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Like U.S. housing in the last crisis, China is the nexus of the oncoming one. Base commodities and the countries heavily reliant on their exports are in serious trouble, and may create a domino effect to an already struggling global economy. Iron ore stands out given the extent of the price boom, misallocation of capital, and concentration to China.
I’m going to use this as a soapbox for some macro views on the general thesis of how a China boom is best looked at and some ways to play it. I have gone back and forth whether this is worth posting and is value add. It may not be new news and there was a fair bit of talk about China earlier this year on VIC, but one cannot spend too much time on this issue and especially on the ramifications of a China collapse. Hopefully this can restart more of a discussion on various themes and trades.
If you don’t think China is in serious trouble, particularly due to their massive credit explosion, housing bubble, inefficient economy, massive overcapacity, and the misallocation of resources on a near historic scale, then this write-up isn’t for you. There are many very excellent sources for that information (if interested in the comments I will list my favorites) and a very long discussion on VIC. While I have my specific take, my goal here is to discuss the implications and anatomy of the crisis. I would like to get a longer conversation about how things play out in the comments, and I would be happy to elaborate more on my thoughts about China. There is nothing more important to think about and plan out, then the ramifications of a once in 30 year bubble bursting as China will be.
How the Boom/Bust in China will Impact the Rest of the World and the Anatomy of How it will Play Out
After the rubble settled in 2009, it was in vogue to discuss how the crisis could not have been predicted. However, the nexus of the 2008 collapse, U.S. housing started to deteriorate almost 3 years before there was a full global meltdown. To see it coming was just to understand the inner workings of the system and the domino effect that would take place. 2008 was a grey swan, not a black swan and the slow evolving crisis is playing out again in China. If subprime housing was ground zero from 2005-2007, China is ground zero with a 2011-2013 devolving timeline leading to a 2014 crisis. Mining sectors peaked in mid-2011 making them some of the first assets to start declining, just like homebuilding stocks topped out in mid-2005, over 2 years before the S&P. The July-August 2012 episode for iron ore, when it dropped $30 dollars in a matter of days from a supposed floor of $120, was very similar to the August 2007 subprime shock when the market first experienced a serious volatility episode that finally caught the world’s attention, if only briefly.
Today, people discuss a soft landing in China or create a false paradigm that a soft landing is 7% GDP growth but a hard landing is no worse than 5%. This further leads the hypothesis that China cannot pose a significant issue, because it is already well disseminated. Yet, everyone knew there was some housing froth from 2005-2007, at the time the soft landing was “goldilocks.” In each bubble, there is always some buzzword for the concept of a dip from a top to what is in fact still overbought extreme that is perceived as a new sustainable normal. Everyone is then lulled into complacency. The variant view on China is not that it will be okay versus a soft or hard landing; it is that things are much worse than the complacent soft/hard false paradigm consensus. China is a massive grey swan; while the data is in plain view, there is a misconception that it is understood correctly, giving the false illusion of being prepared. There has never been a soft landing in the history of any bubble.
I do stress one reason why there is such a misperception to the degree of problems in China: China as an economy is covered for media dissemination and popular consensus by economists. Economists love data and they use it almost entirely to make their conclusions. The problem is that most of the data out of China, particularly the kind a standard economist uses for economic analysis, is questionable at best. Short sellers know that a fraud is a fraud and if you cannot trust the numbers, you would be a fool to think it cannot go a lot deeper. There is no such thing as a 50% fraud. This was the problem with the reverse merger China frauds. The logic would be if it is only a 30% fraud, then it is really cheap. Economists know the Chinese data is suspect, so they might qualify their conclusions because the data is questionable. However, they still conclude that the GDP is growing at 8% anyway (or only 7.0%!). It is no accident that short sellers like Chanos, trained to discredit data, were among the first to express concerns about the quality and reliability of Chinese growth.
Every crisis needs leverage and a transmission mechanism. If fundamentally China has a problem of the misallocation of resources, then the key consequence for the world has been a breakdown of the invisible hand pricing goods accurately. China has been the marginal buyer of nearly every commodity for the last handful of years. Irrational users, not reflecting sustained rational demand, have created a global commodity bubble. The conclusion often missed is, while mining supply may be inelastic in the intermediate term, the largely price agnostic Chinese buyers are divorcing prices from the cost curve and economic reality. This has in turn created operational leverage throughout the global economy. Technically the world should be better off with cheaper commodities. In the short run, with the marginal buyers using debt to buy these commodities, the effect has been massively reflationary and created a net wealth effect. People blame Bernanke for irresponsible commodity inflation, but he is nothing compared to Chinese. This is a major factor in the perversion of commodities being positively correlated to markets in recent years. Without the bid on commodities propelling wealth throughout the system, the easy money from western central bankers that people think is the true bid on global markets may prove to be a useless liquidity trap. The empty gun of Bernanke will be revealed if the Chinese no longer provide cover.
