The return of the super-cycle
Chinese demand for minerals is on the rise, again.
Summary: The latest GDP numbers from China, showing growth of 6.8 per cent, has shredded any suggestions its economy is slowing. Coupled with a national clean-up program, Australia’s miners remain very well placed.
Key take-out: With minerals demand from China set to increase, miners will need to ensure they reinvest more capital into their operations. But that would need to be at the expense of higher dividend payouts.
No one has been brave enough to refer to the recovery in the resources sector over the past 18-months as the start of a new super-cycle in mineral prices, until now.
More importantly, the revival of the largely discredited super-cycle term has come from the same investment bank which coined the expression a decade ago to describe China’s insatiable appetite for resources and its effect on commodity prices.
Goldman Sachs has returned to the scene of the original phrase, tipping the start of a new super-cycle, though with subtle variations – but there’s no change in the result: higher prices.
China is at the centre of the new super-cycle, according to Goldman, but this time it will play a key role in driving mineral prices but cutting domestic supply, even as its economy continues to grow rapidly.
The other factor in the new super-cycle is that western-world mining companies will play the same role. They will be slow-reactors to the change in China.
Mining companies were slow to respond in the original super-cycle because of doubts about the sustainability of Chinese commodity demand. This time they’re being slow to react because their capital is being re-directed into dividends rather than mine development.
China’s big clean-up
The net result of events in China, which are largely the result of a countrywide environmental clean-up and the forced closure of heavily-polluting mines and processing plants, is that locally produced materials, such as iron ore, metallurgical coal, zinc, bauxite and alumina, are experiencing a shortfall in supply.
Alumina and rare earths are two of the best examples of what’s happening inside China, with output of both being reduced because of the pollution generated in their production.
For Australian companies such as Alumina, one of the world’s biggest suppliers of the aluminium feedstock, and Lynas Corporation, the only major rare earth miner outside China, the result is stronger profits and higher share prices.
Alumina is trading at a six-year high of around $2.43, having risen by 50 per cent over the past 12-months, Lynas, which suffered a near-death experience five years ago thanks to low prices and trouble building a processing plant in Malaysia, is up 225 per cent over the past 12-months ago, rising from 6c to 19.5c.
“The 2004-to-2012 mining super-cycle was driven by the mismatch in timing between Chinese demand growth and global supply growth,” Goldman said.
“We contend that we are again in a period of mismatch between demand growth and supply growth, which could facilitate a period of stronger-than-normal commodity prices.
“This time, however, rather than double-digit demand growth driving a mismatch and pricing volatility it is supply rationalisation, both domestically in China and by major western mining companies.”
For China, an environmental clean-up has emerged as a major political issue, especially in smog-choked cities such as Beijing, with the crackdown on polluting factories likely to last years, backed by massive investment in renewable energy, and nuclear power, to replace coal.
In theory, this shift in locally supplied resources, should be creating a significant new opportunity for international suppliers of raw materials.
Dividends over development
In fact, most of the big miners have shunted exploration and development onto the back-burner, with shareholder rewards top of board agendas.
“While miners are making more money in the current commodity-price environment they appear more focussed on returning capital than investing in regenerating supply,” Goldman said.
“Of every dollar of excess cash generated by strong prices, we estimate 53 cents is being returned to shareholders.
“This is returning (mining) sector exploration and mine development to a level last seen a decade ago.”
The headline on the Goldman report best summarises the situation: “Underspending their way to the next super cycle”, a comment on the lack of exploration and mine development planning even as China’s appetite for imported raw materials expands.
Apart from satisfying the demands of shareholders who suffered several lean years in the commodity-price downturn after the original super-cycle, it is possible that mining-company management is not convinced that China’s environmental clean-up will be a long-term event.
In the case of BHP there is also the issue of maintaining a high dividend payout ratio to satisfy activist investors such as the US fund manager Elliott Management, which is demanding even greater generosity in dividends and share buybacks.
The challenge for the miners is that they have a business model based on extracting ore that must be replaced when a mine is depleted or, as Goldman puts it: “you need to find it to mine it”.
As for the longevity of the supply cutbacks in China, the bank’s view is that they will be long-lasting, partly because of political pressure and partly because a substantial amount of China’s mineral inventory is made up of low-grade, high-cost, ore.
“Insatiable metals demand in China saw China’s contribution to global supply increase from around 10 per cent to around 20 per cent,” Goldman said.
“Much of that increase in supply was from low-grade, high-cost, operations with a negative environmental footprint.
“With China now increasing supply-side structural reform, domestic volumes are being negatively impacted.
“Consequently, Chinese production volumes of many materials are likely to be lower in 2017 than in previous years.”