World Bank fears that prices for the steel-making commodity may be poised to take another tumble. The bank expects iron ore to fall a further 46pc in 2015 as production outstrips supply.

Other specialist iron ore mining companies, such as Fortescue Metals, are now under severe distress. The Western Australia-based company says it can remain profitable for as long as iron ore prices remain above a threshold of $ 39 per tonne, which is perilously close to the level that the World Bank believes the commodity could sink to. Fortescue has a strategy that is entirely dependent on iron ore, and is also winning the current production race that is under way in the industry, making it perhaps the most vulnerable of all the mining stocks.

If the World Bank’s forecast proves to be correct then the large producers such as BHP Billiton are already in a race to the bottom, trading market share for smaller margins. With a strong balance sheet, BHP Billiton should be able to maintain its dividend policy. Rival Rio Tinto, which is even more heavily weighted towards iron ore, should also be able to maintain its 5.5pc dividend yield. However, beyond these two giants the risks grow exponentially.

Jefferies has downgraded BHP Billiton’s specialist metals spin-off, South 32, to a “hold” from “buy”, after the company signalled $ 1.9bn of write-downs were coming. The future for South 32 looks uncertain and the focus will be on its first set of earnings, which are due in about a month. The company’s assets could be a target for other mining predators such as Glencore (Xetra: A1JAGV – news) or even Mick Davis’s cash vehicle X2 Resources.

Is mining mogul Ivan Glasenberg eyeing new deals?

Ivan Glasenberg, the chief executive of Glencore, has gone to ground since he failed with an audacious bid last year to lure Rio Tinto (LSE: RIO.L – news) into a mega-merger that would have created the world’s biggest mining company. While Mr Davis is sat on a $ 5bn war chest, he will eventually need to spend once the right assets can be identified, which is the crux of the problem facing the entire industry.

During the commodities super-cycle mining investments were easy. All resources were then viewed by investors to be equally likely to benefit from China’s remarkable economic transformation. However, in the current environment it has grown harder to identify the assets which mining companies covert the most, ones with long-term demand profiles that can be developed cheaply.

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