Iron ore: Fundamentals absorbing iron ore headwinds

About the author:

Adrian Prendergast
Author name:
By Adrian Prendergast
Job title:
Senior Analyst
Date posted:
25 March 2022, 8:00 AM
Sectors Covered:
Mining, Energy

  • Potential for short-term weakness in iron ore prices from a combination of diminished steel mill margins, COVID-19 interruptions, and healthier iron ore supply.
  • Chinese steel prices and inventories remain under pressure.
  • Although growth is likely to steady, with supply still at risk, we see iron ore as likely to remain at levels conducive of ongoing bumper earnings for the sector.
  • We upgrade our iron ore price forecasts, factoring in an expected steepening cost curve and higher sustaining steel demand.

Less exciting than base metals…

Iron ore has not seen the same transformation in demand-supply fundamentals that some base metal markets have, but the raw material is still in good shape. Iron ore benchmark prices remain between US$140-$150/t, still comfortably north of consensus expectations with upgrades still flowing.

Although, this could come under some pressure in the short term from:

  1. Reduced steel mill profitability (<US$50/t down from peak US$300/t in 2021),
  2. COVID interruptions to logistics and some steel activity, and
  3. Healthier iron ore shipments out of Western Australia and Brazil.

A switch in focus from steel mills to preserving margins could result in lacklustre steel activity in the June quarter, with iron ore and steel inventories likely to remain low, productivity reduced and potential for added demand for low grade.

…but still in good shape

While we see some short-term headwinds, we do not see them as enough to dislodge iron ore prices from recent ranges. We base this on the gradual improvements in stability to China’s property and financial markets, which is likely to see Beijing shift its focus back towards stimulating some growth.

Steel-intensive infrastructure projects and property construction activity have been popular levers for Beijing in encouraging growth in the past and likely to feature again in 2H22.

On the supply side, we continue to see a mixed performance in terms of shipments from major producers Rio Tinto (Hold rating) and Vale SA (Not rated). For RIO we see risk around its ability to maintain shipments of its Pilbara Blend premium product against a tight mine replacement schedule.

If Gudai Darri (critical new mine) were to slip beyond its current guidance for a Q2 start-up, we expect RIO’s higher grade volumes to slip further – a potential risk for FMG as it may face even more competition in low grade.

Vale meanwhile remains on a tightrope, battling weather impacts and strict government oversight.

Changes to forecasts

We have upgraded our iron ore forecasts to accommodate what we see as a steepening cost curve in iron ore. We expect the surge in diesel prices alone will materially add to opex, while labour constraints and supply chain bottlenecks have also impacted opex directly.

The above conditions also make it difficult for any miners with development activities to stick to schedule/budget.

We have also changed our FMG forecasts after reviewing long-term capex, decarbonisation and FFI assumptions.

This has contributed to increases in our value-derived target prices for BHP (+6.7%), RIO (+4.3%) and FMG (+2.9%).

How to play the ‘Big 3’

While all trading in a narrow range in terms of discount to valuation, BHP remains our standout top preference amongst the iron ore miners. BHP offers superior diversification, operational performances, ability to defend against cost and labour pressures, and a solid yield profile.

We also see potential catalysts around:

  • Completing petroleum divestment,
  • Potential coal divestments,
  • Capital management, and
  • New growth additions.

Post the changes to our forecasts we upgrade BHP Group (ASX:BHP) to an Add rating (from Hold) and our target price moves to (login to view). Key risk to our call is China COVID and growth assumptions.

We remain neutral on Rio Tinto (ASX:RIO) and Fortescue Metals Group (ASX:FMG), both on Hold. For RIO we see strong earnings offset by ongoing operational issues across its business continuing to bite.

While for FMG we also see bumper FCF continuing but believe consensus is materially underestimating FMG's capex profile for the next decade.

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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