Metals & Mining: Pricing correction (again) underway

Iron ore markets have (again) come under immense pressure over the past few days. As a result, the highly-rewarding diversified miners have witnessed a sell-off. While pricing is expected to remain weak/volatile, with the next possible victim being copper, there’s merit in choosing miners based on their respective virtues. While our cautious stance on the sector is re-iterated, there are selective plays, which can outperform and help money managers stay exposed to commodities as an attractive long-term asset class.

Over the past week, the AV metals and mining universe is down 6.6% vs. a 1% correction for its European stock coverage. This fall has been led by Anglo American, BHP Group and Rio – down 16%, 10% and 8%, respectively. Although, the impact of the sell-off on other single metal and/or other diversified mining plays has so far been somewhat less severe.

What explains the diversified miners’ reversal of fortunes?

Just a couple of weeks ago, Anglo, BHP and Rio had announced ‘record’ shareholder rewards on the back of pricing euphoria-driven H1 21 results. This reward ecstasy was rejoiced by the markets, with most of these miners’ shares re-claiming/hitting record-highs. However, since late-July 2021, iron ore markets (a key cash-flow metal for the aforementioned miners) have also been in correction mode, with the sell-off gathering momentum in the past few days. Besides the reversal of excessive monetary easing remaining as a key risk for commodity pricing, the escalating China-Australia tensions – this time in the backdrop of the Australia-US submarine supply deal, and China’s economic vulnerabilities being aggravated by the Evergrande debt crisis and its ripple effects on the entire economy have complicated matters further. Interestingly, the iron ore sell-off should comfort the highly-indebted (zombie) Chinese steelmakers and, hence, help avoid further Evergrande-type steel industry debacles. We won’t be surprised if the iron ore sell-off was (deliberately) triggered by the Chinese State – both to avoid further systematic risks and hurt Aussie miners.

Plummeting iron ore prices

While we are not surprised by the market sell-off – we had been anticipating a correction/normalisation, the pace of erosion has definitely been far faster than our expectations. Remember, our cautious stance was based on the rationale that commodity market optimism would be tested whenever: 1/ excessive liquidity is withdrawn from the system – its impact was witnessed in May-June 2021, when the US indicated a reversal of excessive monetary easing; 2/ there is state intervention, given the importance of metals in the green transition and economic recovery plans – China has already been liquidating its strategic reserves to tame market speculation; and 3/ supply issues have been addressed – production normalisation at Vale (world’s leading iron ore miner) should happen sooner or later. As a consequence of the above factors, we still expect that more volatility lies ahead, and the next victim could be the copper markets, where pricing correction so far hasn’t been as severe.How to play the sector?

We continue to believe that metals would play a pivotal long-term role in the global economy. However, at current levels and given the growing risks, it’s perhaps time to begin evaluating stocks based on their individual virtues. Hence, the following pair trades could be an ideal strategy to remain exposed to metals’ long-term virtues and, at the same time, limit various downside risks. Remember, in falling commodity markets, the better-positioned miners – in unit cost and/or balance sheet terms – are less severely impacted vs. high-cost miners. This was evident both during the 2014-15 meltdown and post-COVID-19 outbreak equity market sell-off.

Long Rio Tinto – Short BHP Group

While Rio has the biggest iron ore dependency out of AV peers, its unmatched cost competence for the steel-making ingredient, valued diversity via aluminium, ‘NIL’ fossil business assets and an enviable balance sheet strength are difficult to ignore virtues. Any progress on the copper division’s normalisation and the new management team (gradually) managing to address legacy ESG issues could further catalyse the attractiveness. Even in the inevitable scenario of reward normalisation, Rio can still manage to outperform peers. Interestingly, Chalco – China’s state-owned aluminium major – being Rio’s largest shareholder (c.14% stake) could be a strategic advantage amidst brewing China-Australia geopolitical tensions.

