Foreign companies wishing to conduct business in China often face difficulties. Problematic labour relations, theft of intellectual property, breaking of contracts are all common and can severely impact profitability. So companies which can dictate the rules to China and thus do business on their own terms tend to present very interesting investment opportunities.
"Being able to dictate terms to China is certainly a rare and valuable position to be in"
One such company is Australia’s BHP Billiton, one of the world’s big three mining companies. Having been holders in our regional funds of Rio Tinto, Australia’s other large miner, for many years, we decided in August 2009 to initiate a position in BHP.
The investment case for BHP, and, for that matter, for Rio Tinto too, is both simple and compelling: roughly two thirds of the world’s population is in the early stages of a path to prosperity, a path that will require the consumption of vast quantities of minerals. India and China alone account for 55% of the aforementioned two thirds. The other 45% is accounted for by Brazil, Indonesia, Pakistan, Mexico, and the numerous other countries that make up the emerging markets universe.
The economies of countries in the early stage of development tend to be driven by investment in infrastructure and secondary industries such as shipbuilding, commercial vehicles, and construction machinery. These industries require heavy use of steel, the major feed stocks for which are iron ore and coking coal. While China is itself the largest producer of iron ore, it is not able to satisfy its own requirements, and thus has to import its excess demand from the likes of Australia.
Australia is not only a major producer of iron ore and coal but is also a very low cost producer thanks to rich veins of high grade ore and coal near the earth’s surface. Even after factoring in shipping costs, BHP and Rio’s production costs are still much lower than those of Chinese mines. To get a sense of the prospects for growth in demand for commodities such as iron ore and coal, analysis by Rio Tinto is instructive. According to the company’s research, consumption of iron ore and coal triples as a country grows from GDP per capita of US$6,000 (where China is today) towards US$15,000. It is not clear how long it will take China to reach this milestone, but even conservative estimates imply strong growth in demand.
Besides iron ore and coal, BHP is also a producer of oil, gas and non-ferrous metals, demand for which among emerging economies is also likely to be strong. In fact demand for non-ferrous metals such as copper and aluminium does not tend to level off once economies reach GDP per capita of US$15,000 as it does for iron ore and copper, and continues to grow even as countries enter developed status.
BHP has assured investors that it is able to satisfy demand from emerging countries by investing in new mines. Thus while the price of commodities will no doubt continue to be volatile, not least because of the increased participation of investment funds, it is the expected increase in volume over the next few decades that provides the most compelling aspect of the investment case.
Currently, there is a tense stand off between the three major producers of iron ore, BHP, Rio and Brazil’s Vale, and the Chinese steel mills. BHP is leading an initiative towards spot market pricing and away from benchmark pricing that was introduced by Japanese mills in the 1970s as a way of ensuring the Brazilian miners continued to supply the Asia Pacific region. But the supply-demand dynamics have reversed, and it is now in the interests of the miners to sell at prices dictated by the market.
This looks to have been an astute move by BHP as the spot price for iron ore is now 84% higher than that negotiated with the Japanese steel companies last May. Being able to dictate terms to China is certainly a rare and valuable position to be in and one that should continue to benefit BHP for many years to come.
Published in Euro Magazine
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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