A demand-side dilemma for BHP and Rio

Until recently, markets would get excited about news of record production by the major miners, but record output doesn't mean much unless the global demand is there.

The June quarter production reports issued by BHP Billiton and Rio Tinto this week haven’t exactly got the markets excited. They are, for the moment, more focused on issues other than output.

While the big miners continue to pump out increasing volumes of iron ore, coal and base metals – BHP produced its 12th consecutive iron ore production record and, despite the long-running industrial dispute in its Queensland coal operations, record metallurgical coal output, too – the markets are more interested in what’s going on in China and elsewhere.

As China’s growth rate has slowed so have commodity prices. Iron ore spot prices are down about 25 per cent over the past year and more than 30 per cent off their highs. Metallurgical coal prices have fallen more than 31 per cent in the past year and are less than half their peaks. Thermal coal is down about 30 per cent for the year and nearly 40 per cent off its peak pricing.

Some of that is obviously related to the issues within Europe, China’s largest market, and some relates to the too-successful attempts by the Chinese authorities to kill off a speculative property bubble. Those authorities are now trying to reflate the non-residential property sectors of their economy.

Given the scale and cost of the expansion programs BHP, Rio and their peers are committed to, of course, a near-term slowdown in China’s economy is of little consequence. What matters is the medium to longer-term.

Both the Anglo-Australian miners are cautious about the near-term but retain their confidence in the longer-term outlook, based on a view that China has a massive amount of industrialising yet to do. While they both see the rate of growth in China’s demand for commodities falling back, a slower growth rate on a far larger economic base still means rising demand for commodities in absolute terms.

There is, of course, a massive supply-side response underway – Fortescue Metals this week reported that it is on track to treble its iron ore production by the middle of next year – and the combination of slower growth in China and the increased supply makes it most unlikely prices will return to their peaks, or anywhere approaching them.

The big miners are, however, operating on a thesis that along with the continuing growth in demand for their commodities there will be some displacement of high-cost and low-quality domestic production of iron ore and coal in China with low-cost and high-quality supply from Australia and elsewhere. To some extent they will offset the lower pricing with much greater volumes, hence the rapid and continuing ramp-up in their iron ore and metallurgical coal production.

There is also considerable upside in supplying coal to India, whose economy is short of energy and coal for its power and steel sectors.

There is, however, a peculiar question mark over thermal coal, where there is some structural change in the sources of supply occurring as US coal, displaced by the sudden emergence of massive resources of low-cost shale gas, is being redirected from domestic energy usage to export markets.

At the moment there are rail and port bottlenecks on the east coast of the US that limit the extent to which US coal producers can enter the seaborne trade, although there are proposals to invest in that infrastructure.

Whether the US will allow new large-scale infrastructure for shifting and loading coal on its east coast is another matter and in any event Australian producers would still have a considerable cost advantage, given the already-developed infrastructure and proximity to Asian markets.

While BHP and Rio remain confident in the outlook for steel-making materials (and copper, where there is a supply shortfall) they are both cautious about the general global economic climate and are being more selective about new big investment decisions.

BHP, as has been well chronicled, has pushed back decisions on its three mega projects – the Outer Harbor at Port Hedland, the Olympic Dam expansion in South Australia and the Jansen potash project in Canada – until at least late this year. No-one expects all three to get the green light and there is a question as to whether any of them will be approved before the global economic environment is more settled.

A year or 18 months ago, when the ‘’super cycle’’ was still in place and prices were at stratospheric levels, the production reports of the major miners were major news because every extra tonne of ore or coal produced generated super profit margins. Today the market is much more focused on demand than supply.

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