Energy / Resources

Sani Group, China’s biggest maker of construction machines has announced a cut to its workforce.

Given lay-offs did not occur in the down cycles of 2005 and 2008, this is a clear sign some pain is being experienced in China’s industrial heartland.

Sany’s 60,000 staff produces concrete machinery, excavators, cranes, pile drivers and road machinery.  Its revenue exceeds RMB80 billion or US$12.5 billion.

With the tripling in demand for machinery in China since 2001, it appears Sany has recently been selling machines on generous credit terms.  As a result the machinery maker saw its net receivables double over 2011.

The slowdown in Chinese construction activity is not a good omen for the iron-ore price, currently US$135/tonne. China’s demand accounts for 63% of iron-ore’s global seaborne trade.

by Roger Montgomery Posted in Energy / Resources, Insightful Insights.

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As you already know, despite the enthusiasm for mining service companies back in April, we sold our holdings substantially and in some cases completely.  We have not shared our peers’ – some of whom include themselves in the ‘value investing’ camp – enthusiasm for BHP.  Our reasoning for this is our thesis regarding iron ore prices, which is unchanged from late last year.

Back then it was simply the classic investment response to higher prices.  Iron Ore prices between 1985 and and 2004 have traded between $11 and $15  and in real terms since the 1920’s prices have traded between $30 and $45. In 2004 the price of iron ore started rallying and hit $187 in 2007.

Putting aside the fact that iron ore experts now ‘guess’ $140 is the new medium term price and $100 the long term price, the rally in price from 2004 to now has produced a huge investment boom and turned millionaires into billionaires as they revalue their reserves (or other bulls value them for them).

It follows that  the investment boom will now produce additional supply.  The impact of this additional supply cannot be anything but falling prices.

Well, that was our thesis.  And then China began slowing down.  We wrote about that too

If you have been a regular to the Insights Blog, you will be familiar with some of our recent thoughts on iron ore here:

April 3)  http://rogermontgomery.com/mining-services-a-crowded-trade/

April 18) http://rogermontgomery.com/building-heaps-piles-at-bhp/

APril 11) http://rogermontgomery.com/will-china-demand-iron-or/

And you can watch this video I published here on December 8 last year:

Since July last year BHP is down 30% and RIO down 36%.  Since April and early May they are down 15% and 20% respectively.  Many investors are now thinking they are cheap.  But there is the possibility of a classic Value Trap.

Forecast valuations may yet decline further, even if share prices bounce. Here’s our thoughts…

PORTFOLIO POINT: BHP and Rio’s review of capex programs represents a stark turnaround from comments made just two months ago, and it’s a worrying sign for the rest of the sector.

BHP is trading at three-year lows, Fortescue is down 17% from recent highs and Rio is visiting lows last seen in 2008. If you own shares in any of these companies, only Telstra would have saved your portfolio from a shellacking.

The big caps, however, are not the only stocks that have suffered. Over recent years, it is likely that you would have observed my interest in mining services. That interest was a product of the presence of value for money.

This is a sector I know well and have covered numerous times. I have discussed and brought listed businesses – including Decmil Group (DCG), Forge Group (FGE) and Matrix Composites & Engineering (MCE) – and IPOs – GR Engineering (GNG) and Maca (MLD) – to your attention.

This was mostly at a time when there was little market interest, despite their apparent growth profiles, quality aggregated balance sheets and (now with the exception of MCE) management.

Today, however, that story is very different and I find myself erring on the side of caution when it comes to ‘picks and shovels’.

Each week, a stronger case is building that a key growth engine for capex spending by our miners is slowing – that is, commodity prices are falling.

Take one commodity I have discussed recently: iron ore.

In 2010-11, world iron ore production grew 8.1% (or 227mt) to 2.80bt. Assuming similar growth levels in 2011-12, iron ore production will grow to 3.04bt, an increase of about 237mt. (In a classic supply response, BHP production is forecast to grow by 20%, Rio by 30% and FMG by 25%.)

And assuming China consumes 60% of global production again (highly optimistic), its demand would increase by 136.2mt. However, moderating growth means current estimates for China’s iron ore requirements are half this level. With few other countries growing or competing heavily with China, who will pick up that supply overhang in a low-growth environment?

By 2015, two entire Pilbara regions (700mt) in supply terms are estimated to come onto the market. It’s a far stretch to expect China to absorb 420mt (60%) of that.

The impact, I expect, is pressure on iron ore prices.

Many other commodities are looking like they are set to suffer a similar fate. Record prices over a decade have created an investment boom that is climaxing at a time when global demand is losing interest. And you need two to tango. When soaring supply meets softening demand, lower prices follow.

