2023-06-26 08:13:38 ET
Summary
- China’s economic slowdown has cast a shadow over metal prices, and mining stocks, over the past year.
- Demand in the US, and global growth in renewables, should more than offset the Chinese slowdown.
- BHP's superior profitability and returns compared to peers make it a resilient investment option despite market volatility.
China's laggard economic recovery provides headwinds for commodity prices
China’s growth and commodity prices have been intertwined for the past two decades – at least. The main thesis for investors in commodities, or commodity-linked companies, has been China’s growth story, and what seemed to be China’s endless demand for commodities to fuel the growth of its massive infrastructure and property sectors. But since the pandemic started, this relationship has not been as fruitful as it was in the past. China’s extensive and extended lockdowns have added fuel to the fire of an already slowing down economy. The de-coupling between China and the US, started by Donald Trump and extended by Joe Biden and US allies, are certainly not helping. While China has also self-inflicted damage through clamping down on large business groups, and spreading uncertainty across the business environment.
As a result, China’s exports have been slowing down, as well as China’s property market. Debt levels across the economy have been hitting record levels. Room for manoeuvring and stimulus is tighter and tighter.
All these factors, and others, have been made China’s steroid-fuelled economic growth a distant memory. Now, doom and gloom scenarios are more persistent about China’s growth outlooks. BHP (BHPLF), like other market operators, was too optimistic when it noted in the Operational Review of Half Year ending 31 December 2022 that “ BHP believes China will be a stabilizing force when it comes to commodity demand in the 2023 calendar year, with OECD nations experiencing economic headwinds. China’s pro-growth policies, including in the property sector, and an easing of COVID-19 restrictions are expected to support progressive improvement from the difficult economic conditions of the first half. China is expected to achieve its fifth straight year of over 1 billion tonnes of steel production .”
US to the rescue
On the other side of the Pacific, the US economy remained buoyant and pressing ahead at full charge. US GDP and manufacturing output have slowed down since the beginning of this year, following high levels of growth last year. But still economic activity remains very strong. The US government’s industrial stimulus packages are helping. The Inflation Reduction Act ((IRA)) that was passed by the US government last year includes US$ 500 billion of government spending and tax cuts to mainly support the growth of the renewable energy industry. In addition, the Chips and Science Act pours more than US$ 50 billion of funds to support the chips and semiconductors industry in the US. All of this provides very positive demand boosts for the metals industry, as copper, iron and nickel are main components for these industries.
Renewables boosting global growth
In addition to strong US growth in renewables, wider global growth in renewables and electrification is, and will keep on pushing growth in demand for copper, iron, nickel and other metals. According to the International Energy Agency ((IEA)), global renewable capacity is expected to increase by 107 gigawatts ((GW)) this year to more than 440 GW, which would mark the largest ever absolute increase.
According to the IEA, “ This unprecedented growth is being driven by expanding policy support, growing energy security concerns and improving competitiveness against fossil fuel alternatives. These factors are outweighing rising interest rates, higher investment costs and persistent supply chain challenges .” According to the IEA, global renewable capacity can increase by another quarter to 550 GW within next year. These are very strong boosters for demand for BHP’s metals. According to the National Renewable Energy Laboratory , wind turbines are predominantly made of steel (66-79% of total turbine mass); iron or cast iron (5-17%); copper (1%); and aluminium (0-2%). Solar panels are similarly mostly made of aluminium. Electric car batteries are also mainly made from BHP’s metals; aluminium, copper, iron and nickel are all important ingredients.
BHP is paying more attention to nickel – but more is needed
Over the past year, BHP announced several investments in nickel – seeking to have a more solid foothold in this critical metal for electrification, while reducing concentration on iron ore and copper. In January of last year, BHP announced a US$ 100 million investment in a Tanzania nickel project. Later in August of last year, BHP announced a US$ 100 million investment in an existing mine in Australia to develop nickel deposits. Over the next two years, BHP plans to invest another US$ 100 million or so in developing nickel deposits – most of which is going to electric car batteries, boosting BHP’s green credentials. BHP needs to expand its production of nickel even further to grab more market share from the leading four miners that precede it.
Volatility of market prices will continue to be excessive over the short term but long-term trend should be upwards
Investors and traders of commodities cannot be blamed for being confused in the short term over the likely direction of metal prices. Metal prices are some of the most exposed assets to economic boom and bust, and movements in metal prices are hypersensitive to any news indicating economies are heading one way or another.
In May 2022, iron ore reached a peak of USD 215 per tonne and copper reached USD 4.7 per pound. All of them took a nosedive a few months later, with iron ore dropping by 60% to a bottom of USD 86 per tonne in November 2022, while copper dropped by a third to USD 3.4 per tonne in September 2022. And then the rollercoaster swung again, raising iron ore price by 34% since it’s the bottom of last November, while copper is up by 12% since September. Coal, which has been in the doghouse for years, has witnessed a tenfold multiplication its market price from October 2020 to September 2022. This has been reflected in bumper profitability reaped by BHP in coal last year. Coal is trading today at a third of the September peak, but still two times the levels of two years ago. Market prices remain very volatile, swinging sharply since the beginning of the year – there is no reason to expect that this will change anytime soon, given the mixed very volatile global economic outlook.
Long term trends are fully supportive of sustainable growth in demand for the commodities that BHP mines and sells. Global population will keep growing, economies will keep growing, industrialization and urbanization continue to grow heavily, and the shift to renewable energy and electrification is accelerating at an exponential rate. At the same time, supplies of metals are not expected to get better; there are limited volumes of metal in the ground, and a handful of groups in the world have sufficient financial muscle and expertise to extract it at an economic rate. Put all these factors together, and it is crystal clear that prices of industrial metals should be heading in one direction over the long.
Returns and profitability remain superior to peers, valuation could be more tempting
BHP still enjoys superior profitability and returns versus its peers. In the last reporting period of H1 2022/23 (ending 31 December 2022), BHP achieved a 54% underlying EBITDA margin, and 29% Return on Capital Employed (ROCE). In the last reporting period of Rio Tinto (full year 2022, ending December), Rio achieved an underlying EBITDA margin of 47% and ROCE of 25%. Anglo American achieved ROCE of 30% and underlying EBITDA margin of 47% during the full year 2022. Although reporting periods are not directly comparable, since BHP’s financial year ends in June not in December as its peers, yet the comparison does provide insight into BHP’s more superior returns.
BHP’s valuation has always been on the higher end compared to its peers, due to having higher quality assets, operating in lower risk jurisdictions and having a lower cost of production. BHP is currently trading at a P/E of 8.3x, market cap to operating cashflow of 11.5x, with a current share price range that is 16% above the 52-week low reached in July 2022. Dividend yield of 9.3% is likely to drop within the coming year to around 6.5%, based on current running rate of net income and the company’s policy of distributing at least 50% of net income as dividends.
Rio Tinto, BHP’s closest peer at about half its market cap, is trading at a P/E of 8.3x, and a much lower 5.3x market cap to operating cashflow, with a current dividend yield of 8.2%. Anglo American, about a fifth of BHP’s market cap, is trading at a P/E of 7.8x, market cap to operating cashflow of 3.5x, and a dividend yield of 7.3x. BHP is not the cheapest, but maybe the most resilient. Some further discount on BHP’s share price would make an entry more appealing to this trophy mining investment.
For further details see:
BHP: Clouds Gathering But Solid Investment Status Remains