This leads to a conclusion about how destructive the 2009-2011 stimulus initiative was for the long term economic health of China. It is bad enough that China did an enormous amount of wasted uneconomic fixed asset investment that is now poorly maintained and will in large part fall into disrepair such as the New South Mall. The worst part is that by bidding largely against itself and pushing up raw material prices far above marginal cost, it has caused a massive loss of wealth. It will be challenging for China to rebuild its economy after a bust with the country’s cheap labor and demographic dividend largely in the past.
The transmission mechanism that will take this disease that started quietly in the summer of 2011 and spread it globally are the CRABS. Perhaps Jim O’Neil would have reinvented himself with this acronym if he wasn’t so busy with his love affair with China. Instead, I beat him to it. The CRABS are the commodity rich countries that are riding China’s spending spree. They are Canada, Russia, Australia, Brazil and South Africa. There are clearly many other smaller countries such as Chile and Indonesia. These are countries that have all been booming on top of China and many have housing bubbles of their own. The CRABS have a total GDP of ~$8 trillion versus China’s GDP of $7.3 trillion. Combined, the CRABS and China have GDP close to that of the U.S. or Europe. This is the part of the world economy that is supposedly healthy and what the world is counting on to drive overall global GDP growth. One might also call this the end of the secular bull market in the emerging market countries, as many emerging markets have been fueled by commodities. If this whole area goes into a recession, who will make up the slack with Europe and Japan on life support and the U.S. struggling along? This is how we get the next global recession.
While all the CRABS are interesting derivative plays off China, Australia is the most interesting due to the country having the closest ties to China growth and a much deeper and more liquid financial market than many other countries. Canada, while similar to Australia and despite their housing/consumer debt problems, should fair better due to their integration with the U.S. and stronger exposure to commodities that are not as tied to China. Brazil is probably interesting, but I don’t have a good handle on it and would be interested if someone has some good ideas. Russia strikes me as already very beat up.
South Africa is interesting because it is a country facing secular decline despite all time commodity strength. Its mines have been in operation for a very long time and they are some of the oldest and most troubled in the world. The country is struggling with social issues and weak political leadership and instability, even during the biggest tailwind it could have. Shorting the RAND or a basket of South African companies seems like an interesting idea, as things could unravel worse than a normal business cycle recession.
A final note on the CRABS: Looking around the world today, what seems very dangerous to me is that there are almost as many housing bubbles, as there are ones that have busted in the past 5 years. It appears the world hasn’t fully learned just how destructive that was. Every country thinks, for whatever reason, its housing market is rationally expensive and should exist outside the laws of gravity. When has that ever worked out? Many of these housing bubbles are in these commodity boom countries so this is another angle to the domino effect.
There’s a lot of good material already published on why Australia is in big trouble. I highly recommend the recent Variant Perceptions piece that compared Australia to Spain given its high consumer debt and balance of payment issues. Shorting the Australian dollar is as good a trade as there is in the next 2-3 years particularly since it is still less than 5% off its all-time highs, whereas most of the commodities linked to AUD are in 18 month bear markets. Besides iron ore, coking coal is the main commodity driver for Australia. Regardless of a China slowdown, Mongolia is going to disintermediate Australia over the longer term, given their cheaper costs and proximity making Australia, to some degree, a secular short. It’s also a unique setup to short an economy that has not had a recession in 20 years; it has been my takeaway from history that the longer the natural business cycle is postponed, the nastier the inevitable recession is when it hits.
The main point about the Australian dollar is one way or another it has to weaken, because it is at an intolerably high level. I was in Australia several months ago and figured out that just about everything was 30% more expensive than most other high end major metropolitan cities across the globe. With the high prices hollowing out the domestic economy in a classic case of Dutch disease, either the RBA is going to weaken the currency (or at the very least cap the upside) or a commodity collapse will do it on its own. Part of the setup persisting from this summer has come from the notion that Australia with its AAA rating was a safe haven to move money. Flows from the trend and classic carry trade/yield pigs have been overwhelming macro-economic fundamentals in the short run. I like to joke that most advisors would outperform 98% of their peers if they just liquidated their equities to short AUD and went to the beach for 2 years even if the optics would make this highly impractical.
