How Chinese reform is hitting the resource sector...

One of the mistakes we all make in investment appraisal is to look at things in terms of silos.  And so when we want to know the likely demand for resources, we turn to analysts and the same pattern is duplicated across the board.  But in fact demand for resources is as much linked to the Chinese banking system as it is to any other source and rarely are the two put together. 

And so in talking about resource shares today I want to start with what is happening in the Chinese banking system.  I will never forget in the middle of the global financial crisis writing - in almost stunned amazement - that Chinese bankers were being told from above that they had a lending quota. There was a joke that if bankers didn’t meet their lending quota they would go to Mongolia. The joke helped emphasise the strength of the order.  Whenever there is unlimited credit and bank managers are virtually forced to lend, there will always be repercussions.  And so many of the lending patterns that were established in the boom are now coming back to bite.

An unconventional security

None more so than the bizarre technique the Chinese adopted to fund new buildings. In essence, the security for those buildings was copper in Chinese warehouses. Something like a third to a half of all the copper in Chinese warehouses is now secured on property. 

You don’t have to be a genius to realise the implication of that, should the copper price fall and stay down. And in time that metal  will come onto the market.

Similarly, late last year Chinese steel makers were being squeezed for money partly as a result of lower exports but they found they could obtain money via letters of credit to buy iron ore and, as a result, the iron ore price in the last few months skyrocketed. There were no hedges, so as the iron ore price started to fall, margin calls were quickly made, which pushed the price even  lower.

We have seen Chinese banks taking advantage of very low US interest rates to borrow in US dollars and maybe via a few currency protection deals, and lend in China where high rates are available for higher risk propositions like property loans based on copper; or loans to steel makers based on iron ore.

The Chinese government wants a growth rate of about 7.5 per cent and to  switch the current emphasis from property development to more consumer purchasing.

China also wants to close smaller high-cost high polluting steel  manufacturers.  In the current crisis it has a chance to do that.

China is also concerned about the US hot money that is entering the country. No-one can be sure just how all this will unravel. But if starts to unravel badly, the Chinese government will almost certainly step in and find a way to stabilize events.  In addition, my guess is that the banks will take control of the iron ore trading stock and not allow it to be flogged onto the market in panic selling caused by margin calls. Accordingly we are likely to see a zig-zag pattern from China in the next few years. When markets saw big dangers in the Chinese bank funding of iron ore and copper loans this week we saw big falls in the price of  both iron ore and copper. 

Iron ore and copper outlook

But iron ore and copper have very different long-term outlooks. Last month BHP’s investor outlook and interim report showed that demand for copper was likely to exceed supply in the next two or three years.  I know Rio Tinto has a very similar view.  And so copper is going to have a turbulent time as part of the gymnastics linked to the Chinese banking system. But, longer term, it is going to be a good performer because major mines are shutting; (copper-hungry) telecommunications are becoming an even bigger part of national economies; and demand, particularly in China, will remain strong. 

With iron ore - at least for the next two or three years - it is almost the reverse. There will be a big increase in production which will rise well above the likely increase in demand. 

And that situation will remain until high-cost mines shut. And many of those mines are in China and the Chinese have the habit of keeping on producing long after economists normally consider wise given the price differential.

And of course demand will be crimped by steel plant closures.  Longer term, once high-cost iron ore production has been shut, growth will gradual sop up the excess capacity and iron ore prices will rise again. Unless there is a meltdown in China - and I am certainly not forecasting that - I don’t really expect the iron ore price to collapse. But certainly if the Chinese steel mills want to play hard ball. there is enough stock in the system to really curtail their purchases and send the price plummeting. But in the process bankers would lose a lot of money, so logic says further iron ore price falls may be restrained.  But in markets, logic is a dangerous concept so I note the possibility of another sharp fall as a danger.

Click to enlarge

Oil - the next to face turbulence?

We are clearly moving into a period of time when there is going to be considerable turbulence in the resources sector because of the link to the unstable Chinese banking system and the over-capacity that has been created in iron ore. In the case of coal, we have already seen big price falls as over-capacity created by US shale gas and oil discoveries have pushed out coal and made it a much lower-return business. Oil now looks shaky.  Banking turbulence has  a way of spreading.

BHP believe that, in due course, coal demand will return because coal is the only way less-developed countries can generate power at low-enough costs to enable them to compete in world markets.

Click to enlarge

Local resource shares too focussed on iron ore

Resource stocks have fallen back sharply, but unfortunately we have allowed our resource industry to be very iron ore-oriented, with Rio Tinto at around 90 per cent of its production/profit from iron ore.  Our Australian corporate tax revenues are very heavily skewed toward iron ore and gas.  

Big falls should be  cushioned by a lower Australian dollar …but there are no certainties in currency predictions.  I think longer-term world growth - and the fact that we are a low cost producer of iron ore - will help Australia return to prosperity in the resources sector. What is happening in the iron ore and steel industry will force the exit of high cost producers in both steel and iron ore, which will both make it more stable and allow BHP and Rio to do well.  I am not worried about the longer term.

But in the next two or three years this is going to be a turbulent area and not for faint hearted. But  for long-term investors remember that falls in the iron ore price should lower the dollar so  there is a hedge.  I think the best major resources place to be is copper because we know that first cab off the recovery rank is going to be copper and if there is recovery copper is likely to perform best because of the looming shortage of supply.  So I would use the current turbulence and low prices to aim for copper stocks particularly those that are not too highly leveraged.