A mining sector correction may be coming

Miners make up 10% of the FTSE 100 and gains in the sector this year have significantly helped the index. Is this trend about to reverse?

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  1. Garry White

UK-listed miners are on a tear. Rio Tinto shares are up 40pc this year, BHP Group is up 27pc and Anglo American 26%. These gains have been good news for the FTSE 100, where miners make up almost 10pc of Britain’s blue-chip index by weight. But, with Donald Trump’s trade war continuing to rumble on and a Chinese slowdown this year looking inevitable, are valuations in the sector now getting ahead of themselves?

The iron-ore price has been a major driver of this year’s gains for London-listed miners. The price of the steel-making ingredient has soared following the closure of a number of mines in Brazil after the collapse of a tailing dam at one of Vale’s operations in the country. The reduction in supply from Brazil has benefitted the Australian-based producers in particular. Price gains were given further impetus this week after the Brazilian Senate committee investigating the accident recommended that Congress pass a blanket ban on all tailings dams, with those already in place to be decommissioned within 10 years. The committee also recommended that taxes on mineral production be raised and that a law should be passed to create additional types of environmental crimes.

Although this jump in iron ore prices has benefitted London-listed miners in the short term, tightening environmental rules and raising taxes could results in a significant increase in long-term costs for the sector. Legacy costs to put environmental issues right could prove substantial. Last month, Vale said it needed to set aside $1.9bn (£1.5bn) to cover the costs of decommissioning just nine of its upstream dams in Minas Gerais state, where the January accident occurred. The history of a tailings dam disaster at a Vale/BHP joint venture, Samarco, in 2015 indicates how lengthy the process can be to fix the problem. The Samarco operation is yet to re-open.

The iron-ore price may now have peaked near $130 per tonne, but is still lower than the record of $191 per tonne set in February 2011. Should the supply situation continue for some time the price could move much higher, couldn’t it? Well, that all depends on the demand side of the equation too – and things may not be so rosy on this front.

China accounts for half of global steel output, and trends in its mammoth industry shape the worldwide market. The debate over whether China has hit “peak steel production” has been raging for some time. UBS (incorrectly) called it in 2014 – and a number of others have claimed the height of steel output in the country was hit last year – including the China Iron and Steel Association (Cisa). The trade body said in April that the country had now reached peak annual steel consumption of 850-900m tonnes but also noted that “such a level will last for several years”. Cisa expects that China’s yearly steel consumption will fall to 750-800m tonnes between 2020 and 2025, followed by a fall to around 700m tonnes by 2035.

However, it is likely the high iron ore prices will ease in coming months as steel demand in China eases. Stimulus measures that were introduced by Beijing to try and help the economy through the trade war slowdown have boosted some infrastructure spending, but this is set to tail off and markets cannot rely on further measures. When Chinese Premier Li Keqiang spoke at the World Economic Forum earlier this week he specifically said that such measures were unlikely. He said that China will avoid massive policy stimulus, and keep to a “prudent monetary policy”. Of course, stimulus measures may still be introduced by Beijing, but investors cannot rely on it.

Data from the Chinese property market also makes grim reading. Property sales by floor area – a widely-watched indicator of demand – dropped 5.5pc in May from a year earlier, compared with a 1.3% rise in April. May’s decline was the biggest since October 2017, when starts slipped 6pc, according to Reuters. For the first five months, sales fell 1.6% following a 0.3% decline in January-April. This is likely to have a negative impact on growth and demand for iron ore.

This week, the Australian government’s commodity forecaster accepted that this rally simply cannot last. The country’s Department of Industry, Innovation and Science – predicted that iron-ore prices will average $81.10 a tonne in 2019, up sharply from $62.60 last year. But that’s as far as the good news goes for prices, with the return of Brazilian output and higher Australian production pushing the average price down to $61.40 a tonne in 2020 and $57.50 in 2021.

However, miners’ balance sheets are in a better state than they were during the previous two iron ore spikes, having learned the lessons of the boom in the early millennium. The boards are more interested in boosting shareholder returns than large vanity M&A projects, which loaded the sector up with significant debt before the financial crisis – a move that led to companies such as Rio Tinto being put in a very precarious position where investors were concerned whether they could service this debt and valuations tumbled.

A version of this article appeared in Friday’s Daily Telegraph

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