When Andrew "Twiggy" Forrest first announced grandiose expansion plans for his Pilbara iron ore development, there was much rolling of eyes from the analyst community. Twiggy had a track record of being a lot of talk. Some analysts simply said "no way", others crunched the numbers to arrive at a heavily "risked" valuation with an air of sceptism, and few took Twiggy at his word. For one thing, where was he going to find all the iron ore?
It mattered not to the market herd who bought up shares in Forrest's Fortescue Metals ((FMG)) like there was no tomorrow, to the point a stock price consolidation became necessary. At least one old WA mining analyst was quoted as saying, "Find the ore? The Pilbara is made of iron ore!"And it wasn't long before such an observation proved accurate, given FMG kept announcing discovery after discovery.
The only problem was that FMG's iron ore deposits are mostly of a lower grade than the premium ore mined for years by the likes of BHP Billiton ((BHP)) and Rio Tinto ((RIO)), and that FMG was starting from scratch on the infrastructure front. The company has been able to borrow to fund its capex without much difficulty, but a combination of lower grades, capex spend and debt funding has meant that Twiggy's seaborne ore costs a lot more to produce than ore from the long established majors. Which is why the company has proven very susceptible to the recent collapse of the spot iron price.
The uncertainty the collapse implies, and the unmovable object of debt servicing, this week forced FMG to announce the planned future stage of the production expansion will be shelved for the time being. The throughput target will be left at 115mtpa for now, rather than pushing on to the ultimate 155mtpa target.
The announcement surprised no one, and realistically expansion halt may only last but a year. Indeed, FMG's final expansion has a lot more chance of being re-announced than BHP's Olympic Dam expansion, also similarly shelved, or its Outer Harbour infrastructure project at Port Hedland. Were the iron ore spot price to remain at today's level for all of FY13, FMG would hit cashflow problems. No one is expecting it will, and indeed the fall below US$90/t (reflecting the fall in steel prices) may be just what is needed to bring the Chinese steel industry back to earth, but it doesn't mean this is not a time to be cautious.
One is reminded of the time a couple of years ago when BHP finally managed to get Rio on side to force the Chinese into quarterly pricing for iron ore contracts, rather than yearly. The ultimate intention, analysts assumed, was to move all the way to spot pricing. The big miners felt they were being hindered at the time by being locked into lower than spot contract prices. The market loved the idea. One writer in particular, who will remain nameless, did point out that prices could also fall. Seemed silly at the time. Not quite so now.
The problem is, many in the market have only been involved with investment in iron ore producers as iron ore prices have risen. They have risen because of the "super-cycle", which has been generated by China, and the super-cycle should last for a couple of decades. Suddenly it looks like one decade might be the end of it, if the spot iron ore price is anything to go by.
Suddenly it looks like Australia's mining boom is over.
"Debate about the end of the resources boom has attracted numerous headlines, again, "note the Commonwealth Bank economists. "Is mining investment approaching its peak? Yes. But mining investment still has some way to run".
One first must come to grips with what the supposed "super-cycle" actually means. Does it mean prices just keep going up? No. It never meant that. Early last decade mining analysts were caught out by being stuck in their old ways, which included a mantra that "commodity prices always revert to the mean", or historical average. What China did was blow away the mean. The super-cycle effectively implied a step-jump in base level pricing. It did not imply China would grow forever and it did not imply there could never be smaller up and down price cycles within the larger super-cycle. What we have seen is an astonishing burst of growth from China over the past ten years. That growth rate has now decelerated, which does not mean China's economy has contracted. A new norm is being established.
Miners, too, were caught out by China, having just experienced a decade of very low global commodity demand. Supply-side response to the new demand thematic was always going to take years, not months. Australia's "mining boom", in the form of once in a lifetime explosion of supply-side development, is a reflection thereof. Growth plans have been nothing if not ambitious, and arguably overly so. Suddenly the miners, and the market, have been caught about by a slowdown in China's growth rate that is more rapid than expected, and a reflection of that is a very sharp and unexpected fall in iron ore prices. At the same time, the cost of mining has continued to rise. Something had to give in the short term, and it has given in the form of postponement ? of Olympic Dam, of Outer Harbour, of Fortescue's final Pilbara stage, and of many projects from junior companies in between. But these are plans, not completed projects.