So what are the implications? Put simply, for those who dig stuff out of the ground and export it, margins and cash flow will be squeezed (a situation I have been monitoring closely and alerting readers to for at least six months). It’s why I haven’t bought BHP.

In previous periods, a revenue squeeze has been a precursor to capex plan deferrals or delays lasting years. Barely economical projects are shelved as miners focus instead on financing core (capital-intensive) operations, rather than aggressive growth targets.

Indeed, the 1990s was a very different period for miners, and those who serviced the mining sector barely made it onto investment radars. Companies struggled to cover their cost of capital and total annual capex was less than $20 billion for the entire mining industry.

Today, many miners are generating returns on equity in excess of 30% (‘super profits’?) and capex runs in excess of $60 billion per annum. Are such numbers maintainable forever? No. And if it can’t go on forever, it must stop.

Just a few days ago, BHP Billiton and Rio Tinto announced that they are re-evaluating their capital expenditure programs. These comments are in stark contrast to their latest financial reports and presentations made just two months ago.

In those reports, confidence was effervescent and the deployment of $40 billion in a global cash capex spree was on the cards. Today, as China’s growth rate slows and some investors lobby for a greater focus on cost control and returning funds to shareholders, tens of billions of dollars of an extensive development project pipeline is under review.

When the two leading businesses that account for about 35% of total industry investment start to make noise, it’s time to sit up and pay attention.

We are bound to see many other miners follow suit and the chorus is growing louder by the day. Citigroup conducted a survey in April and found that 50% of all miners were considering lowering their investment budgets.

That compares to less than 20% in January.

Figure 1. A picture tells a thousand words

At the start of the financial year, capital expenditure was forecast to rise 34%, with an increase of 18% in 2013.

The forecast today is for a rise of only 13% this year and a fall in 2013. This represents a material deterioration in market conditions in a very short period of time. All of this weighs on the ‘bright prospects’ that once surrounded those companies which service the miners.

This brings us back to Decmil, Forge and investing. I bought both of these businesses in the Montgomery [Private] Fund near its inception.

Forge is a business that has a significant exposure to second-tier miners, especially those expanding their iron ore operations. Decmil, on the other hand, has around 43% of its business exposed to resources and the balance to oil & gas.

While plenty of work is still forecast to be in the pipeline for mining services companies, there are also plenty of companies trying to win it.

If we are at the peak of the current capex cycle, this is as good as it gets in terms of margins for mining services businesses and also workloads.

With that in mind, and coupled with prices increasing to levels I deem attractive for what are businesses with high operating leverage, I have decided to read the writing on the wall and position our investments in a more conservative manner. I sold our Forge holding some weeks ago and also scaled back our holding of Decmil.

It is possible I am early to leave the party – the band is still playing. But the mining industry is bracing for a pullback in investment spending, as the biggest companies reassess their capital expenditure plans amid escalating costs and an uncertain growth outlook. I anticipate that analysts will revise their earnings forecasts lower for 2013 and beyond.

The valuations I look at in Skaffold will also fall, I expect, as those earnings revisions are fed through. Of course, I could also be completely wrong but I reckon the big mining companies’ historical predilections for over-paying for acquisitions (another reason I have been loath to invest) may just revisit them.

The combination of a contracting market and high operating leverage means I simply prefer the safety of cash. Better to be confident of a good return than hopeful of a great one.

This article was first published on May 16, 2012

by Roger Montgomery Posted in Energy / Resources, Insightful Insights, Intrinsic Value.

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In The Australian Roger Montgomery discusses why the laws of supply and demand suggest demanding times ahead for mining companies. Read here.

by Roger Montgomery Posted in Energy / Resources, In the Press, Investing Education.

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In TheBull.com.au Roger Montgomery discusses his insights into the outlook for Australian commodities share prices over the near future.  Read here.

by Roger Montgomery Posted in Companies, Energy / Resources, In the Press.

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In light of my recent posts about China slowing, the price of iron ore under pressure from a gigantic supply response, our avoidance of BHP/RIO/FMG as investments and our profit taking last month in our mining services holdings…

In April, we warned more frequently than before that the mining boom appeared to be on shaky ground.  Of particular interest to us has been the support for Iron Ore prices even in the face of a very great supply response.

If you are keen to study our thoughts on Iron Ore and why we don’t own BHP currently and why we have already sold the bulk of our mining services holdings you can read the following links:

April 3)  http://rogermontgomery.com/mining-services-a-crowded-trade/

April 18) http://rogermontgomery.com/building-heaps-piles-at-bhp/

APril 11) http://rogermontgomery.com/will-china-demand-iron-or/

In 2010-11, world iron ore production grew 8.1% or 227mt to 2.8bt. Assuming similar growth levels in 2011-12  – in a classic supply response BHP production is forecast to grow by 20%, RIO by 30%, FMG 25% – iron ore production will grow to 3,037bt, an increase of 237mt.

