A Brief Overview
Metals, given their characteristics -- high strength, durability, conductivity and aesthetic appeal -- command a pivotal role in daily life and economic development. The global population growth, phenomenal rise in the Chinese economy, urbanization in the Asian countries and the increasing requirements in the developed countries have created an unprecedented demand for minerals and metals. The metals & mining industry caters to this ever-rising demand by extracting (mining) and through primary and secondary processing of these metals.
The industry is oligarchic in structure, with certain producers accounting for a lion’s share of the output. The industry is highly cyclical and competitive. Metal producers are subject to cyclical fluctuations in prices, general economic conditions and end-user markets. However, the tepid global economic growth outlook has currently emerged as a major headwind for the global metal industry.
With respect to volume, iron and steel command a majority in the global metal industry, followed by aluminum. We have thus divided the metal industry into two broad parts: ferrous and non-ferrous. Ferrous indicates the presence of iron and it includes steel, iron and alloys of iron. Non-ferrous indicate metals that do not contain an appreciable amount of iron. Popular non-ferrous metals include aluminum, copper, lead, nickel, tin, titanium and zinc, and alloys like brass.
Let’s have a look at the ferrous and non-ferrous industry in detail, including driving factors, price dynamics, performance, outlook, etc.
Mining - Ferrous: Iron & Steel
The steel industry, as well as its provider of raw materials -- the iron ore and coal mining industries -- have historically been highly cyclical and are highly susceptible to general economic conditions. This is particularly due to the cyclical nature of its main customers: the automotive, construction, machinery and equipment industries.
Iron Ore Price Trends
The cost of iron ore is crucial for the global economy as it affects the price of steel and consequently changes the cost of everyday goods. It is also critical for the profitability of two of the world’s largest heavy industries: mining and steelmaking.
In the first half of 2012, iron ore prices were more or less stable before plummeting to a three-year low of $88.50 per ton in September last year. The price was dragged down by low buying activity due to a weak economic environment. It recovered by the end of 2012 due to aggressive restocking driven by Chinese steel mills.
In the first quarter of 2013, iron ore prices attained a high of $160 per ton, aided by strong steel production in China, seasonally weaker supply of the seaborne iron ore and increased demand growth from steel end-consumers, particularly the Chinese construction sector.
However, iron ore prices remained volatile in the second quarter with an average price of $137.4 per ton in April, $124.7 per ton in May and then down to an average price of $114.5 per ton in June. The volatility owed much to the uncertain outlook for steel demand in China. Post-June, iron ore prices have trended higher as sentiment improved across the Chinese metals sector. Steelmakers were no longer destocking raw materials like iron ore, thus necessitating iron ore buying to meet the demand of the steel mills.
Iron Ore Industry Performance So far
Emergence of Chinese industrial demand has led to a paradigm shift in the iron ore market over the last two decades. China has become the largest producer of steel and consequently the largest consumer of iron ore, accounting for around 60% of the global seaborne market.
Incidentally, global exporters of iron such as BHP Billiton Ltd (BHP - Analyst Report), Vale S.A. (VALE - Analyst Report) and Rio Tinto plc (RIO - Analyst Report), which together control 70% of total iron ore exports, largely benefited as China’s inland production failed to meet the burgeoning demand.
Meanwhile, just as the iron ore and steel market recovered from the effects of recession in the second half of 2009 and through the first three quarters of 2011, the Euro-zone crisis and significant destocking caused demand to weaken again in the fourth quarter of 2011.
In 2012, contraction in Europe and a slowdown in China dampened both iron and steel prices. In the first half of 2013, demand continued to be weak, particularly in Europe where demand plunged to about 30% below the 2007 peak.
In 2012, demand in China weakened in response to policy tightening, mainly directed toward the real estate market. However, demand picked up thereafter from the fourth quarter of 2012 on the back of acceleration in infrastructure approvals, which has continued through the first half of 2013.
Major Game-Changing Projects in the Iron Ore Industry
BHP Billiton’s $3.4 billion project of Jimblebar Mine expansion in the Pilbara region in Western Australia is expected to augment its iron ore annual production capacity to 220 million tons. The mine will start producing in the fourth quarter of 2013, and help the company cash on the continued appetite for iron of countries like China.
BHP’s rival Rio Tinto is investing heavily in growing iron ore output in the Pilbara region. Rio Tinto has embarked on a major port, rail and mine expansion, which is touted to be the largest integrated mining project in Australia and will up its annual capacity to 290 million tons. Rio Tinto has successfully loaded its first iron ore shipment from its expanded operations in Pilbara, ahead of schedule, marking the commencement of commissioning of the expansion program.
