BHP Billiton Slides Down as Iron Ore Corrects

It wasn’t too long ago that BHP Billiton [ASX:BHP] found itself in an extraordinary rally. From 29 February ($15.57) to 7 March ($18.55), BHP added $2.98 to their share price. A 19.14% return in five days of trading isn’t too bad at all.

BHP share price 01Apr16


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And it seems almost unbelievable. Remember, we are talking about a company which is in a market constantly beaten down by pessimism. But in that short time span BHP definitely had some help in the form of positive press.

In that time, BHP was able to wrap up the Brazilian dam disaster, while also keeping their A credit rating. Even cutting dividends by more than half still turned out well for BHP. Why? Because they in fact paid out more than what was stated by their dividend policy.

But the big boost to BHP’s share price was down to the activity in oil and iron ore markets — BHP’s most important commodities. During the same time as BHP’s rally, crude oil gained 16.74%, on its way to reach levels above US$40 a barrel.

crude oil 01Apr16


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And iron ore was the talk of the town when it hit its high for the year of US$63.30 on 7 March. Iron ore’s pick up was largely due to an increase in Chinese construction following the Chinese New Year break.

However, since this time, BHP’s share price has receded somewhat to below the $17 mark. Why? I would argue it’s because of growing doubt in investors’ minds.

An ice age for steel

This morning, iron ore fell another 0.8%, to US$53.75 a dry tonne. This means iron ore has retraced more than 15% from its high in early March. A major problem for iron ore is slowing Chinese demand.

The second largest steel maker in mainland China, Angang Steel Co., said after posting a net loss of US$710 million last year:

In 2015, China experienced a slowdown in economic growth and excess steel capacity, which caused the domestic and overseas steel industry to enter into an Ice Age.

What’s happening right now has not happened for a whole generation. Steel demand is shrinking in China, as policymakers steer the economy towards consumption.

Even Baosteel, China’s biggest listed steelmaker is forecasting problems in the near future. They expect output to increase by 20% in 2016. Baosteel produced 22.6 million tonnes of crude steel last year. But they say it’s likely they will eclipse this figure by 4.5 million tonnes.

This will ultimately underline the problems facing the British steel industry. China’s industry is not the only one suffering.

The UK’s entire steel annual output is a little over 10 million tonnes. Tata Steel, a large Indian steel maker, has blamed cheap imports for forcing the sale of its operations in Britain. These imports Tata is talking about is China’s doing.

China has been aggressively shipping its surplus steel products overseas. They are doing so at fairly low prices which, like Tata said, is putting strains on multinational steelmakers. Exports hit a record 112 million tonnes last year, and it’s estimated to increase further in 2016.

Total steel capacity in China is estimated at around 1.2 billion tonnes. Yet the Chinese Iron and Steel Association expect capacity to further increase this year.

Put simply, there is a global glut of supply right now. The research company McKenzie & Co. are expecting iron ore to slide back to US$45 levels. And many other analysts agree with them.

So what does all this mean for BHP?

A logical conclusion one could draw is that the current activity in the steel industry is bad news for BHP. Why? Because Chinese steel consumption is not improving. They already have an oversupply of steel, so why would they increase their iron ore imports?

Oliver Ramsbottom, a Tokyo-based partner for McKenzie, stated in an interview:

There’s plenty of supply, there’s relatively week downstream demand and sure, you get some uplift in price, but it’s not really that significant…There’s little reason that iron ore is going to go above US$45 to US$50 per ton. If anything there are probably more downside risks.

Big investment banks like Goldman Sachs and Citigroup don’t expect the situation to get better any time soon either. Goldman has a year-end target of US$35 a tonne. Citigroup projects an average of US$38 for 2016; and US$35 for 2017 and 2018.

However, lower prices aren’t bothering BHP too much. Tony Ottaviano, Vice President of strategy, development and planning at BHP, said on Thursday:

With iron ore, we see it sitting where it is for a little while longer…When you see the EBITDA margins we make, I cannot understand why we wouldn’t operate these assets to their full value, maximise every bit of production we can.

In their first half-yearly report for 2016, BHP acknowledges that iron ore could remain lower for the short term. However, on a long term basis, BHP believes iron ore will peak in line with China’s steel production.

When that will be is anyone’s guess.

China’s infrastructure and construction account for about half of their steel consumption. But, right now, China is moving away from an industrial nation. Their growth is now being led by consumption.

Why is this happening? Because more Chinese citizens are moving into the middle-income wage bracket. While this shift could pose other problems for China’s economy, at present it’s a big factor that’s putting downward pressure on iron ore prices. And, therefore, putting downward pressure on BHP’s share price as well.


Härje Ronngard,
Junior Analyst, Money Morning


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