On the other hand, BHP, despite its impressive FY21 results and, hence, rewards, lacks inspiration on the strategy side. With high dependence on iron ore and copper (100% of ‘reported’ operating profits), unwanted diversity coming from (met) coal assets, oil & gas assets – after many years of denial – finally being merged with Woodside, still unaddressed Samarco (penalty) uncertainties, and investments being pursued in potash (an unchartered territory), BHP’s balance sheet strength – re-attained over the years, after numerous tough decisions – is not being put to good use, especially from a long-term planning perspective. Instead, listing structure changes are being prioritised. If these strategic priorities remain lopsided, eventually it cannot be ruled out that BHP loses its valued-tag as the world’s largest miner (in market cap terms).

Long Glencore – Short Anglo American

With market volatility on the rise, the likes of Glencore would be well-positioned, thanks to its impressive legacy trading operations. Add on top, the turnaround in industrial (i.e. mining) operations, impressive green positioning (via its dominance in copper, cobalt and nickel), balance sheet resilience being attained over time, a new promising leadership in place – which should also help moderate the ire of global regulators, and focus on ramping down fossil assets – though effectively exploiting near-term market/price opportunities, we continue to believe that Glencore is ahead of peers in terms of its green positioning and, hence, is a must-have stock for money managers chasing green metal stories.

Although Anglo American has had a phenomenal run in the current commodity market euphoria, we have continuously held the view that its underlying vulnerabilities – material emerging market exposure, primarily to South Africa (c.26% of non-current assets) and ownership of less cost competent assets – cannot be ignored. Hence, Anglo’s sharper share price correction over the past week isn’t surprising. Moreover, with management already having committed to ambitious capex plans, the firm could be forced to (again) rejig its strategic ambitions. Lastly, its use of ‘excess’ cash flows – to reward shareholders and invest in existing areas plus pursual of lesser known crop nutrients via the Woodsmith acquisition – vs. the likes of Sibanye-Stillwater pursuing lithium seems odd, especially considering the long-term commodity market dynamics.

Long Boliden – Short Antofagasta

Uncertainties in China would impact fortunes of miners heavily-exposed to the country. However, the likes of Boliden (with c.97% European sales exposure) seem well-covered to withstand the brewing macro risks. Remember, with Europe being well ahead of other countries/regions with respect to green transition plans and the region not owning any sizeable mining deposits, the domestic mining stories like Boliden are likely to be key beneficiaries. Moreover, with valued diversity via smelting exposure, healthy ESG positioning and lower cost blowout risks (vis-à-vis emerging markets), the Swedish miner-smelter remains a prized European base metal bet.

Antofagasta is an apt long-term green metal proxy, but its current price simply does not acknowledge the risks that lie ahead. While copper prices have corrected in recent months, we believe that more correction – like iron ore – can’t be ruled out, especially once monetary easing reversal becomes a reality. Moreover, with output risks (as flagged by management during H1 21 results) and high input cost uncertainties in Chile, the current profitability environment is unlikely to be a sustained phenomenon. This perhaps is also reflected in management sticking to its conservative H1 dividend payout of 35%, despite exceptional operating results.

Other ideas

Besides the above pair trades, another interesting but high-risk play is Nornickel. With an exposure to high-potential metals and exceptionally run operations – reflecting in healthy margins/returns through the business cycle, the Russian mining giant is attractive – also thanks to its shareholder reward extragavence (perhaps best-in-class, after Rio). Although there are risks – in the form of the recent penalty by Russian Fisheries Agency pertaining to the Arctic disaster, and the prospect of further taxes on Russian miners and, hence, volatility on this stock – despite underlying potential – seems inevitable.

While aluminium remains our preferred base metal, i.e. being the least vulnerable to market volatility, the run-up in Norsk Hydro and Rusal’s shares – also catalysed by the uncertainties after the recent military coup in Guinea – already reflects the promising virtues and, hence, any correction should be capitalised as an entry point, rather than entering at current multi-year highs. Remember, the recent uptick for bauxite/alumina/aluminium stocks due to Guinea-related concerns are yet to reflect in the form of major supply disruptions.

Overall, our cautious sector recommendation is maintained, but selective stock plays can be considered to capitalise on the base metals’ unchanged long-term (green) demand dynamics.

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