Separately, Vale was recently granted an environmental license for its $20 billion investment, in new iron ore production capacity at its Carajas mining complex in northern Brazil. This will help Vale to scale up its iron ore production and will be the largest project in Vale’s history as well as in the iron ore industry. It is also considered to be a path-breaking project that will fully replace in-mine trucks with conveyor belts.
Iron Industry: Outlook
The industry has been affected by the falling iron ore prices. However, the companies have stayed afloat by reducing costs to maintain their margins in the falling commodity prices scenario. We see improved future prospects for the industry on the back of ongoing industrialization in China, India and in other developing economies.
The steel industry is considered an economic indicator, as it plays a critical role in infrastructure and overall economic development.
Steel Price Trends
Steel prices have been on the decline in 2013 due to a glut in imports, oversupply in the market from zealous steelmakers, weak demand in Europe and slow growth in Asia. A sustained downside in steel prices will materially and adversely affect the margins of steel companies. We believe that the recovery in pricing momentum will be driven by a reviving economy, stabilization in the Euro-zone and a rebound in construction activity in the developing countries, particularly in China, India and South Korea.
A lingering Euro-zone sovereign debt crisis, economic stagnation or slow growth in developed economies and a cooling of emerging market economies have taken a toll on the steel industry. Furthermore, overcapacity has been a perennial problem. Stiff competition in the United States from cheaper imports and from domestic producers with new or expanded facilities or under-utilized existing facilities continues to result in significant oversupply of steel compared to demand.
Steel Industry: Outlook
The World Steel Association projects global steel usage to rise 2.9% in 2013 to 1.454 Mt. In 2013, the steel industry will continue to face headwinds in the form of overcapacity and surge of imports. The steel companies are going through a restructuring process, which will have a positive impact on operations in the mid to long term. Some of the major industry trends are strategic cost reduction, vertical integration and capital optimization.
Growth in the United States will be supported by strong momentum in the auto sector and recovery in construction markets. Concerns surrounding China’s growth and the European debt crisis remain overhangs on the sector’s outlook.
The overall scenario is expected to improve in 2014 with global demand expected to increase 3.2% to a record 1,500 Mt. The increase will be driven by a further pickup in global steel demand as the developed economies increasingly contribute to growth.
Mining - Non-Ferrous
Given its unique characteristics -- lightness, strength, flexibility, non-corrosive and infinitely recyclable -- aluminum is one of the most widely used metals. The world’s leading aluminum market is China, which accounts for over 40% of global aluminum consumption thanks to the rapid development and urbanization of China. Japan, Europe and the US are next in line in the aluminum market. Aluminum’s main markets are transportation, machinery and construction.
About the Industry
The aluminum industry is an extremely competitive and highly consolidated sector with 40% of global output commanded by the largest producers: Russia’s Rusal, Alcoa Inc. (AA - Analyst Report), Aluminum Corporation of China Ltd and Hydro Aluminum (part of the Norsk Hydro group).
The demand for aluminum in developed countries stems from the rapidly growing auto market. A strong focus on environment and strict restrictions on carbon emissions prompt the automakers to increase the energy efficiency of the vehicles.
Due to its lightness, aluminum makes cars more energy efficient, decreasing fuel consumption and cutting hazardous emissions. In developing countries, the construction industry is the biggest consumer of aluminum as these countries are expanding their infrastructure to satisfy the needs of a growing population.
Industry results suffered because of the decline in realized aluminum prices. Alcoa kicked off the second quarter earnings season with a revenue decline of 2%, affected by weak aluminum prices. Alcoa continued to see pricing pressure with London Metal Exchange (LME) cash price falling 8% sequentially in the reported quarter.
Adaptive Measures to Combat Falling Prices
Following the decline in aluminum prices, BHP had to sale its 33.3% stake in the Guinea Alumina joint venture to Dubai Aluminum and Abu Dhabi state-owned Mubadala. In 2012, it had halted bauxite exploration at its Boffa-Santou-Houda site in Guinea and abandoned plans to build a smelter in the Democratic Republic of Congo.
Rio had earlier planned to sell its underperforming Pacific Aluminum, which has high-cost smelters in New Zealand and Australia and an alumina refinery. However, it had to abandon its plan after failing to find a buyer. Rio will incorporate Pacific Aluminum back under its larger aluminum umbrella, Rio Tinto Alcan group.
Prices have been under pressure, prompting companies to cut back on production. Aluminum prices have fallen to four-year lows and the market continues to be uncertain and volatile. Rusal, the world’s largest aluminum producer, reported losses in the first half of 2013 and announced that it will further reduce production by 357,000 metric tons (mt) in 2013, or 9% compared with 2012. Rusal plans to accelerate aluminum output cuts in the second half. Rusal is also contemplating production halts at its least efficient smelters and cut down production at certain smelters in Siberia.
