Commerce can make for strange bedfellows. In July of 2009, Rio Tinto, plc (NYSE:RIO), negotiating on behalf of a mining consortium with the China Iron & Steel Association (CISA), was accused of accepting bribes totaling approximately $US13 million and stealing trade secrets for the purposes of maintaining artificially high iron ore prices. One year later, a Chinese court convicted four Rio Tinto employees, sending them to jail for terms ranging from seven to 14 years. China's relationship with Australia soured, and RIO's stock dropped like a stone.
Four short years later, it appears that all fences have been mended. China's steel manufacturers and Aussie miners are currently enjoying a mutually rewarding relationship, and investors stand to benefit.
Iron ore commodity prices are in the $150 per tonne range, and Rio Tinto Group, BHP Billiton Limited (NYSE:BHP) and Fortescue Metals Group Ltd (OTCQX:FSUGY) are trading higher. This pricing reflects increased exports as China builds inventory ahead of the March construction season. The rally was also fueled by weather-related disruptions as the cyclone season closed key ports in Western Australia.
On the steel side, rebar for delivery in October, the most-active steel contract by volume, rose as much as 0.9 percent at 4,293 yuan ($689) a metric ton on the Shanghai Futures Exchange in the week before China's New Year holiday. Reports from Hebei, one of China's leading steel production provinces are also positive. Domestic prices of steelmaking pig iron increased approximately 4% in January and flat rolled carbon steel prices have risen by about 14% since end-December. While some of this increase is attributable to the pass through of higher ore prices, I believe it largely reflects a much awaited market optimism.
Near term investor opportunity - Australia Mining
Despite being the largest producer of iron ore worldwide, China is unable to satisfy domestic demand and therefore must rely on imports, primarily from Australia. There are essentially two reasons for this, both of which point to the high cost of production for miners. First, China's ore typically has low iron content, making it sub-optimal for efficient steel production, and second, China's tax policies have resulted in an oppressive burden on mining operations.
Not only are China's mining companies subject to traditional value-added tax, resource tax, income tax and land-use tax, they are also levied mineral resource compensation fees by the government, the owner of the China's resources. In addition, since many mining companies are located in remote areas, local governments rely on their tax payments to help develop the district economies. With all of this, miners can pay upwards of 25% in taxes, significantly higher than the rates in other countries. The CISA has been unsuccessful in its efforts with China's Ministry of Finance to reduce the rates.
That being said, even if CISA was successful in reducing the taxes by 10 or even 15 percentage points, it is estimated the cost of domestic iron ore production would fall from approximately $110 to approximately $80 per ton. Nowhere near what would be needed to be competitive with BHP and RIO, who benefit from favorable tax rates and incentives, resulting in a $30 to $40 per ton cost.
RIO, BHP and Fortescue are due to report earnings in the next ten days, and market expectations are good. Commonwealth Bank and UBS analysts are particularly bullish, emphasizing the upside to earnings should iron ore prices remain at current levels through the first half of 2013; BHP and Rio 2012 earnings would jump 22 percent and 23 percent respectively, and Fortescue's would be expected to increase 54 percent.
Even though these reports are close at hand, I do not believe they are fully reflected in the prices of RIO, BHP or Fortescue at this time. However, as general consensus is that the $150 per tonne level is not sustainable over the long term, keep a watchful eye on the price of iron ore and consider a shorter investment horizon for these companies.
Longer Term Investors - China Steel Manufacturers
Steel remains a favored industry in China, often benefiting from fiscal policy. However, the industry has also been subject to a number of burdensome regulations as Beijing seeks to bolster appearances within the global marketplace. Looking to establish China as a leader in "circular economy" policies, President Xi has established resource utilization guidelines in an effort to reduce the Country's infamous pollution levels. The current plan calls for, among other things, manufacturers to use less than 580 kg of standard coal for each ton of steel produced. This amounts to a 3 percent decrease for the major steel companies, who used an estimated 602 kg of coal for each ton of steel produced in 2011.
While these goals are admirable, many of China's larger public steel companies were established as state-run operations at a time when neither efficiency nor the environment were of primary concern. Chinese steel producers' energy consumption is approximately 15% higher than developed countries with advanced technologies. Saddled with antiquated equipment, idle divisions, and outdated distribution networks, these large manufacturers will likely find compliance with the new regulations arduous and costly.
I believe the firms that will benefit most from these policies are the modern, mid-size manufacturers with the ability to manufacture high quality, value-added products. Some of these companies include Sutor Technology Group, LTD. (SUTR), General Steel Holdings, Inc. (NYSE:GSI) and China Industrial Steel Inc. (OTCPK:CDNN), all of which I have written about previously. Unencumbered by outdated equipment and non-strategic investments, their technology driven manufacturing facilities enable them to concentrate their resources on production of the high quality, middle range steel products demanded by growth industries.
SUTR and GSI have both performed well recently on improved financial results and I believe that CDNN will follow suit as it continues to broaden exposure with investors. CDNN operated profitability well into the global financial crisis, even reporting record results in 2011. The Company remains profitable year to date, despite reporting its first quarterly loss for the period ended September 30, 2012, thanks to an efficient, cost conscious management team. With China's demand for steel trending up, I believe the Company is on track to return to its 2011 levels, when it reported revenues of $823 million and net income of $45.8 million.
Although they remain on opposite sides of the negotiating table, Australia's miners and China's steel manufacturers rely heavily on each other. Both are benefiting from China's improving economy, creating opportunities for investors.
In the short term, I am looking for an uptick in RIO, BHP and FSUGY as they continue to profit from strong pricing and demand for iron ore. This is likely to be a short term opportunity as I question the sustainability of current iron ore prices, so keep an eye on the commodity's futures pricing.
Longer term I'm still partial to China's mid-size steel producers, most notably CDNN. I encourage investors interested in participating in China's economic growth to take a closer look at this company as I believe that a lack of market awareness is the only thing holding China Industrial Steel back.
Investing in smaller-capitalization companies, as well as investing in companies in emerging markets, including China, is not suitable for all investors, and can be risky. It's important that investors thoroughly perform their own due diligence and analyze the potential risk.
The companies discussed above include smaller capitalization companies with Chinese operations. But the Chinese companies whose shares trade in the U.S. are all U.S. reporting issuers, and subject to the reporting requirements of the U.S. Securities and Exchange Commission, so U.S. transparency and disclosure is available to investors.
Disclosure: I am long OTCPK:CDNN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.