Context:
Author: Sid Ruttala
At TAMIM we remain of the view that, given the global impetus for an expansion of fiscal stimulus combined with substantial increases to infrastructure spending, we are about to enter a secular bull cycle in commodities. For those of you unaware of this argument, feel free to refer to previous articles on this particular issue and the rationale behind it. However, there is a caveat. There are certain commodities that are more likely to perform better than others moving forward. Not least because the price action so far may have already baked in some of this future growth.
So what are our favourites at this stage? Copper, aluminium and oil. Not so favourable in the short-run is iron ore (despite our long-term bullish view on the commodity).
The rationale for this view? Let’s examine copper first and why we think that this is one commodity likely to go significantly higher, even in the short- to medium-term, despite spot prices now hitting close to 9, 940 USD per metric tonne at the time of writing. There are two reasons why I believe this to be the case:
- The minerals game is heavily capital intensive and requires a long lead time from exploration to first production (an average of 8-9 years for greenfield projects). One of the key issues for Dr Copper has been the scale of the lack of investment in new copper production over the past decade, due almost entirely to its previous collapse in 2015-2016. Five years on, the world has seen very few new tier-1 assets come online outside of Rio Tinto’s Winu and SolGold’s Cascabel, which both BHP and Newcrest remain in contention for (though the company has been doing its best to remain independent).
- All this comes at precisely the time when governments globally continue their push for new infrastructure, more specifically green infrastructure, as a way to stimulate growth. A single 660 kW wind turbine, for example, contains approximately 800 pounds of copper and a photovoltaic solar plant requires about 5.5-5.6 tonnes of copper per megawatt generated. If we assume current growth trajectory in output in terms of production and assume current rates of capex, our view is that there could be a supply gap of close to 10mT by 2031. In the short- to medium-term, we could easily see spot prices hit above $13,000 USD even on news flow related to the passage of the Biden infrastructure bill (much more consensus than the minimum wage issue and could be done via reconciliation with the current majority).
Similarly, aluminum should also see some catalysts, not only with the infrastructure spending but also the reflation trade (i.e. consumer electronics and
retail construction). In the case of oil, we have previously written about the likelihood of US shale production declining rapidly through to the end of the year and my overall bullishness due to increased demand as the world comes out of lockdowns. Reiterating my view, oil will see $80 USD per barrel before the end of the calendar year (though this may only be short-lived). For Iron ore, my view is a short-term bear market. This is despite my previous assertions that, even in the expectation of Brazil’s Vale coming back online, the demand generated by fiscal stimulus for steel should see spot prices continue higher. But at $185 USD/tonne, it is looking rather toppy despite China’s continued growth in steel production. We see substantial headwinds for Chinese demand as the CCP tries to reign in steel production and gets rid of export incentives. Long term spot prices should trend higher, but spot prices are now where I expected them to be mid-next year assuming continued global recovery, that is, not quite so soon (i.e. when I previously wrote on this the price was about $112 USD/tonne).
So with that context in mind, let’s proceed to the securities in question.
BHP Group (BHP.ASX)
Stellar results from BHP with EBITDA of $14.7bn USD (up 21%), margin of 59% and, most importantly for the yield hunters, a 101c US p/s dividend. This was pleasantly higher than expected and supports my thesis of the business being an effective substitute for the banks for the income starved investor. On the flipside, the company’s copper production declined 9%, unfortunate given the high demand globally but somewhat expected due to short-term declines in production at Escondida though cost guidance has been lowered going forward. The grades are also likely to lower as the mine continues through its maturity. Somewhat surprising however was Olympic Dam which continues to maintain production. Petroleum production continues higher with about 9%. Importantly, BHP’s increased interest in the Shenzi platform – a deepwater oil and gas field in the Gulf of Mexico with a processing capacity of 100,000 barrels per day along with a handling capacity of 50m cubic feet of gas – should see production continue to increase through ‘21-’22. This is an exciting prospect. That being said, we would have liked to have seen more acquisitions within both petroleum and copper but stellar results so far with costs being kept minimum.
On the coal front, metallurgical (met) coal production increased slightly by 1% while thermal continued its dismal performance, -17% year on year, driven by strikes and labour issues in Colombia. Mt Arthur’s wet weather also didn’t help. There has been little progress on the divestment of the coal assets which, in my view, remains a headache for the company going forward and the sooner this takes place the better. Though any divestment deal would probably have to be sweetened with better performing assets (perhaps even on top of the Bass Strait Gas assets as mentioned six months ago). An IPO/bundle and spin out of the assets could be on the cards but I have doubts that the market would pay a decent multiple given how the space has been tracking recently.
Red Flags & Risks: Many of my red flags remain the same. While BHP remains diversified in terms of commodities, weakening demand for steel production in China could hamper future growth and much will be contingent on maintaining cost discipline. The divestment of the coal assets and a strategy around this still remains the biggest issue. Chile’s recent proposals to change the tax laws pertaining to mining remain a big risk for the company, though we doubt passage is likely with a staunchly conservative President.
My Expectations: Management continues to deliver and has pleasantly surprised on the cost front. We would like to see more corporate development, especially in Copper and especially in LATAM. Ecuador remains a key focus for the firm but we have yet to see significant acquisitions. One would hope to see a resolution on the coal business before the beginning of the new year but I don’t have much optimism. Nevertheless, this is one I would personally continue to hold.
Dividend Yield: Assuming a share price of $48 AUD, then BHP has a great 4.1% dividend yield.
BHP remains a credible substitute for the banks from an income perspective.
Fortescue Metals Group (FMG.ASX)
In terms of capex and additional projects, the increase is likely to be 10% more than expected. The EnergyConnect project, which aims to decrease the firm’s carbon footprint by investing in hybrid solar-gas transmission infrastructure, though going according to plan is likely to increase capex to around $4bn USD, though the guidance has been to $3.4bn USD. I base this on likely additional cost escalations in Iron Bridge. The firm retains close to $4.3bn in debt. Going forward in the short- to medium-term, FMG remains fair value at $22.26 AUD per share.
Red Flags & Risks: FMG is a leveraged exposure to the iron ore spot price. Personally, I remain convinced that the spot price is relatively overvalued (on a short- to medium-term outlook). FMG also trades at a significant premium to NAV (1.4x) compared to counterparts BHP and RIO. That being said, I remain a big fan of Elizabeth Gaines (and Twiggy), who cannot be faulted in her execution or cost discipline. In the medium- to longer-term the overreliance on Chinese steel manufacturers might hurt prospects. As mentioned, there is a marked push to move production out of China.
My Expectations: While Vale production still remains below market expectations, I remain a little uncertain about the price action for iron ore. FMG remains a good long-term investment but, nevertheless, it might pay to take some profits in order to buy back at a later date (hopefully lower).
Dividend Yield: The current dividend yield stands at an exceptional 13%, assuming a price of $22.26 AUD.
