Iron ore prices should hold above $100 in the medium term on the back of continued demand from China and stimulus in developed markets, says John Ayoub from Wilson Asset Management. These continued high prices should allow BHP to provide higher capital returns later this year, despite the conservative dividend recently announced by management.

Over the longer term, an increasing focus ‘future metals’ – those with above average growth prospects – will diversify their revenues as commodities such as nickel, copper, and potash play a larger role.

Following BHP’s recent annual report, I spoke with John about the result, the sustainability of the recent iron ore rally, and what the future looks like for the company.

How long have you held BHP?

BHP's been a core holding of WAM Leaders pretty much since inception. We do flex the weight up and down depending on macro drivers, but yes, it's been a core holding for the better part of four years now. More recently, it's been a bigger overweight than it has been traditionally.

How big is your position in the stock currently?

We're reassessing it post the result, but over the last year, it's been around seven percent of the portfolio.

Could you give us a bit of an outline of what attracted you to the company?

Our process is two-part. First, we look at macro drivers and then we look at the micro drivers of individual companies. For some time, we've been positive about bulk materials. So, iron ore has been a thematic that the WAM Leaders' portfolio has been very attracted to, particularly following the Brazilian supply issues, but moreover, the positive demand coming from China.

First and foremost, we were attracted to the iron ore production and the cost discipline that BHP has implemented. Secondly, its copper and nickel exposure, which we've also been rather positively disposed to. Putting those together, it has a lot of the elements that we were looking for from a macro standing.

The one headwind has probably been oil, but they have constantly been evolving their portfolio to ensure that they're at the bottom end of the cost curve. So they're probably one of the better-positioned oil producers in the market.

Under the current management, Mike Henry, we thought there would be more cost discipline.

What were kind of the key points from the recent result?

There were a couple of clear messages. The shape of the company is very much geared towards future metals – metals that will demonstrate above-system growth for the next three, five, 10 years. Additionally, you'll start seeing consolidation of the overall portfolios. You'll see a few more divestments, more organic growth. They'll be looking to do more exploration and finding new assets that way.

But what we really liked in the result was the productivity measures announced for the next two to three years. The goal is to extract further margin, to insulate any macro headwinds from increased supply out of Brazil, and as you start seeing supply from copper come back online post-COVID shutdowns.

Could you explain the dynamics of the iron ore market and whether you think that the recent rally is sustainable?

There are two sides to this – the supply side and the demand side. So, let’s start with the supply.

The events of early last year in Brazil were always going to take longer to be resolved in the market than originally anticipated. These were serious and tragic events that needed remediation and the public needed answers. It was difficult to supplement the lost supply in the iron pellet market, as the Brazilian producer Vale controlled most of the market globally. As a result, Vale begun to ship their stockpiles. So when their production starts coming back online, not only do they need to hit their supply targets, they also need to replenish the stockpiles that they've depleted. That means that you will probably get a doubling of the impact due to the depleted stockpiles. Brazil also has a severe wet season, so they typically work with larger stockpile and inventory levels to manage this seasonality.

On the other hand, BHP, Rio and Fortescue have been able to run at or just above nameplate capacity to help offset the supply disruption from Brazil, but they can't keep doing that. They’ve been running extremely hard to mee the demand out of China, but there’s maintenance work that needs to be done.

This was always a multi-year story before a normalising of supply from Brazil, but we're starting to get closer to normality now. We're 18 months or so into the journey. Our expectation is that toward the back end of this year, we should start seeing Vale produce numbers like late 2017. However, they are very much a bottom-line driven company. Given the $130 iron ore price, they won’t need to supply as much volume to produce healthy profits. A balance should come into the market and you'll start seeing a bit supply curtailment from the domestic producers as it increases from the Brazilians.

The other side is demand. We don't see the demand from China slowing down anytime soon. With the fixed asset investment announcements and the stimulus in the market, we can't see a change in that demand for the next 12 months at least. The other question is whether demand from other markets such as Japan, Korea, and other developed countries starts to pick up again. If you see the rest of the world kick in on the back of stimulus measures being introduced globally, you could see the iron ore price hold above the hundred-dollar mark. I'm not saying it's going to stay at $130 levels for a prolonged period, but certainly you can see it sitting above a hundred dollars for the next six to 12 months if you start seeing strong demand indicators coming from some of those markets that were more impacted by COVID.

How did the recent result compare with your expectations and also those of the broader market?

For the most part, BHP delivered on a lot of their core KPIs. The disappointing thing was the dividend. I can understand from their perspective that they took a conservative approach, given the increased volatility in markets today. So they took a prudent approach to distribute towards the lower end of their payout ratios. This gives them a buffer to see how the rest of the year plays out. My expectation would be that if iron ore markets hold up for longer than what most expect, then there may be additional capital returns later this year.

Were there any surprises?

Markets were somewhat expecting the divestments of some of the coal assets, but perhaps the timing was a slight surprise. The delay of the Jansen potash project seems prudent. Under Mike Henry, it's a safe pair of hands delivering on strategy. He's articulated his strategy and continues to own it. So no, not really any surprises.

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