Resources sector: boom or bust?

By Angus Geddes, Fat Prophets

The resources sector faces further tough decision-making in 2013 as the high Australian dollar, lower commodity prices and higher input costs strangle the returns on expansions and new projects.

The $270-billion investment pipeline of work in place will sustain earnings and activity for many years, but it is the next $246 billion of potential resource investment that is in jeopardy.

For a decade or more, Australia and its giant resource projects have been lulled into a "she'll be right" stupor as soaring commodity prices sent revenues skyrocketing.

The big resource companies have enjoyed a bonanza, especially from Pilbara iron ore and Queensland coal, but the price party is over and only those with world-class assets, lower costs and established infrastructure will be able to keep shareholders happy.

The liquefied natural gas (LNG) industry has had similar issues, leading to project cost blowouts of huge dimension.

The principal driver of commodity demand has, of course, been China, but even the great urbanisation trend and its associated infrastructure demand for roads, rail, hospitals, power generation etc. have come off the boil this year.

China's economic growth rate has eased towards 7 per cent, but the country's new leadership has a window of opportunity to reset parameters and policy to reignite the momentum. This is a key prerequisite for Australia's resource sector to find its mojo in 2013.

Oil

The oil price is the world's temperature gauge of geopolitical risk and it looks as though 2013 might bring a fever.

QBFO daily oil chart - Q1 2012 to Q4 2012

Source: Fat Prophets

Iran and Israel are at the epicentre of political tension across the Middle East region and who knows what level of uncertainty that will bring? Iran's posturing on uranium enrichment sounds about as convincing as Japanese whaling for research purposes, but with potentially much deadlier consequences.

At time of publication, Israel's frustration with its neighbours is verging on a much bigger conflagration that could engulf many other Arab nations simply based on religious alignment.

China is flexing its muscles in the South China Sea with Japan and others, as a concerned US military machine peers into the Asian arena. The unpredictable North Koreans have gone a little quiet but cannot be taken off the watchlist of geopolitical problems.

The combination of these particular flashpoints will keep world oil prices bubbling at or above US$100 a barrel. The US Strategic Oil Reserve remains a crucial backstop in any circumstance.

Gold

Demand for gold as a default currency has probably never been higher.

Quantitative easing (a form of monetary policy to stimulate economic growth) remains the predominant central bank theme around the world, with consequent downward pressure on the major currencies. As the US Federal Reserve maintains the mantra of "lower interest rates for longer", echoed by many other countries, demand for gold will rise, and its price will rise.

Strong jewellery demand from an increasingly wealthy Indian and Chinese middle-class is being supported by central bank buying of physical gold, providing further support for the price.

Big gains in the Australian-dollar gold price (the blue line) since 2005

Source: Fat Prophets

Bulk commodities

Of all Australia's resource commodities, the bulk commodities of iron ore and coal have epitomised the boom with vast open-cut mines dotted with ant trails of gigantic dump trucks, never-ending ore trains slithering over the outback to desolate ports and cavernous ships, destined mostly for China.

As China's economic growth rate has inevitably succumbed to slower world growth, so too has the demand for crude steel constituents - iron ore and coking coal. The chart below shows the relationship between the iron ore spot price (the red line) and Chinese economic growth (the black line).

Relationship between the iron ore spot price (the red line) and Chinese economic growth (the black line)

Source: Fat Prophets

Yet Australia's proximity to China (relative to Brazil and Africa) and its high-quality ore will continue to provide an increasing proportion of China's raw material for crude steel.

Between Western Australia's iron ore and Queensland's coal reserves, the country has a big enough bread basket of commodities to feed developing Asia's appetite for essential raw materials. The chart below, from BHP Billiton, shows its expectations for rising steel production demand.

Global crude steel production - 2000 to 2025F

Source: BHP Billiton Forecast

BHP, Rio Tinto and Fortescue Metals Group provide by far the largest part of the Pilbara iron ore pie and have committed to hoisting capacity substantially over the near term. But the increase in volume of product from Western Australia will be nowhere near what the companies had until recently been planning.

BHP, instead of building its US$20-billion Outer Harbour project at Port Hedland as part of its march to 440 million tonnes per annum (mtpa) of iron ore, will be working much harder to wring 260 mtpa out of its existing assets.

Rio Tinto will plough on towards its mammoth target of 353 mtpa after it reaches its first-stage target of 283 mtpa next year, but will think long and hard about the next phase.

Fortescue has yet to decide if it can commit to tripling its capacity to 155 mtpa, and Gina Rinehart's Roy Hill saga drags on as funding problems plague the $10-billion 55 mtpa project.

The important themes for 2013 will, therefore, be the productivity improvement drive and the re-costing of expansion plans.

Coal

The same themes apply to coal mine developments because prices have slumped and development costs have spiralled.

Xstrata's Wandoan thermal coal project could either become Australia's biggest coal mine at 22 mtpa or it could find itself on the casualty list awaiting better financial conditions.

Queensland projects face additional barriers over rail and port infrastructure, which is a mish-mash of privately and publicly owned facilities. Infrastructure is the real choke point in the Queensland resource equation and progress is hindered by too many vested interests.

Company watch

Investors should keep a very close eye on the two majors, BHP Billiton and Rio Tinto, which have spent most of this year revising capital expenditure plans. The catalyst will be any hint of economic reform from China's new leadership team that will kick-start demand for steel production.

(Editor's note: Do not read the following ideas as share recommendations. Do further research of your own or talk to your financial adviser before acting on themes in this article).

Rio Tinto is the most leveraged to iron ore, while BHP has additional exposure to copper and oil prices. BHP's search for a new chief executive will take time, but will likely bring with it a new set of priorities. In the meantime, don't expect to see BHP making any substantial new takeover bids.

Fat Prophets believes one way to play the gold price is through Evolution Mining, which has four good producing sites and a fifth well on the way.

In oil, Woodside Petroleum CEO Peter Coleman's considered approach is a welcome change to the breakneck pace of his predecessor. As the company's LNG projects inch forward, Woodside has stepped up its efforts to re-gather some momentum from its oil and gas portfolio. Potential new investments in Cyprus, Israel and Myanmar could lift Woodside from its lethargy.

About the author

Angus Geddes is chief executive of Fat Prophets, a leading investment newsletter.

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