BHP Billiton's Chinese chill

BHP chief Marius Kloppers' new, cautious outlook on the mining sector comes amid growing concerns over China's ability to stimulate domestic consumption, and the possibility of a rapid change in metals pricing.

There wasn’t anything especially new in Marius Kloppers’ presentation to Bank of America Merrill Lynch’s global metals, mining and steel conference in Florida overnight but the tone was slightly gloomier and the context in which the presentation was made is evolving in an equally gloomy direction.

The macro theme of the presentation was consistent with recent commentary from both BHP Billiton and Rio Tinto’s senior executives: China’s growth rate is slowing and the composition of that growth is shifting from investment to consumption, which will change the nature of its demand for commodities even as a wave of supply, delayed by the global financial crisis, enters the market.

Both of the major Anglo-Australian resource groups, however, while acknowledging that steel intensity would peak first as China’s economy matures, have remained confident that China’s demand for steelmaking commodities will remain strong for at least another decade.

Kloppers, however, painted a less optimistic picture of the shorter term outlook yesterday, saying that the cash flows for most miners were going to be lower now than they would have been a year ago, with lower commodity prices and higher project costs squeezing them.

Both BHP and Rio have spoken about changes to the "sequencing" of their planned major new projects – being more discriminating about where and when they invest and stretching out the timing of the pipeline of new projects.

The big end of the resource sector had already factored in some softening of commodity prices this year as China had made it very clear it wanted to slow the growth rate in its economy to deflate a property-centred investment bubble. It is officially targeting 7.5 per cent growth this year, from 9.2 per cent last year and 10.4 per cent in 2010.

Recent economic numbers out of China – and China’s response to them – however, have sent some disturbing signals.

On Monday China reduced the amount of cash its banks have to hold in reserve for the third time in six months, in an attempt to encourage the banks to lend and stimulate activity. That followed April economic statistics that showed a sharp slowdown in both exports and imports.

The new European crisis and the continuing weakness of the US economy help explain the drop-off in export growth, which fell back from 8.9 per cent in March to 4.9 per cent, or 1.5 per cent seasonally adjusted. The potential for a eurozone implosion and new global financial and economic crisis has strengthened in recent weeks as the backlash against austerity measures has developed, making it most unlikely there will be a significant rebound in exports in the near term.

Virtually flat imports (up 0.3 per cent year-on-year), however, were probably the bigger surprise. Among the declines in import volumes were iron ore (minus 8.2 per cent from the March numbers) and steel products (minus 11 per cent).

That signals a sharp reduction in domestic demand and suggests the measures taken so far by the Chinese authorities to stimulate demand have failed to gain any real traction, a view supported by the fact that China’s bigger lenders are disclosing significant reductions in their rates of new lending.

In the near term commodity prices have fallen back – as have the stock prices of miners big and small this month, with a particularly sharp sell-off this morning – but they remain at historically high levels. If China can’t stimulate domestic consumption, however, the pricing environment could change quite rapidly.

With a leadership change due later this year the Communist Party will presumably do whatever it can to ignite some meaningful growth. So far, however, its actions haven’t had the desired effect.

The long-term picture of continued increases in demand for steelmaking materials from China, India and other developing countries probably remains intact, but the new crisis in Europe and the subdued medium-term outlook for the US has clouded the near- to medium-term outlook for commodities.

The other complicating and adverse factors are the extent and pace of the escalation in project costs, both capital and operating, that have been occurring and the amount of new supply entering and nearing the market.

Higher costs and lower prices aren’t good for project economics, although at least the Australian miners have (so far) dodged the bullet of changes to the tax treatment of over burden removal and the abolition of the diesel fuel rebate that were widely speculated about in the lead-up to the federal budget.

There used to be a consensus that the market for iron ore would move towards a balanced supply-demand equation around the middle of this decade as the crisis-deferred production started flowing into the market.

The unexpected acceleration of the slowdown occurring within China and the new financial and economic fissures that have opened within the eurozone, however, have the potential to bring that moment where supply meets demand forward.

BHP is fortunate that it has yet to make final investment decisions on a cluster of mega-projects – the Outer Harbour expansion at Port Hedland, the Olympic Dam open-cut expansion and the Jansen potash project in Canada are the big ones – that are scheduled to be made later this year.

It is pretty obvious that at least one and probably two of the projects will be deferred unless conditions turn around quickly, and that Rio and other miners will be adopting the same defensive approach until the environment stabilises.

There will still be a continuing boom in resource sector investment – there are hundreds of billions of dollars' worth of projects already underway that will have to be completed – but a big dent is now emerging in the pipeline of future projects. The prospective returns from those projects underway or recently completed may not be quite as lucrative as was once envisaged and the odds on the minerals resource rent tax raising anything material have lengthened even further.

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