Alcoa is aggressively slashing costs and pursuing strategies to move down its cost curves in its upstream businesses. The company remains committed to achieving its target of moving down the cost curve by 10 percentage points in smelting and by 7 percentage points in refining by 2015.
In May, Alcoa announced its plans to curtail 460,000 mt over a 15-month period of smelting due to falling aluminum prices and maintain cost competitiveness. In line with this, Alcoa announced closures or curtailments representing 269,000 mt, which included the permanent closure of 105,000 mt of capacity at Alcoa’s Baie-Comeau smelter in Canada and its Fusina, Italy, smelter representing 44,000 mt that was not part of the May review. Recently, Alcoa announced that it will close or curtail 164,000 mt of smelting capacity in the United States and Brazil.
Energy prices and other input costs are expected to pose challenges for the aluminum industry. In addition to the curtailments, the companies will step up activities to reduce the escalating cost of raw materials.
In the medium to long term, aluminum consumption is expected to improve on a global basis. The revival is palpable in the automotive and packaging industries, one of the key consumer markets. The automobile market is also becoming increasingly aluminum-intensive, benefiting from its recyclability and light-weight properties.
The global push to improve fuel efficiency in vehicles is expected to more than double the demand for aluminum in the auto industry by 2025. Further, the surge in substitute metals such as copper and zinc has triggered a switch among manufacturers to aluminum. Automobiles, air conditioners and industrial components manufacturers are now shifting their focus to the more economical metal.
To capitalize the growing aluminum demand for auto production, Alcoa recently broke ground on its $275 million expansion of Alcoa's Tennessee Operations. This marks Alcoa’s second automotive expansion to cater to the car makers. The previous one was a $300 million expansion of Alcoa's Davenport, IA plant that has already begun commissioning and is set to be completed by the end of 2013.
We expect aluminum demand to increase over the next three years, outstripping supply growth. Following China, India also holds promise as its current low level of aluminum consumption and high urban population growth make a favorable combination. As a result, the aluminum market is likely to witness deficits for a prolonged period and creates the backdrop supportive of high alumina and aluminum prices.
Copper is a major industrial metal with its price strongly depending on the economic growth outlook. The metal’s strong cyclical leverage accounts for its nickname “Dr. Copper.” The metal’s popularity in industrial usage is due to its high ductility, malleability and thermal and electrical conductivity, along with its resistance to corrosion.
In terms of consumption, copper holds the third place after iron and aluminum. Construction is the single largest market for copper, followed by electronics and electronic products, transportation, industrial machinery, and consumer and general products.
Movement in Copper Prices
Copper prices witnessed record high levels from 2006 through most of 2008 as limited supplies, growing demand from China and other emerging economies led to the surge in copper prices and low level of inventories. In Dec 2008, copper prices dipped to a low of $1.26 per pound due to reduced consumption, turbulence in the U.S. financial markets and concerns about the global economy.
During 2012, LME spot copper prices ranged from a low of $3.29 per pound to a high of $3.93 per pound, which averaged $3.61 per pound, a 10% drop from 2011. This drop reflected concerns regarding a slowdown in the Chinese economy, Europe’s sovereign debt crisis and a slowing U.S. economy.
During first-quarter 2013, LME spot copper prices ranged from $3.42 per pound to $3.74 per pound, averaging $3.60 per pound. During the second quarter 2013, LME spot copper prices ranged from a low of $3.01 per pound to a high of $3.42 per pound, averaging $3.24 per pound.
Lower prices hurt the results of copper producers like Freeport-McMoRan Copper & Gold Inc. (FCX - Analyst Report) and Southern Copper Corp. (SCCO - Snapshot Report) and Newmont Mining Corporation (NEM - Analyst Report). Demand from key end-markets, including construction materials and electronics, remains weak due to the overall economic softness.
In the wake of recent decline in metal prices, Freeport has reduced budgeted future capital expenditures, exploration and other costs by a total of $1.9 billion in 2013 and 2014.
Freeport has recently taken a major step to venture into the U.S. energy space by wrapping up Plains Exploration & Production Company and McMoRan Exploration Co. for $19 billion as part of the company’s strategy to diversify from its bread-and-butter copper mining business. The merger positions the combined entity as a leading natural resource conglomerate in the U.S., leveraging Freeport’s industry-leading mineral assets and the oil and gas resources of Plains and McMoRan.
