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Investment & Strategy

European Steel and Iron Ore: Opportunities still exist

After being out of favour for over four years, metal stocks emerged as top gainers in 2016, with the MSCI World Metals & Mining index advancing 53.2%. Within metals, steel and iron ore rose 61.9% and 81.5% respectively, lifting mining and steel stocks along with them. This gain contradicted consensus expectations of weakness in metal prices following the slowdown in Chinese steel production, which consumes nearly two-thirds of the global seaborne iron-ore supply.

Chinese steel production was stronger than anticipated due to the stabilising real estate market in China, which accounts for half of the country’s steel demand. The demand upswing lifted iron-ore prices to ~USD 60/mt in 1H16 and to ~USD 80 in FY16, after the US elections raised hopes for infrastructure stimulus. Mining stocks are strongly correlated to iron ore prices, as seen in the sharp gains made by mining majors like Rio Tinto and BHP Billiton, which rose a staggering 71.8% and 61.2% respectively.

Steel demand in FY17 is expected to be stable with the World Steel Association forecasting a 0.5% growth to 1 509.6 MT. Although the Association expects Chinese demand to fall 2%, this would be offset by inventory restocking and growth in the US and other developed economies. We believe that this demand should also support the demand for iron ore.

On the supply side, the market has been in an oversupply situation with global steel capacity utilisation at ~70% vs. the historical level of 85–80%. With the planned Chinese mill closure of ~150 MT by 2020, utilisation is expected to improve to the historical levels. While the iron ore market may still witness oversupply as mining majors ramp up their output, we expect supply from mining majors to be absorbed given their high quality vs. Chinese ore.

The macro-environment remains challenging and metal prices might face resistance after their sharp rise. However, we believe that the metal exposed equities still offer a significant investment opportunity. European metals and mining companies are restructuring their businesses and simplifying their production portfolios. The steel industry is in the midst of consolidation with the potential merger of ThyssenKrupp and Tata Steel’s UK assets. If approved, the merger would create vast synergies and improve utilisation levels, helping offset any potential weakness in demand.

On the mining side, companies are focusing on value as opposed to their earlier focus on volume growth. This has also helped improve their leverage.

In this context, we recommend Rio Tinto and ThyssenKrupp from our coverage universe. Rio Tinto has improved its internals significantly under the new CEO and is focusing on generating shareholder value, while ThyseenKrupp’s diversified business model and potential consolidation make it our preferred pick in the European steel segment.

 

Author
Anirudh Srivastava

Equity Expert

Data & recommendations as of February 13th, 2017 close

This document is an objective and independent explanation of the content of the recommendation and cannot be considered as adapted to a person or based on the analysis of the situation of a person.