2023-06-26 18:00:00 ET
Summary
- BHP is not exactly a one-trick pony.
- But its fate will revolve around one commodity and its pricing.
- We see poor prospects from here.
- We also go over why we covered our short position.
The current narrative has been that the economy has dodged a recession and inflation remains stronger than expected. While the recession avoidance might that of both economic strength.
BHP Group (BHP) ( OTCPK:BHPLF )
BHP is one of the largest and most successful natural resource businesses in the world. The firm explores, develops, and produces iron ore, copper, silver, zinc, molybdenum, uranium, gold, and metallurgical and energy coal. It has also recently expanded into Potash, a key commodity for the agricultural markets. BHP is a global powerhouse and it has activities in Australia, Europe, China, Japan, India, South Korea, North America, and South America, among other places. BHP is also involved in smelting and refining in addition to mining. As a key commodity producer, BHP has often been used as an "inflation hedge". While the company has had several rallies and falls, its performance during 2000-2008 commodity bull run goes to show just how much alpha you can capture versus the broader market when this fires on all cylinders.
Outlook
BHP gets credit for being a diversified commodity producers, but the real story comes down to iron ore. You can see in the slide below that about 60% of the total EBITDA is coming from iron ore. Copper forms a valuable second place here but it is hard for the company to do well unless iron ore performs.
While some other factors do account for part of the price performance, there is no doubt that you could predict a great deal of the price movement based on one commodity. We have shown the price of iron ore and BHP over the last decade to make our point.
Our outlook on iron ore is hence the most important in predicting total returns over the next 3-5 years. How do you predict where iron ore is going? The commodity like most other commodities is very sensitive to the rate of change of GDP. More importantly it performs really well when GDPs are booming as that is when capital investment really picks up. There is a huge difference in the iron ore that is used at 4% GDP growth rates versus 1% growth rates. In the case of iron ore, the primary consumption is by one market and for one product. That country would be China and the "product" and its gigantic property bubble. China consumes 70% of the world's seaborn e iron ore and an estimated 70-80% of that is related to its housing market.
The story began in the late 90's with China targeting GDP growth via construction in general and housing in particular. Over time this became the only game in town as investment in this sector grew. Of course a bubble means that everyone and their brother is in on it and speculation became a rampant fuel to this fire. By 2021 China was outcompeting New York 5:1 on price to rent ratios.
That bubble has now been pricked and is slowly deflating. The initial problems came when Evergrande's blatant Ponzi schemes came to light.
First, scale. Publicly acknowledged debt is $300 bln. That is 2.4X the $123.8 bln cost of the bailout of the savings and loan industry to the U.S. government in 1998-99 and twice the $169 bln direct cost of the 2000-2001 Chinese bank bailout, both of which had enormous consequences for their respective economies.
Second, number of people affected. Evergrande is essentially a Ponzi, collecting cash from the pre-sale of an ever-growing number of apartments, plus hundreds of thousands of individual investors, and using the cash to fund further sales by accelerating construction in progress and funding down-payments. Like any Ponzi, this works as long as it’s accelerating. But inevitable for every Ponzi is the same endgame. When the market slows, those incoming streams of cash start to fall behind the growing arc of cash demands.
Source: Fortune
Over the last two years this has been a slow motion train wreck with the Government of China moving back and forth on bailouts and completing existing projects from underwater companies. We think that this drop is about to accelerate as the government comes to grips with the only way out. Stop digging themselves further in the hole by building more properties.
Chinese real estate investment slumped further in May, showing both extended weakness in a key engine for economic growth and the challenges facing the nation’s cash-strapped developers.
Investment in real estate declined 7.2% in the first five months of 2023, worse than the 6.2% decline recorded in the January-to-April period and deeper than economists’ expectations of a 6.7% drop.
Source: Bloomberg
Here is a longer term look at where this slump is.
BHP Implications
We would note in the iron ore price chart that the commodity fell as low as $50 even when economies slowed and China's property bubble had not burst. One reason that iron ore can fall so low (and even lower in our opinion this time) is that the marginal cost of production is extremely low. BHP's marginal cost is under $20/tonne. In fact until $80/tonne (from the current $114/tonne price) there is almost no production that will be curtailed. The pain point will come well below $50/tonne.
“Iron ore producers are enjoying exceptionally high margins as well, around two thirds of seaborne supply only require prices of per dry metric tonne to break even.”
Source: Australia Mining
Alongside these headaches, the Eurozone just confirmed a recession . We also believe that the US economy is currently in a recession. It would be certainly unprecedented for the recession to be dodged after 14 months of falling leading economic indicators and the most inverted yield curve we have ever had.
So if we get the price collapse we expect in iron ore, we think BHP could easily drop 40-50%. Its dividends would also be reduced to a pittance.
Verdict
Over the last year we have had a short bias on BHP. Our initial trade was added to our hedges by selling $65 strike February 2023 naked calls for $2.85. BHP did close over $65 at contract expiration and our effective short price was $65+$2.85=$67.85. We did cover these short position on the way down and concluded it on May 25 with BHP at $54.87 .
At present we have some more talk of stimulus from China and it remains to be seen whether it will actually add to the supply problem is country is already facing. Materials sector has also been quite oversold relative to the broader market and we could see a short term rebound. Our strategy would be to look to short in the $63-$65 range with naked calls that add a layer of buffer on the price. More importantly, we think iron ore is the riskiest sector of the commodity market and we would at least avoid BHP (if not short it) until the commodity pricing reflects the fundamentals.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
For further details see:
BHP: Iron Ore Prices Likely To Decline Substantially