The massive BHP bond issue last week highlights the attractive, predictable fixed income returns available in the resources sector. We assess the relative merits of investing in resources for shares and bonds and recommend strategies for both
BHP’s massive US$6bn subordinated bond issue last week was more than two times oversubscribed. BHP offered the bonds in USD, GBP and Euros, with yields ranging from 5-6% per annum. Clearly the market believed the offer was highly attractive, so it is timely for us to extend our global economic commentary to also cover the outlook for commodities.
FIIG’s outlook for the global economy is for slower economic growth than expected by most, lower interest rates than expected and lower share prices than expected, as we’ve outlined in our research and seminars over the past year.
But what does this mean for the resources sector? In short, we expect prices to be range-bound within 10-20% of current prices until at least 2020. The ‘new normal’ lower prices are already forcing production cuts for less profitable mines, creating both stability in current prices but also a lid on the potential price increases for a long time to come.
This outlook is positive for corporate bonds and equities of the larger producers, but will cap earnings growth so equities should only be considered where PE ratios are below long term averages.
Strong demand for the BHP bonds implies the demand for debt securities from large producers will increase as investors recognise the upside on earnings is limited, but cashflows are strong.
Commodity prices range – bound
1. Low cost producers are the winners.
While equity markets are yet to come to grips with the weak global economic outlook, commodity prices have already priced in this ‘new normal’ scenario. The sudden drop in commodity prices experienced over the past two years is the result of a fall in demand without an offsetting fall in supply.
Supply always lags demand in resources due to the long lead times involved in opening and closing mines. China’s total iron ore production fell 10% in the past 12 months, somewhat stabilising prices in the commodity. More Chinese mine closures are expected with around 90% of China’s mines having a cost base of more than $70 per tonne. BHP’s average cost of production is just $15 per tonne, and RIO’s is even lower.
Similarly, demand for most bulk and metal commodities is expected to weaken slightly in the 2016 given lower supply and prices are forecast to remain relatively flat for 2016 and probably for much of the next five years. The downside for commodity prices is therefore limited to another 10-15%. Iron ore for example is expected to range from $45-55 per tonne in 2016, compared to today’s $53 price level.
Beyond 2016, many forecasters, including the World Bank and the RBA, are projecting annual increases in iron ore prices, but there is little to support this, so we prefer a medium term forecast of around the current USD50 level. In the long term, commodities tend to mean revert for the simple reason that supply eventually responds to demand, so it is worth noting that our forecast is also in line with the average price over the past 35 years of USD49.
Oil is the exception in that the downside risk is considerably higher in 2016/17 as Iranian supply re-enters the market after years of sanctions.
2. Earnings growth will be constrained by chronic excess capacity.
While the downside risk is constrained by the likelihood of reduced supply, the same supply response means that higher commodity prices are unlikely any time in the next decade. The reason is simply that any project that is shut can be reopened quickly in the event of higher prices. This quick response will keep a lid on prices until demand exceeds supply capacity again. This is not likely to occur unless China surprises the world and maintains its 7% p.a. GDP growth rate.
Lower commodity prices for a longer time means earnings growth will be increasingly difficult to achieve for resource companies. Cost cutting will increase earnings only to a certain extent, but after that higher prices are the only mechanism to increase earnings. This will put downward pressure on the share prices of many resource companies.
The end of this range bound phase will likely come when demand from India, Indonesia and Mexico increases due to higher infrastructure investment. The timing is likely to be after 2020 at the earliest. This means that the outlook for commodity prices is range-bound for the next five years and quite likely longer. But with some strong longer term support for demand that will keep the big resource producers, ie those able to cut production costs, in profits for well beyond our lifetimes.
3. Australian resource producers have a natural hedge via AUD.
Australian mines, that are costed in Australian Dollars, have a natural hedge in the event of lower commodity prices; the commodities-linked AUD. The AUD is very closely correlated to commodity prices, and in fact has become a proxy for emerging market currencies. This means that if demand for commodities falls further and therefore prices fall, Australian producers, paying their costs in AUD, will see their costs fall too.
Higher volatility in the short term, then lower PE ratios and lower dividend payout ratios
Relying on cost cutting reduces the upside potential for earnings growth. This means that resource stocks with a high PE ratio are likely to come under pressure. There will also be pressure on those with high dividend payout ratios, although it is expected that the large producers such as BHP, Vale, RIO and Fortescue will be able to reduce costs sufficiently to justify paying some level of dividends to their shareholders. Macquarie Group’s research on BHP and RIO highlights the risk of dividends being cut if commodity prices do not rise, and several other leading researchers have made similar forecasts.
Questionable profit growth for the resource sector means equity markets will be very sensitive to commodity market volatility. This means that for the next 5-10 years as the world gets used to a slower China, equity market volatility for resources stocks will be high.
Range-bound prices mean stability, and cashflows for large producers will be strong
For fixed income investors, the large producers will offer good value while equity market volatility continues. These producers typically have very strong balance sheets after years of high cash flow, and as they have lower cost bases or at least the ability to lower them further, they have the capacity to maintain strong cashflows at current prices.
Over time, it is likely that credit spreads on these securities will fall, increasing prices. In the immediate term, there will be opportunities to buy the securities at attractive yields due to the volatility associated with the market’s adjustment to the ‘new normal’.
So, should I avoid or invest in resource companies?
The doom and gloom talk about resources has been well and truly overdone. For both equities and fixed interest securities, selling has been overdone. The outlook for larger producers is very strong in terms of cashflow, but limited in terms of earnings growth beyond the immediate term’s cost cutting gains. Limited upside on earnings is fine for bond investors, but something to watch for equity investors if PE ratios or dividend payout ratios are too high.
1. For equities:
a. Volatility will continue through much of 2016, particularly for those companies with high long term PE ratios.
b. Avoid companies with long term high dividend payout ratios above 70%. If dividends are cut, share prices will be savaged in the current yield hungry market.
c. Share prices are sustainable for those larger producers with no dividends and low PE ratios.
d. Look for takeover targets whose share price would rise on a bid.
2. For corporate bonds:
a. Given the strong cashflow outlook, corporate bond yields are currently very attractive for the large producers.
b. For shareholders in larger producers such as BHP and RIO with higher dividend payout ratios, consider a switch to corporate bonds. Dividends will be cut long before bond interest payments are impacted.
c. Small producers that are unable to reduce costs should be avoided.
Issues such as the new BHP bond, offered in non-AUD denominations are particularly attractive to Australian investors. In the event that China continues to slow down, the AUD will fall relative to the USD and GBP at least, meaning that investors in the USD issue will profit on the currency. Further, the strength of BHP’s balance sheet means that it is unlikely to see a fall in credit quality.