Thursday, September 3, 2009

Steel as a proxy for BHP

Getting back to my ruminations of a couple of days ago – want to explore the world of BHP a little more.

BHP – broker consensus has it a BUY?
While some naysayers in the broker community have deemed BHP a ‘Hold’, the majority of the professional pundits rate it a ‘Buy’.  The investment thesis is broadly based on the principles that:
1)    The developed world has turned the corner, and therefore will resume its demand for commodities,
2)    China’s economy has gathered a ‘fresh head of steam’, and, 
3)    Medium to long-term commodity demand is underwritten by China’s industrialisation. 
Simple enough, and certainly fits with the ‘recession is over’ theme.
While I’m not going to build a full-blown model for the mining behemoth, I think we can have a closer look at this consensually conceived thinking.  Let’s take one analyst’s forecasts as a guide.  Following is a summary of earnings (EBIT) by division:

Some quick observations on the three-year outlook:
-       Petroleum remains a strong contributor on rising volumes
-       Base metals make a resurgence with greater volumes
-       Carbon steel remains the stand-out contributor, after a weaker 2010 reflecting lower prices/higher costs, volume and price picks up again into 2012
-       Steaming coal takes a hit on lower prices in 2010 and kicks up again thereafter on rising volumes and prices
No sign of a global recession there - volumes just going to keep heading higher.  And a similar story with the price assumptions behind these forecasts:

There you have it – volumes rise and so do prices.  Couldn’t have asked for more.  But before we boldly embrace the broker recommendation, let’s test the investment thesis using steel as the divining stick (particularly given it is so important to BHP’s earnings).

China’s insatiable demand for all things steel
Consider the following profile of world steel production since 2003 (from the World Steel Association):

First conclusion is that non-China production has fallen into a ditch.  While it may be climbing from this lower base, it would be fanciful to assume that it is going to reclaim its pre-crash levels anytime in the near future.  Just as construction activity in the developed world benefited from the debt inspired binge, it will struggle along with the chastened consumer in an extended period of fasting.  On this basis, it’s probably not a great idea to hang your hat on the premise that the non-China world is going to drive growth in world steel production.
Not to worry though cause China has taken up the slack.  As of July 2009, it accounts for  approximately  50% of world steel production up from 5% in the early 1980’s.  And while the 2008 year was a slow one by its usual standards (annual growth of only 1% in production volume), 2009 promises to be the harbinger of things to come with at least 10% annual growth seemingly in the bag.
So to support the broker assumptions of growing volume and prices, we only need to look to China’s steel production that will keep growing by 10% to 15% per annum for at least the next 10 years …right?  (Small detail that is beyond my scope here – but the broker in question assumes BHP increases sale volumes of iron ore by more than 20% per annum from 2009 to 2012.  Well, if the big Australian can’t grow its market share, who can?)
I reckon this scenario is a little optimistic for the following reasons:
      1)    China’s internal demand for steel has peaked - We have just witnessed an extraordinary capital injection from the government.  With in excess of 60% of the fiscal package being directed towards infrastructure, and assuming an implied steel content of capital of around 15%, you can pretty quickly see how the recent surge in steel production has come about (and for that matter every other raw material that could be tucked away in a warehouse somewhere).  Without a further impetus from the government (which is not out of the question), it will be a while before the level of internal demand is bettered.
2)    China is an exporter of steel with no markets to export to – what the chart of world steel production doesn’t tell you, is the fact that until recently China has been a net exporter of steel (in fact the world’s largest).  It’s conversion into a net importer wasn’t by choice, as the following chart from the Iron and Steel Statistics Bureau shows:

With the impact of the fiscal support fading, we are about to find out what the ‘real’ internal Chinese demand for steel is.  The question then becomes what happens to the surplus capacity?

One answer may be that steel producers that would otherwise export product may get government assistance to reignite their export markets.  Consider for example, the announcement on 8 June 2009 that the government will refund the 9% value-added tax rebate on exports of several high-end steel products.  This is aimed at effectively undercutting the pricing of Posco in its own market (South Korea was the biggest importer of Chinese steel).
In short, I suspect that we are about to get a clearer picture about the real demand and supply of the Chinese steel industry (granted it will probably have vasoline smeared across the lense but at least the lense-cap will be off).  On current indications, it looks less than supportive for an investment thesis that rests on double-digit growth in Chinese steel production over the next few of years.

3) China will gain pricing power – China’s steel industry struggles against persistent overcapacity (it produced 500mt in 2008 against a capacity at the time of around 600mt) that is spread across a plethora (72) of small and mid-sized producers.  This creates an industry that is particularly vulnerable to demand and supply shocks.  The flipside to the recent fiscally inspired boom is that once it is has passed, producers need to be weaned off the assistance.  In an environment where export markets are particularly hard to find, it’s not surprising to hear reports of rapid stockpiling.  

If you add into the mix that China’s producers operate on relatively thin average margins of around 5.5% (according to IMF working paper “Is China’s Export Oriented Export Growth Sustainable Aug-09) then there are all the ingredients for consolidation of the industry if it comes under stress.  Hence, the statement from the China Mining Association that the industry lost money in the first four months of this year has special resonance.  If you don’t believe me, have a look to the CISA for the direction that this is taking:

From China Steel and Iron Association on 31 July, 2009 – Secretary General of CISA suggested that steel makers accept a single ore price…to regulate excess ore shipments by small steel makers and intermediary traders, which have hampered negotiations by creating unnecessary demand.

(And for a little bit more colour on industry consolidation China style have a quick look at the state sponsored takeover of Rizhao Iron & Steel by Shandong Iron & Steel.)
It is highly likely that the likes of BHP can’t continue to make out like bandits, while the world's steel industry struggles with excess capacity.  Expect consolidation in China's industry to deliver cohesive negotiating positions and pricing power – input prices will share in the pain of the ‘transition process’.

In summary, this doesn’t sound like a glowing endorsement of a financial model that suggests 20% per annum growth in volumes over the next 3 years as well as rising prices.  As a litmus test for the investment thesis, it’s coming up red (or is it purple?).

What this discussion does throw into stark relief is the implicit reliance that world economic growth has on that red-lacquered flight-box China.  The accepted wisdom is that we can rely on China to continue to grow at 8% per annum – cause without this there will be rioting and pillaging on its streets.  There’s bound to be some truth in the myth, but as with all things, the truth is a whole lot more complicated.  My take on it is that China may well continue to grow at 8% per annum, but in the current environment this may not translate to higher prices, perhaps not even higher volumes, for the likes of BHP.

I know this has been rather long but couldn’t leave the following out as I think summarises the current market with a certain panache…

The main reason of arousing price decline is that traders and speculators’ selling lead to low market expectation.  Because of the overcapacity, once the downstream demand fluctuates, it will increase the stock.  According to the present, the steel stock will still increase in few weeks.”

The report then goes on to point out how critical the recovery in the US is….  

More and more professionals believe that market risk is increasing. Steel enterprises, traders and end users all think that it will have a big change on September in China’s steel market. There is an important mark is that the change of American economic data in third quarter as American economic recovery is the prerequisite of the global economic recovery. If American economic indicator of third quarter is improved, it will be a huge inspiration to Chinese economy even the whole world. Demand of steel and steel price will increase. Otherwise, the steel price will drop severely.

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