On the contrary, banking on strong returns from the copper business, BHP Billiton and Rio Tinto are jointly investing $3 billion in a sea desalination plant that will supply water to Chile’s Escondida copper mine. BHP, which has a 57.5% ownership in the mine, is investing $1.97 billion and Rio Tinto, which owns 30%, will contribute $1.03 billion. BHP Billiton expects global demand for copper to rise by 3% annually.
Copper Industry: Outlook
Notwithstanding the current volatility in prices, we have a long-term bullish stance on copper, supported by its widespread use, limited supplies from existing mines and the absence of significant new development projects. Prices will be influenced by demand from China and emerging markets, economic activity in the U.S. and other industrialized countries, the timing of new supplies of copper and production levels of mines and copper smelters.
Companies that have a high leverage to copper prices will benefit immensely from the potential demand for the metal in the developing markets.
Overall Industry Ranking
Within the Zacks Industry classification, the industry is broadly grouped in the Basic Materials sector (one of 16 Zacks sectors) and is further sub-divided into three industries at the expanded level: Mining – Gold, Mining – Iron and Mining – Non-Ferrous. We rank all of 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available in the Zacks Industry Rank page.
The way to align the ranking and outlook from the complete list of Zacks Industry Rank for the 260+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #87 and lower) is positive, while the outlook for the bottom one-third (Zacks Industry Rank #174 and higher) is negative.
For the Mining Industry, Iron Mining barely makes into the top 1/3rd with its Zacks Industry Rank #81, while the Non-Ferrous (aluminum, copper, etc.) is barely in the bottom 1/3rd at Zacks Industry Rank with a Zacks rank of #222, respectively.
The steel producers industry makes it to the bottom 1/3rd with a Zacks Industry Rank #174, followed by steel–pipe and tube industry producers with a Zacks Industry Rank #198. The steel specialty industry is near the bottom of the list with a Zacks Rank #244.
This indicates that the overall outlook for the steel industry is on the ‘Negative’ side. Given the exact location of the three mining industries on the Zacks Industry Rank, one could say that the near-term outlook for the group depicts a Neutral outlook.
Please note that the Zacks Rank for stocks, which are at the core of our Industry Outlook, has an impressive track record, verified by outside auditors, to foretell stock prices, particularly over the short term (1 to 3 months). The rank, along with Expected Surprise Prediction (ESP) (Read: Zacks Earnings ESP: A Better Way to Find Earnings Surprises) helps in predicting the probability of earnings surprises.
Earnings Performance in 2Q13
Looking at the overall results of the Basic Material Sector, earnings dipped 11.1% in the second quarter of 2013, deteriorating from the 1.8% decline in earnings witnessed in the first quarter of 2013. However, revenues for the sector went down 1.4% in the second quarter, faring better than the 2.1% decline in the first quarter.
Second quarter earnings across all 16 sectors covered by Zacks increased 2.5% with the Finance sector being the only saving grace. Barring the finance sector, earnings dipped 2.9% with the Basic Material sector being one of the laggards. Nevertheless, the Basic Material sector had a beat ratio (percentage of companies coming out with positive surprises) of 56.5%, though lower than the 69.6% noted in the first quarter.
The Basic Material sector has suffered given its heavy exposure to the negative cross-currents in the global economy, particularly the emerging markets. The weak global conditions are a deterrent factor for volumes and falling metal prices has dented the earnings for the companies.
Expectations for 2013 & 2014
The Basic Material sector is one of the sectors experiencing material negative estimate revisions, largely reflecting the overall negative tone of guidance provided by companies. However, the overall projection of a 3.0% dip in the third quarter paints a somewhat better picture when compared with the 11.1% drop experienced in the second quarter.
The sector is expected to return to growth with a 12% increase in earnings. Revenues are expected to rise 1.5% in the third quarter and 2.1% in the fourth quarter.
In the first quarter of 2014, the sector’s earnings are expected to rise 14.3% in the first quarter of 2014 despite a decline of 14.9% in revenues.
Overall Industry Outlook
Cost inflation in the sector is expected to be a headwind for metal and mining companies over the next several years, driven by a number of factors viz. labor, energy, ore grades, currencies, supply constraints and taxes. Global economic uncertainties, softening commodity prices, higher input costs are increasing the pressure on company margins.
To combat this, mining and metals companies are reviewing their portfolios to identify underperforming assets and shut down or divest these high cost and non-core assets. Industry consolidation, automation technology, owner-operated mines and investment in energy assets are some of the steps that companies are taking to mitigate the impact of rising costs.
Persistent recessionary conditions in Europe will have residual effects elsewhere. This synchronized global economic slowdown is the biggest headwind for the metals space at present. Thus, the long-term picture remains a lot more promising as growth in the emerging markets, particularly in China and India, will be a major driver of metals demand.