Another interesting trade off of the Australian dollar is to take the concept that the whole world is undergoing a debt deleveraging/housing crash, but some parts of the world have not started it yet (e.g. China and the CRABS). EUR and AUD are both risk-on currencies and reasonably correlated, reducing the volatility of the trade vs a straight AUD short. Both Europe and Australia are going through or about to go through serious debt problems amid structurally unbalanced economies. However, the EUR is 3 years into its crisis and pricing in a lot of this weakness while the AUD is not. It’s hard to see the AUD going above $1.10 with the EUR below $1.20. However, in a major shock the EUR could go towards $1.00-1.10 with the AUD heading to $0.60-0.65. This creates a trade at 1.26 today with downside to ~1.10 but upside to ~1.70, for roughly a 3 to 1 risk/reward. It’s important to note in 2008/2009 when Australia didn’t even technically hit a recession, EUR/AUD went over 2. I am a strong fan of a straight short on AUD, but a EUR/AUD cross is also an interesting long term play.
EUR/AUD 5 Year Chart
It is instructive to look at the solar industry over the last two years for what is about to play out in the steel industry. In both cases, there is an industry where demand was being artificially boosted by government stimulus that has faded away, but not before the industry and supply chain totally mistook this non-normal boost of demand as an indication of an ongoing growth trend. The industry built out supply for growth rates off unsustainable demand levels creating a mistaken ramp up of supply with a long lead time. Compounding the problem as the dynamic starts to shift, will be unprofitable bad actors in China that exacerbate the issue and make it more difficult for the market to find a natural bottom. The core of the problem is that if China needed 100 million tons of steel and a mill produced 5 Mtpa, they would build 20 mills, forgetting that there was a year 2 (let alone year 10) of production. This pretty well sums up China in a whole but steel is perhaps the core of this problem.
The dirty secret on iron ore is that it is not a commodity that is becoming rarer or even much more expensive and harder to extract; the world is still awash in iron ore. It is just particularly capital intensive with long lead times to build out mines given the scale and infrastructure needed. 2013 is the turning point when the time to market and capital barriers end and a deluge of supply starts flooding the market. For a non-rare commodity where supply becomes unconstrained, prices should revert to the marginal cost. Iron ore prices were persistently in the mid $30s before the recent bubble. If prices revert as all bubbles do, the long term iron ore price should be at best in the $60s. It should be noted that the cost curve should shift down as the boom ends and cost pressures ease.
The supply chart below illustrates the massive supply that begins to hit next year. This chart is from October and it doesn’t factor in the 40Mt Fortescue Kings expansion that is not technically in the queue at the moment but will be restarted given the incremental cost vs project economics. The production is likely to hit the market near the end of 2014. This graph only shows the major producers and thus leaves almost 100Mt of ancillary global supply additions that is still expected in the next four years. Except for some of the FMG and the MMX, this is all the very low cost supply that given how far along construction is, will be economical to complete in any scenario.
Iron Ore Expansion Plans
Source: Genco Shipping and Trading
The second chart from a must read iron ore report on 12/17 from Credit Suisse does an excellent job of reconstructing a true iron ore cost curve. As discussed below in particular relevance to Fortescue, the typical iron ore cost curve graphs are highly deceptive in reflecting the actual economics of the mines. Instead, the CS approach is to construct more of a margin curve like how one would adjust for copper credits in gold mining. The first bar adds back to reported cost indirect operating items such as royalties, corporate costs, and sustaining capital. The second bar adjusts for freight and the pricing premium/penalty. As the bars show, these are substantial adjustments. The report contains 2012-2016 years but 2014 is a good indication of what the near term future looks like, as 2014 is likely to be the breaking point where supply increases and demand cut backs.
2014 Seaborne + China Cost Curve
Source: Credit Suisse
The bull case for higher iron ore prices is the belief that high cost China miners are the swing producers on the cost curve and will keep the floor high as they have a marginal cost in the $120-$140 range. This is especially considered the case because grades have been getting even worse for these Chinese mines. This floor will not hold after next year. The reason is that while there is about 350Mt of Chinese iron ore production, this misstates what is actually the swing factor. 100-150Mt is stranded iron ore that goes specifically to steel mines in the interior of China and does not compete with the seaborne market. Of the reminder, some of it is more cost competitive and would remain viable at $70-$100. As a result, the actual swing ore is more like 100-150Mt. Given the incoming supply, this does not seem like that much of a margin of safety even if steel demand remains firm.
