Commodities shake trade war fears

Summary: Recapping the major moves across iron ore, battery metals, coal, copper, nickel and gold, that have lifted the ASX minerals and metals index (XMM) to a 7-year high.

Key take-out: Much of this was unexpected. It's impossible to forecast the short-term, but long-term factors are stacking up in favour.

In case you missed it, the Australian mining industry, as measured by the ASX minerals and metals index (XMM), hit a 7-year high on Monday even with the unfinished business of the China v US trade war. It could likely still go higher.

The immediate factor lifting mining shares is the iron ore price. Major producers including Rio Tinto, BHP and Fortescue Metals are rising sharply as a supply shock caused by the closure of several Brazilian mines hits Chinese steel mills just as they restock after the northern winter.

Iron ore

Rio Tinto, which reports its full-year results for calendar 2018 later this month, has risen by 20 per cent since the start of the year to $92.20. This is its highest level in 10 years. The stock could clear the magic $100-mark if a price tip of $102 from Citi, an investment bank, is correct.

BHP, at $36.04, is at a 7-year high having risen by 7 per cent since the start of the year, while Fortescue, a pure play iron ore miner, is up 50 per cent at $6.25.

Eye-catching as those price moves are, they could come down just as quickly as they have risen if Brazil is able to quickly resolve a crisis involving the safety of dams used to store waste material (tailings) from its vast iron ore mining industry.

The challenge is fixing a problem caused by a ‘wet’ upgrading process used to produce ore suitable for export, and then storing the residue in a region with a high rainfall at a time when weather extremes have become a routine event. Excess water causes the tailings to liquefy, overpowering the dams designed to hold them.

Australian iron ore is produced in a dry climate without the need for tailings dams, meaning, companies such as BHP, Rio Tinto and Fortescue have become the go-to providers of an essential steel-making raw material.

Unanswered in this classic example of what happens to a commodity when a major ‘outage’ occurs is why iron ore demand was so strong before the dam collapses in Brazil. These collapses have killed more than 200 people, hamstrung the country’s national mining champion, Vale, and triggered a government safety crackdown that could see some mines permanently close.

The answer to the unexpected strength of iron ore, and most other commodities from late last year, is the trade war has not yet inflicted the damage expected on demand for raw material. Last year’s correction is now seen as an overreaction.

Two important tests of how the resources sector is performing will occur over the next two weeks. First with BHP’s half-year results, scheduled for February 19, and then Rio Tinto’s annual results on February 27.

Both the big diversified miners are expected to report reasonable profits, but more importantly, they are expected to reveal further strengthening of their balance sheets with Rio Tinto tipped to be net debt free. This means there should be the financial firepower to continue rewarding shareholders with strong dividends.

What’s happening in the broader resources sector is a combination of reasonable demand and a lack of investment in new projects. This is leading to an inevitable squeeze on supply which can be severely tested when part of the system breaks down, as has happened in Brazil.

Battery metals

A smaller version of the supply disruption factor is starting to drive the manganese price higher, which will benefit another big Australian miner, South32.

What’s happening in manganese is the forced closure of a mine in Ghana because the government of that country has demanded an audit of the Chinese-controlled project’s operations. This has effectively removed about 5 per cent of global supply of the steel-hardening mineral, as such boosting the manganese price, and lifting South32’s share price by 13 per cent since the start of the year.

Not all commodities are benefitting from shortages and outages. Lithium and other battery metals have been undergoing a sharp price correction largely because they rose too far, too quickly, as investor enthusiasm for electric cars got ahead of the market.

Coal

Coal has also been on a roller-coaster ride. It rose sharply in the first half of last year, but slipped in the last three months as supply rose to meet demand. However, what’s most interesting about coal is demand was widely tipped to decline under the weight of tougher government environmental regulations, and it has not. Asian demand for coal is as strong as ever.

If there is a common theme running through the resources sector, it’s one of limited investment in the basics of exploration and project development leading to the supply squeeze now being experienced across several commodities.

In iron ore, the primary profit driver for BHP and Rio Tinto, the new mines being developed (South Flank in the case of BHP and Koodaideri for Rio Tinto) are simply to replace ageing mines which will close in the next few years. New mines but no increase in supply.

Copper

Copper, sometimes called the bellwether metal because it has widespread applications across multiple industries, has been pushing higher since the start of the year. Copper has risen 6 per cent rise to $US2.78 a pound. We’re possibly seeing the start of a rise back above $US3/lb for the first time since May last year, if a forecast by Citi is correct.

What Citi said about copper last week is as much a comment on the trade war as the commodity market because the bank’s analysts tested ‘real’ Chinese demand for the metal against future demand expectations as measured by that country’s Purchasing Managers’ Index.

The PMI, a widely-cited measure of future economic activity, stood at 49.4 points in December, with a number below 50 indicating a slowdown. Copper consumption was up 4 per cent.

Citi said the PMI was a ‘soft’ measure of the Chinese economy whereas copper consumption was a ‘hard’ measure. “The last time a sizeable divergence occurred was in 2016 when the stronger (hard) data won out,” the bank said.

Nickel

Nickel, always a hot-and-cold metal, is another commodity seemingly headed for a significant rerating as supply falls behind demand and a deficit widens.

Macquarie Bank calculated that three years ago, the total global stockpile of nickel, which is mainly to make stainless steel but has increasing use in batteries, stood at 851,000 tonnes. This is equivalent to 21.9 weeks of demand. Last year, the stockpile was down to 595,000t or 13.3 weeks of demand, and this year, the numbers are forecast to be 502,000t and 10.9 weeks of demand.

Because it has a mercurial record of extreme price highs and lows, nickel is a tricky metal for investors, but the fundamentals are interesting. A deficit in supply and rapidly declining stockpiles point to the potential for a positive price response.

Gold

Gold, the metal with a love/hate reputation like no other, is proving to be a big winner for Australian producers because of its commodity/currency status.

At the commodity level, where it is measured in US dollars, gold is roughly where it was at this time last year. A fall in the first half of 2018, offset by a rise in the second half, resulted in a move from $US1325 an ounce 12 months ago to $US1307/oz today.

The currency factor, however, paints a very different picture. The Australian dollar has fallen from US80c to US70.6c, so the Australian gold price has actually risen by 10 per cent from $A1690/oz to now bump against an all-time high of $A1860/oz.

It’s the higher local gold price which explains the upward share price rush by major producers such as Evolution, up 45 per cent to $3.79 over the past six months, and Northern Star, up 30 per cent to $8.81.

What’s happening in the Australian resources sector was not expected when the China/US trade war started early last year.

While a continuation of strong performance is impossible to forecast in the short-term, the long-term factors of continued global growth, sluggish investment in exploration and project development, and unexpected outages, are positive signs.