And assuming China consumes 60% of global production again (highly optimistic), their demand would increase by 136.2mt. However moderating growth means current estimates for China’s iron ore requirements are half this level. With few other countries growing or competing heavily with China, who will pick up that supply overhang in a low growth environment?

By 2015 we estimate that two entire Pilbara regions (700mt) in supply terms will come onto the market. It’s a far stretch to expect China to absorb 420mt (60%) of that.  The impact we expect is pressure on iron ore prices.

And finally, just days after BHP and RIO said they are reassessing their development plans…This just flashed across our screens:

*DJ BHP Chairman: World Faces Increasing Volatility, Uncertainty

(MORE TO FOLLOW) Dow Jones Newswires
May 15, 2012 23:37 ET (03:37 GMT)
*DJ BHP’s Jacques Nasser: Australia One Of Higher-Cost Countries For Miners

(MORE TO FOLLOW) Dow Jones Newswires
May 15, 2012 23:38 ET (03:38 GMT)
*DJ BHP Chairman: Shareholders Have Lost Confidence In Health Of World Economy

(MORE TO FOLLOW) Dow Jones Newswires
May 15, 2012 23:39 ET (03:39 GMT)
*DJ BHP Chairman: Tailwind Of Higher Commodity Prices Moderating

(MORE TO FOLLOW) Dow Jones Newswires

May 15, 2012 23:40 ET (03:40 GMT)
*DJ BHP Chairman: Will Redirect Capital If Any Product, Geography Doesn’t Suit

(MORE TO FOLLOW) Dow Jones Newswires
May 15, 2012 23:44 ET (03:44 GMT)
DJ BHP Chairman Says Commodity Price Tailwind To Ease Further

SYDNEY (Dow Jones)–The tailwind of high commodity prices, which have helped the mining
sector report record growth in recent years, is moderating and is expected to ease
further, the chairman of BHP Billiton Ltd. (BHP) said Wednesday.
The sector also faces continuing global volatility and uncertainty since the global
financial crisis, which has led shareholders to lose confidence and focus more on cash
returns and dividend yields, Jacques Nasser said at a business lunch in Sydney.
“Rather than the world settling down, we will face increasing volatility and
uncertainty,” he said. “It is really going to feel as if the ground is shifting
under our feet.”
Nasser described the 2008 crisis as a structural shift and said ongoing developments in
the eurozone were a short time ago “almost unthinkable.”

-By Rhiannon Hoyle, Dow Jones Newswires; 61-2-8272-4625

(END) Dow Jones Newswires
May 15, 2012 23:49 ET (03:49 GMT)
Copyright (c) 2012 Dow Jones & Company, Inc.

Posted by Roger Montgomery, Value.ableauthor, SkaffoldChairman and Fund Manager, 16 May 2012.

by Roger Montgomery Posted in Energy / Resources.

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BHP Billiton (BHP), Rio Tinto (RIO) and Fortescue Metals (FMG) have all announced significantly increased production in the future – on Radio 2GB Roger Montgomery discusses with Ross Greenwood why this, combined with Chinese demand levels is likely to have an adverse effect on their respective share value for some time to come. Listen here.

This program was broadcast 16 May 2012.

by Roger Montgomery Posted in Companies, Energy / Resources, Radio.

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Roger Montgomery is not surprised by the slump in Mining Services share prices – here he discusses with Ticky Fullerton on ABC’s The Business how the growth in supply and the limits to Chinese demand have allowed value investors to anticipate the current share price levels. Watch the video.

This interview was broadcast on ABC1’s The Business on 15 May 2012.

by Roger Montgomery Posted in Companies, Energy / Resources, Investing Education, TV Appearances.

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Learn Roger Montgomery’s Value.able insights into the latest 50 basis point cut in the the base rate and how it may impact housing prices in this interview with ABC The Business’ Ticky Fullerton broadcast 2 May 2012. Watch here.

by Roger Montgomery Posted in Energy / Resources, Financial Services, Investing Education, TV Appearances.

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Roger Montgomery uses Value.able investing techniques to assess the management choices made by BHP executives over the last 20 years with Ross Greenwood and stockbroker Michael Whiting. Listen.

by Roger Montgomery Posted in Energy / Resources, Radio.

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Roger Montgomery discusses how and if you should respond to the impact of changing global conditions on your BHP [BHP] stock holding. Read here.

by Roger Montgomery Posted in Energy / Resources, On the Internet, Skaffold.

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