Hugh Dive, Head of Listed Securities

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Tales from the Trenches - Prices are down, but volumes are up!

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Whilst the downward trend in commodity prices since 2010 is often interpreted as a sign the commodity boom is over, the overall increase in the volume of minerals being exported gets very little attention in the financial press. Obviously a company's revenues and profits are determined by quantity sold multiplied by price, not just by price alone. Philo Capital view that we are moving into stage three of the mining boom, which will be dominated by the high volume low cost producers. Over the last week Australian listed resource and energy companies have all reported their production results. In an environment of falling prices, the companies that are able to deliver higher volumes from their assets at lower costs will be the winners. In this piece we are going to look at the winners and laggards and the themes coming out of the production reports released over the past seven days.


Production Reports

Production reports provide a guide to the profits and ultimately dividends that the mining and energy company will present to their shareholders in August.  These reports indicate the operational performance of a company’s mines or oil wells, along with the average prices the company has received for their minerals or hydrocarbons.


BHP delivered a very solid production report and ended the 2014 financial year on strong note, delivering record production of iron ore, metallurgical coal and petroleum. BHP also upgraded their production guidance for 2015, indicating a stronger than expected year for iron ore. Clearly the company is achieving improved productivity out of its assets, which will serve to maintain profits and returns to shareholders in an environment of lower prices. Based on these production numbers and the resulting higher cash flows, we see that BHP will be well placed to announce capital management initiatives at their results in August.

Similarly Rio Tinto reported record iron ore shipments (+20%) in 2014 and that its Pilbara iron ore system of mines, rail and ports reached a run rate of 290 million tonnes a year, two months ahead of schedule. The company also upgraded 2014 guidance for copper, based on better than expected grades at Kennecott Utah Copper and the ramp up of the giant Oyu Tolgoi in Mongolia. As with BHP, Rio Tinto is driving higher productivity out of its iron ore assets with a large amount of this extra production being produced with minimal additional capital expense.

Shareholders in Woodside Petroleum enjoyed a range of good news after the company reported production ahead of expectations and raised full year guidance from 86-93 Million Barrels of Oil Equivalent (MBOE)  to 89-94 Million Barrels of Oil due to the strong performance from the Pluto field. We were also impressed that Woodside’s LNG prices were up +20%.  This has occurred as legacy contracts for LNG (which were signed at a discount to help develop the Pluto field) come to an end and have been repriced upward.

Santos reported mixed production that was below expectations. The company benefited from production at PNG LNG coming online earlier than expected, but also suffered from lower productivity out of their base business. The company’s US$18.5B GLNG project also looks to be facing strike action which could cause delays. 


Unlike the large diversified miners which surprised on the upside, Fortescue Metals shipped 124 million tonnes of ore in 2014 versus guidance of 127 million tonnes. What was more concerning to the market was that the company’s ore had been sold at a 20% discount to the benchmark index. This discount is due to both the lower iron ore content in Fortescue’s ore and higher levels of impurities such as alumina (Al₂O₃) and silica (SiO₂). To put this in perspective in the first six months BHP received an average of US$96/t for their iron ore, wheras Fortescue achieved US$82/t.

Australia’s largest gold miner Newcrest has had a tough couple of years and has seen its market capitalisation shrink from $30 billion to $8 billion. Pain continued for shareholders after Newcrest announced that it would be writing down the value of its assets by A$2.5-$1.5 billion, mostly linked to its Lihir gold mine in Papua New Guinea. Unlike the large diversified miners, Newcrest has struggled to reduce costs and drive increased production out of its assets and is not expected to pay a dividend over the next few years.

Juniors doing it tough

Junior iron ore producer Atlas Iron announced that they had shipped slightly more ore that expected. Whilst normally this would be a cause for celebration amongst shareholders, based on the heavy discounts the company had to take for its ore and its high cost of production, Atlas actually lost money selling iron ore over the last 3 months! Steelmaker and iron ore miner Arrium faced the same issue in that it was forced to accept large discounts from Asian buyers for its lower grade ores after their higher grade iron ore was disrupted by weather. OzMinerals reported higher production, but managed to burn through 60% of the company’s cash balance over the last six months due to adverse working capital charges. This is concerning for a company whose main mining asset is expected to run out in 2018!


One of the key features from the past week’s report was the growth in production was being delivered ahead of schedule from the large low cost producers. This is putting downward pressure on prices, which is clearly hurting the smaller higher cost producers more than the big end of town and will discourage further investment outside the majors. Furthermore it was clear that investors have to pay attention to the quality of the product that iron ore companies are producing, rather than just look at the headline price. Those companies with lower quality product are being penalised by the buyers.

At Philo Capital we view the mining boom can be broken up into three stages. During the first stage (2004-08) prices surged making marginal projects suddenly very profitable, which boosts the share prices of small resource companies.  During the second stage 2010-2013, we saw significant capacity added in both energy and minerals, which resulted in strong profits from contracting companies benefiting from this capital expenditure. We see that we are now in the third phase of the boom, with declining prices, but accelerating volumes from completed projects. During this phase, the large low cost producers will benefit from their higher volumes and reward their shareholders, whilst the smaller higher cost miners should face a long period of financial stress.


This article has been prepared by Philo Capital Advisers Pty Ltd ABN 70 119 185 974 AFSL 301808 (Philo) and contains general investment advice only. The information in this article does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information readers should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, neither Philo nor any of its related entities accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this article. The information in this article is based on information obtained from sources believed to be reliable and accurate at the time of publication but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. Past performance is not a reliable indicator of future performance. Any forecasts included in this article are predictive in character and may be affected by incorrect assumptions or by known or unknown risks and uncertainties. Nothing in this article shall be construed as a solicitation to make a financial investment.

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Hugh Dive, Head of Listed Securities

Prior to joining Philo, Hugh was Head of Basic Materials Group Investment Research; covering the chemicals, building materials and steel sectors. In the 2011 Reuters StarMine Equity Analyst Awards, he was rated 5th overall in Australia for stock picking and first in the Diversified Industrials and Chemicals sectors. Hugh has extensive portfolio management experience gained at Investors Mutual, with a successful track record managing both small and large cap value funds. In 2009, one of the funds he helped manage, the IML Future Leaders Fund, won the AFR Smart Investor Award for the best Australian small cap fund.

Hugh started in funds management with CC&L Investment Management in Vancouver; Canada’s largest independent fund manager with C$37B under management. At CC&L he focused on asset allocation and then Canadian equity analysis. Hugh holds bachelor’s degrees in both Economics and Law from Sydney University and the University of British Columbia, Canadian Securities Course (Honours) and is a CFA charter holder.


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