Just as in solar and steel, one cannot discount that as prices fall and uneconomic mines should be shut down, bad actor iron ore mines may continue to run and the government could also lower taxes and subsidize the industry. The Chinese government has stated they intend to increase domestic production over the next four years, which makes little sense economically and lends credence to the likelihood many mines will not be shut down. Since there is little guarantee the key parts of the cost curve that should be shut down will be shut down, there are higher than expected downside risks to the price than people realize, as was shown in August.
In the shorter term, iron ore has since bounced and recovered well above the magic $120/t level. The calm and complacency is lulling people away from what is still a worsening situation. Note that Shanghai rebar prices have not been recovering commensurately meaning this is likely speculative buying and unsustainable restocking. Either way, what matters for the health of the iron ore market in 2013/2014 is end user demand for steel. Whether China is still firing most furnaces today based on stop gap stimulus demand or companies for now can afford to run at a loss should not lead people to feel more bullish about how overall demand will be in 2013. Overall iron ore demand is just being pushed forward, which leaves the market even more vulnerable to shocks next year as supply increases with demand dwindling.
Where the solar analogy ends is that steel is too big a world market to be overproduced with the kind of subsidies that China has given its domestic solar industry to continue to produce uneconomically. If China continues to drive overcapacity in a highly uneconomic manner, it is either going to flood the global markets with steel causing others to shut down or eventually China will be forced to shut down its own capacity.
Michael Pettis recently made a great analogy worth quoting about short term stimulus bounces and how they are a sign of the end game: “It is as if you saw a middle-aged man in terrible physical shape running a marathon, and you predicted that after five or six miles he would be forced to quit. If however he took out a syringe and shot himself up with crystal meth, he would be able to continue running a few more miles, but this doesn’t mean that your analysis and prediction were wrong. It means that in a few more miles he will be worse off than ever (or will have to take an even bigger dose of crystal meth).”
Fortescue Metals Group (FMG AU)
I intended to write-up FMG as a short at various times this year. It had seemed Andrew Forrest was channeling a combination of Jimmy Cayne and Aubrey McClendon as a reckless risk taker who as a smaller player in an industry in the eye of the storm, like Bear Stearns in the last crisis, had over bet his company into a solvency crisis. Forrest like Cayne and McClendon started with great insight into a trend and were both incredibly successful. But both became enamored with the success. To a man with a hammer, everything looks like a nail and Forrest didn’t double but tripled down in his decision to expand from their successful 55Mtpa initial mining operation to a planned 155Mtpa expansion. It’s probably clear even to him he might have erred at this point despite being too pot committed for it to matter.
The credit markets have been kinder to Fortescue than Bear Stearns and now it may have gained enough fiscal prudence in raising capital/liquidity with the news this week that it is exploring raising billions from infrastructure asset sales. Along with the boost from higher iron ore prices, this may delay the day of reckoning. I had thought Forrest like Cayne and McClendon was a danger to the company by owning too much stock and thus being too against delevering when prudent, but perhaps FMG will delever after all and the company (partially at least) has seen the light. We will see.
FMG might actually have been lucky that it was so over-levered, as it had a debt scare early enough that the market remained opene and sentiment on the sector stayed decent for FMG to remedy the situation. FMG will still be a great short if iron ore prices surprise to the downside as they almost certainly will, as FMG cannot escape its positioning as a high cost, over-levered producer, but I don’t feel as confident in proving the pitch today. It’s unclear how the numbers get FMG to insolvency right now given recent developments; with the huge leverage and short term prices to manage cash flows. I’d be happy to discuss it more in the comments and will update down the road when the time comes but the situation might be better to monitor for now and wait for the best setup. That said, it is my highest conviction short due to my conviction on the iron ore market so below is a summary thesis.
Like other upstart producers with lower quality assets, the dire nature of Fortescue’s problems are often hidden by the regular cost curve that does not account for lower grade and other factors that raise all in costs or lower realized price . Outside of the CS graph, a new miner’s operating costs, which would need to be breached to shut off supply, are far below the overall cost structure since it has interest costs against the newly constructed mine. These new producers go unprofitable long before prices see relief from supply leaving the market. This is why the iron ore cost curve is so misleading for understanding the health of the industry.