"The first phase of the mining boom, the sustained rise in commodity prices that boosted growth in national income, probably has ended," suggest the JP Morgan economists. "But the more durable and arguably more important volume phases of the mining boom have much further to run". In other words, China has grown very rapidly to a point and is now plateauing. This means that while China initially demanded more and more iron ore, now it will settle at a more consistent demand level ? at a big step-up from last century.
Last week saw the release of the Australian Bureau of Statistics' capital expenditure and expenditure intentions survey for the June quarter. In real terms, Australia's private sector lifted its capex by 3.4% in the quarter, slightly ahead of expectation. The biggest component increase was in buildings and structures, reflecting mostly additional capacity in the resource sector. Miners again led the way with a 10% increase in investment, which meant all the other sectors went backwards.
The survey was taken before BHP made its Olympic Dam announcement, let alone other announced deferrals including Fortescue's final phase. The "money spent" part is basically ancient history, and we've since leaned Australia's GDP grew by 0.6% in the quarter. Of far more importance is the forward-looking "money planned to be spent" part, which informs the market, the government and the RBA. JP Morgan notes (after applying some statistical fiddling) that capex will rise by another 17% in FY13, lower than the 20% the economists had forecast, and well below the 30% implied by the March quarter survey. What will the number look like at the next quarterly survey, post these big deferrals?
Probably not as bad as one might fear, given we're only looking at FY13, JPM notes. Olympic Dam for example planned to even start for a few years yet. A lot of the big deferrals have reflected longer dated and not yet committed plans. Based on an analysis of mining projects recorded by the Bureau of Resources and Energy Economics (BREE), more than one economist expects mining investment in Australia to peak in 2013-14 if we take into account only advanced projects. Add in less advanced projects and the peak would be much higher and perhaps further out in time, CommBank suggests. BREE's "advanced" projects are those currently under construction or at least committed to while "less advanced" implies no commitment at this stage.
The market is somewhat panicked by the number and level of recent project deletions or deferrals, but CommBank notes such deletions do not actually make up a large proportion of all projects. Data suggests the value of all projects deleted over the past 13 months (including Olympic Dam and Outer Harbour but not, as yet, the FMG final phase) adds to $51bn or 11% of all advanced and less advanced projects.
A very important point is noted by CommBank: First comes investment, then comes production. While the peak in the mining boom will subsequently reduce future GDP growth, the offset is provided by the ramp-up in exports. And at the same time, imported capital goods required for the construction phase should fall away in number. A worst case scenario, the economists suggest, would be if all existing construction contracts are completed and no more. The private engineering pipeline currently stands at $133bn. At the current rate of work done, the pipeline would be emptied by early 2013.
And let us not forget that iron ore is not all Australia produces or will produce in the future. While we tend to refer to the "mining boom" we are implicitly including energy sector projects. Australia mines more than just iron ore, but resource projects currently under development in Australia, worth some $264bn to the construction pipeline, are two-thirds represented by "very major" LNG projects, the National Bank economists note, and their development extends though to 2017. LNG exports are projected to grow to the level of iron ore exports (and thus GDP contribution) over the next several years, while iron ore exports are not expected to grow by a lot more over the same time frame. It would take a "massive" drop in commodity prices or "very material" cost overruns for Australian and foreign-based energy companies to curtail development of these projects, suggests NAB.
"Instead, the risk lies with the next generation of projects," the economists note. "A number of these projects always were, always will be under doubt - and at any point in a commodity cycle. Lower commodity prices, high development costs, shareholder agitation and, in some cases funding pressures, are placing these proposed projects under far greater pressure than may have been the case several years previously".
Not that none of these projects will ever go ahead, the economists are quick to add. Less ambitious but higher quality projects likely still will go ahead while others will be watered down somewhat, and rationalisation will lead to efficiency. Making allowances for some less advanced projects to still go ahead, NAB could see the "mining boom" peak extending from 2013-14 out to 2015-16 or even beyond.
"On the downside," says NAB, "the only realistic threats to already sanctioned projects are a large scale collapse of commodity prices or encountering very significant technical development issues".
Iron ore has the market panicked, but even the iron ore price is expected to bounce fairly soon by just about every analyst in the market.