How to get good commodity exposure

One of the more surprising developments in 2017, to many investors, was the strength in commodities. As the Chinese economy continued to transition away from infrastructure and construction investment to services as its driving force, and as Beijing cracked down on pollution and the country’s most inefficient steel mills and industrial plants, it was thought that commodity prices would come under pressure.

The synchronised global economic growth and strong purchasing managers’ index (PMI) figures that we now see, were not envisaged a year ago to the extent that eventuated. Nor were the tightening supply-demand balances in most of the metals, with many in deficit, or facing that situation looming.

In particular, the prices of iron ore, coking (steelmaking) coal, copper and oil finished 2017 at much higher prices than expected. The bottom line for Australia is that continuing Chinese demand seems set to push up the prices of our four biggest exports – iron ore, coking (steelmaking) coal, thermal (electricity) coal and LNG.

While iron ore lost 9.3% over the year, it was much more resilient to China’s moves to fight pollution than many had expected. China’s tough measures on its worst-polluting capacity is actually benefiting Australian suppliers, because their products are generally higher-quality, with less impurities, than their Chinese competitors.

In the second half of the year, renewed Chinese buying of high-grade ore boosted iron ore. Since the end of the September 2017 quarter, iron ore has risen by 28% to US$75 a tonne, helped by the closure this month of Australia’s major iron ore export bub, Port Hedland, after cyclone warnings.

The amount of iron ore shipped from Port Hedland – Australia’s largest iron ore port – hit a record in December, with 46.2 million tonnes being loaded for export. That was a 12% increase on November’s figure, and almost 5% above the previous record of 44.1 million tonnes. It was a stunning performance, given that it is winter in China, and iron ore consumption is supposed to fall as many industries, including steel mills, shut down or cut production during winter.

The bulk miners

Last week, Rio Tinto reported that its iron ore shipments from Western Australia hit a record 330.1 million tonnes in 2017, slightly higher than analysts’ consensus expected, and up from 327.6 million tonnes in 2016. It was not only stronger demand at play: Rio Tinto also benefited from improvements to its rail network and other productivity upgrades.

BHP mined a record 71.6 million tonnes of iron ore from Western Australia during the December quarter, up 3% from last year, and shipped 70.73 million tonnes. The company retained its full-year iron ore guidance, which projects annual growth of about 3%, and said iron ore output should be stronger over the next six months.

Australia’s bulk miners are reasonably placed to benefit from the continued strength in iron ore prices. Each has the ability to increase production: both are focused on free cash flow, cost reduction and shareholder returns.

BHP (BHP:ASX)

FY18 forecast yield: 3.6%, fully franked (reports results in US$)

Analysts’ consensus target price: $31.88 (Thomson Reuters), $31.96 (FN Arena)

Source: nabtrade

Rio Tinto (RIO:ASX)

FY18 forecast yield: 4.4%, fully franked (reports results in US$)

Analysts’ consensus target price: $83.33 (Thomson Reuters), $80.42 (FN Arena)

Source: nabtrade

Australia’s third big iron ore producer, Fortescue Metals, is also well positioned, even though iron ore is its only product. Fortescue appeals as arguably Australia’s best iron ore exposure.

Fortescue Metals (FMG:ASX)

FY18 forecast yield: 6.3%, fully franked*

Analysts’ consensus target price: $5.49 (Thomson Reuters), $5.50 (FN Arena)

 Source: nabtrade

Fortescue is a very impressive operation, considering that it specialises in lower-grade ore than Rio Tinto and BHP: its average ore grade is 58% iron, and customers pay, at present, about 30% less for that ore than benchmark (62% iron) ores. However, Fortescue’s ore is low in impurities, and many of its customers use its cheaper ore to blend with higher-grade ores, to maximise value.

Plus, Fortescue has made stunning progress on its cost of producing the ore. It has told the share market to expect that it will ship 170 million tonnes of ore in FY2018 at a cash production cost of between $US11and $US12 a wet metric tonne. Just six years ago, Fortescue’s CFR (cost and freight) supply cost to China was, at about US$60 a tonne, the highest of the major producers – Fortescue, Rio Tinto, BHP, Vale. But the company says that in 2018 its CFR cost will be about US$25 a tonne, which would make it the lowest of the major producers – with Hancock Prospecting’s Roy Hill operation now added to that group. (Fortescue’s 2018 forecast CFR figure – which include royalties and ocean freight – comes from specialist resources economics consulting company Metalytics.)

The base metals

2017 was also a very strong year for base metals. Copper surged by 12% in the final quarter of 2017, reaching a four-year high of US$7,312.50 a tonne in late December. For 2017, copper rose 30.8%, its strongest year since 2009: the price has gained 66% in the last two years. “Dr. Copper” – as the red metal is known, for its Ph.D-like ability for its price movements to predict the direction of the global economy – is riding high on the global economic uptick, and supply tightness.

Longer term, copper is also set to benefit from the electric vehicle revolution. Global electrical vehicle sales are expected to reach nearly 16.5 million by 2025, which will drive about 1.7 million tonnes of copper demand.

That is about 5% of annual copper demand, which UBS argues might sound modest, but it is predicted to lead to an acceleration of demand growth sustainably above 3% per annum versus the long-term average 2.5% to 3% compound annual growth rate.

Analysts see copper potentially rising as high as US$7,700 per tonne, which is about 7% higher than the spot price.

BHP is also a handy exposure to copper, but potentially a better one is copper and gold miner Oz Minerals.

Oz Minerals (OZL:ASX)

FY18 forecast yield: 1.4%, fully franked

Analysts’ consensus target price: $9.20 (Thomson Reuters), $9.54 (FN Arena)

 Source: nabtrade

Last week Oz Minerals lifted its copper production guidance for 2018 and 2019, flowing from the significant upgrade to the resource base at its Prominent Hill operation in South Australia, which it announced late last year. Oz originally expected to produce 90,000 tonnes–100,000 tonnes of copper in each of 2018 and 2019, but now expects 100,000 tonnes–110,000 tonnes in 2018 and 95,000 tonnes–105,000 tonnes

The miner says it is in a good place to enable its growth plans with fourth-quarter gold production up 34% on the previous three months and exceeding the miner’s 2017 guidance. Full-year gold production of 126,713 ounces beat Oz Minerals’ expected 115,000-125,000 ounces, while full-year copper production, at 112,008 tonnes, was at the top of its forecast range. The average cash cost of copper production at Prominent Hill, at 83 US cents a pound, was also better than Oz had forecast: this compares very favourably with the current spot copper price of US$3.20 a pound.