In the case of FMG, normal cost curves show the company is one of the low to mid cost producers with costs in the low $50s. As the more representative CS chart shows, the Chichester Hub suffers from wet ore issues and at only ~58% Fe, FMG realizes roughly a 15% discount to the 62% Fe price. The consequence is the 95mt of FMG production at a price of $80/t becomes closer to the true swing producer as all the new supply comes online. FMG is essentially running against the narrowing time window of windfall profits; every year it is squeezed by a combination of capex/interest costs/debt repayments or by being pushed out further on the cost curve by incremental production and thus lowering spot prices. To survive, FMG must complete capex and repay debt faster than the industry’s maturing supply/demand structure creates a noose around it.
Sundance Resources (SDL AU)
For now instead of FMG, I’ll offer Sundance as an interesting situation that should finally be reaching the end point. Sundance is an attractive short because it seems very unlikely the company will be acquired. Even though there is a wide spread to the close price, there is still significant downside (50%+) given the mine is unlikely to be developed. This stock is a leftover from a different iron ore market and deal climate and is thus offering an opportunity to short an exploration miner that is unlikely to be developed. With the price at A$0.32 today, there is upside risk of 40%, yet I believe the chance the deal closes is quite low (I estimate only 30%). With alternative development prospects bleak, Sundance will trade down significantly (50%+) once the Hanlong bid evaporates.
Sundance Resources is trying to develop their Mbalam mining project that consists of two iron ore mines, the Mbarga deposit in Cameroon and the Nabeda deposit in Congo. The plan is to build a 35Mta mine. Between the two deposits, there are 350Mt of 62% Fe grade reserves making this a very high quality direct shipping ore mine especially considering the company expects operating costs to be only ~$25/t due to low strip ratios. Even after higher shipping costs vs Australia, the mine compares favorably to RIO/BHP mines. After the 10 year hematite ore runs out, it would switch to a second stage mining of the 38% Fe itabirite ore underneath. The problem is it would cost about $5bn to get Mbalam operational to build a railway and port from scratch. With the project delayed late in the cycle, it is now difficult for it to be running in time to capture the boom level prices to help the payback and de-risk the project.
Hanlong Mining, an opaque Chinese group, which owns 17% of the company put in an offer at A$0.50 while the boom was still at its apex in July 2011; shortly after, they agreed to a buyout price of A$0.57. Then the deal started to run into trouble with the iron ore market weakness and various controversies (such as insider trading) along the way that can be read about in more detail. A revised deal was implemented in May 2012. In late August 2012, Hanlong lowered the offer to A$0.45 owing to Hanlong’s increased negotiating leveraged. On October 22, Hanlong finally received conditional approval for the loan from the China Development Bank (CDB) two weeks later than anticipated and lined up commitment letters from the CDB for $1 billion of the financing and the remainder from China Everbright Bank. Finally on December 2, Hanlong announced it couldn’t secure the funding by the agreed upon date of December 13 and that Hanlong would need more time for whatever reason continues to remain unclear. While Hanlong offered an olive branch of a $15 million convertible loan facility showing its continued commitment to the deal, it has never been in doubt that Hanlong wants to close the transaction.
Throughout all the back and forth news flow, I continue to believe that it will not be in China’s interest to spend $6.5 billion to develop iron ore halfway around the world. $6.5 billion is a lot of money (even to a country with trillions of reserves) and people who pull the gears secretly are fully aware they have more pressing issues than iron ore supply in 3-4 years. The only strategic logic here for China is to secure a source of iron ore and not be beholden to the oligopoly of Australian producers and VALE. This doesn’t make sense however as when you are the only game in town into exploding overcapacity, you set the rules. 35Mtpa is a drop in the bucket amount of iron ore for China. Australia alone is set to export about 700Mtpa in 2016, so there is little strategic value for China.
It also is important to note this is fundamentally different than a Harbin Electric (HRBN) or other controversial Chinese buyouts, because these are western shareholders and the capex is outside the country so few vested interests directly benefit. If China just wants to secure more iron ore, there are many projects that are in various stages of completion already that are being or will soon be mothballed. Even if these projects have worse economics from scratch than Mbalam, they may be a more logical allocation of capital to develop iron ore. One option might be to buy FMG debt as with maybe twice the price of buying and developing Sundance one might be able to own Fortescue’s 155Mtpa of production by the time Mbalam could come online.
A strange event occurred in June 2012 when Sundance raised $40 million at A$0.35 after the amended agreement was reached in May 2012 (when the buyout price was still A$0.57) for a ~40% discount to the buyout price. Has anyone ever heard of such an occurrence? If the deal breaks, there is very little chance it will get funded anytime soon and then what will Cameroon or Congo mining ownership even look like in 5-10 years? The world just doesn’t need more iron ore. Sundance understood this reality and maybe it explains why it raised capital in June.
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