What is currently transpiring in bulk commodity markets, coupled with forward investment guidance, suggests the RBA does indeed believe it is at the limit of its range with traditional measures.
So when terminal velocity in rates is reached, what next? The RBA can only do so much.
There are three things I believe are already happening, judging from the state of the commodity cycle and the fact the RBA wont step in to save them.
- Inefficiency is (and will) be punished
- State and federal governments will scramble to subsidise the struggling sector
- Predators are everywhere (I’ll look to go long investment banks as they are the only winners here)
The story at Atlas Iron is, in my opinion, the beginning of the end for inefficient, high-cost, low-quality, highly indebted operations.
Atlas has consistently pulled out ferrous contents between 55% and 58%, leading to mass haircuts of US$10 to US$15 per tonne sold. It’s estimated that Atlas’s breakeven point is US$63 a tonne and that’s based on a ferrous content of 62%, meaning price would need to be US$73 to US$77 a tonne due to its haircut.
Its current net debt stands at $158 million (as of the February half-year update). Its ability to service this debt two months ago was severely impaired by the spot price as it stood in the mid US$60s at the time. Today’s price makes it impossible for AGO to service that debt, let alone servicing normal operations.
The Atlas story is not limited to iron ore alone – high-cost, highly-indebted companies in oil, coal and copper are in the same situation and the market will punish those who cannot survive. I see this as a new world for bulk commodities.
Tax breaks followed by actual cash handouts will eventuate as the current situation deepens. When this happens, it will be a sign to completely exit. The dead hand of government will signal ultra-low growth and a firm that is unlikely to ever break free of support.
Governments in Australia, Brazil and China are rushing to support their respective local companies and will continue to do so. The Western Australian government has already deferred royalty payments for BC Iron and I expect more to follow. China has now announced that it will halve the tax rate to its local producers to improve the competitiveness of local firms that are being outgunned by Brazil and Australia.
China is also looking to reduce its reliance on Australian- and Brazilian-based producers by buying up mines in both countries. CITIC is now months away from adding to the supply gut with the opening of its Australian mines and will be given preference into Chinese ports on shipping from these operations. This is just adding to the layers of competition - the supply war is far from over.
The winners of the current commodity market will ultimately be investment banks as distressed assets are abundant and M7A deals ramp up.
On a fair-value basis, BG Group was trading at approximately a 25% discount before yesterday’s takeover offer by Shell. Admittedly the assets BG holds are tier 1 and globally diversified in the main, which gives Shell instant scale in the LNG world, making it a very strong target.
However, what this deal means is those companies with quality tier-1 assets or tier-1 assets that are almost complete and have exposure to Asia in particular have seen their market value plummet due to the spot price. They’re now on notice - predators will be circling.
The rulers are out and advantageous bids will be launched – Bradkin is a case in point, as is PanAust. They won’t be the last. M&A deals will be coming thick and fast in the coming years – so I’d say go long investment banks.
The next leg of the mining cycle is here – and from what I am seeing we are at the beginning of a massive consolidation phase, coupled with cash handouts for the poor performers and cash takeovers for those with quality. Do your homework and you may find an M&A gem while staying clear of the rest.
We are calling the ASX 200 up 13 points to 5979.