Shrugging off the China sneeze

The coincidental timing of the release of China's 2011 GDP and the BHP Billiton and Rio Tinto production reports this week appears to reveal a contradiction.

Even as BHP and Rio's iron ore production is running at record levels, and both groups are ploughing billions of dollars into further expansion, the growth rate of China's economy has slowed markedly and appears likely to challenge what is regarded as China's informal base level of 8 per cent in the first half of this year.

While the slowing in China's growth from the double-digit levels of recent years to around 9.1 per cent wasn't a surprise, given both the internal efforts it made last year to bring inflationary-type activity under control and the deteriorating world economic condition produced by the implosions in the eurozone, it does provide a contrast with the way BHP and Rio are steaming ahead with large-scale expansions of capacity across their portfolios of resources, given that the economics of that capacity are heavily dependent on China continuing to grow.

With the World Bank warning that what's developing in the eurozone threatens a crisis that could be worse than 2008, lowering its forecast of global growth from 3.6 per cent to 2.5 per cent and its forecast for China's growth to 8.4 per cent (which would be the lowest in more than a decade) the optimism being capitalised into the big resource groups' balance sheets might appear misplaced. BHP said today it now has more than $US26 billion of sanctioned projects in its pipeline, while Rio said it expected to invest $US15 billion this year.

In the past, BHP and Rio have made it clear that the premise on which their ever-increasing production strategies is based is not one determined by near-term outlooks but is based on their confidence in the long term economic outlooks for China and India and other developing economies.

The lowering of the World Bank's projections for developing economies in 2012, from 6.2 per cent to 5.4 per cent, is unlikely to faze them, although it will presumably cause them to reconsider their price expectations for commodities that are already well off their 2011 highs.

Part of the explanation for the apparent lack of concern within BHP and Rio about the slowing occurring within China is that, whatever China's growth rate might be, the denominator today is so much larger than it was only a few years ago. Since 2008, for instance, the size of China's economy has grown around 40 per cent.

If one looks at iron ore, BHP has more or less tracked that growth. In the December half of 2008, just as the original financial crisis emerged, BHP produced 59 million tonnes of iron ore. In the latest December half it produced 80.6 million tonnes, or about 37 per cent more. In the December quarter it was producing at an annualised rate of 178 million tonnes.

Rio, partly because it had a significantly bigger base of iron ore to start with, and partly because of the financial constraints it faced during the GFC, hasn't grown its iron ore production quite that aggressively (although it's now making up for lost time). In 2008 its share of iron ore production from its mines was about 151 million tonnes. In 2011 it was 192 million tonnes, or an increase of about 27 per cent.

Apart from the sheer growth in the size of China's economy in the last few years (and India's, for that matter), BHP and Rio have other reasons to be comfortable, albeit not complacent, about any near term gyrations in the markets, or at least the prices, for their commodities.

Both are in very strong financial shape, thanks to the deluge of cash that has been flowing through them in the past two years and Rio's rapid retreat to fiscal conservatism after its brush with something unpleasant during the GFC.

More particularly, with Vale of Brazil, BHP and Rio are the low-cost and high-quality producers in iron ore and the other key inputs to steelmaking and industrial production that would be affected by a further significant slowdown in China and elsewhere.

Whatever happens to demand for their commodities, and the pricing of them, they'll be less affected – the last affected – compared with smaller, higher cost and lower quality mines. A sharp downturn would see some existing marginal mines reducing or shutting down production and projects still in the pipeline mothballed.

By continuing to invest through a downturn, the big miners can strengthen their hold on markets when they recover. Capturing peak prices might provide some super profits at the top of a cycle but ultimately BHP and Rio, with their very high margin projects, are most focused on volume.

They do, of course, have the ability to do as they did in 2008 and 2009 and finesse production and investment.

BHP demonstrated during that period, however, the benefits of continuing to invest heavily through a downturn. It emerged from the crisis as the world's dominant non-oil resource group and with a structural leap in its profitability as its almost uniquely expanded capacity flowed into an otherwise supply-constrained recovery.

The widely diversified nature of its portfolio and cash flows, of course, makes it easier for BHP to contemplate that counter-cyclical approach than most miners and Marius Kloppers has made it clear that not only will BHP continue to invest into a downturn but see the potential for opportunistic acquisition during times of stress in the sector.

Rio isn't as diversified, and carries the lead weight of its big aluminium business, but has rebuilt its balance sheet to the point where it too might see another disruptive crisis as providing as much opportunity as threat.