The surging price of iron ore has supercharged the share price of big miners. BHP Group Ltd (ASX: BHP), Rio Tinto Limited (ASX: RIO) and Fortescue Metals Group Limited (ASX: FMG) are trading at highs not seen since the GFC. Buying into this bull run may be gutsy, however if iron ore supply continues to strain and demand from China increases, there may still be more steam in it.
Iron ore surges
Following the Vale tailing dam disaster in January and additional supply constraints, the price of iron ore has surged this year. The iron ore spot price recently hit a 5-year high of US$110.20, marking a 50% increase for the calendar year. As Australia's top export, shareholders of mining and resource companies have been richly rewarded.
Recently the BHP share price hit an 8-year high, while the Rio share price reached highs not seen since early 2008. As a supplier of cheaper and lower quality ore, Fortescue Metals has been the pick of the bunch, trading at 11-year highs. According to an article in the Sydney Morning Herald, analysts at Macquarie believe that if the current spot prices for iron ore continue, Rio an BHP are on track to produce a 50% improvement in EPS for the fiscal year of 2020, while Fortescue earnings could be up by 170%.
Share buybacks
Given the volatile nature of commodities, investors are rightful to query how the influx of cashflow is being spent and how long growth will be sustained. With iron ore prices at a 5-year highs and debt levels relatively low across the mining sector, some analysts believe that shareholder returns can continue to grow in the coming year.
Share buybacks have been a popular strategy among the big miners to improve shareholder value. On a per-share basis, share buybacks are less risky than project expansions and work by reducing the number of shares on offer, hence increasing earnings per share. Since 2011, Rio has bought back more than US$16 billion in its own stock, whilst BHP has bought back more than US$15 billion of its stock over the same period.
Between 2012 and 2017, big miners have reduced their capital spending on new projects. Although Rio and BHP are spending billions on new iron ore mines in Western Australia, the companies are more focused on optimising their production base. The new projects are designed to replace exhausted mines and are heavily focused on maximising production rather than being sources of new supply.
Supply and demand constraints
The iron ore price continues to defy expectations, with many technical analysts warning that the price is approaching bubble territory. However, supply issues are expected to continue for the next few months as weather and fire disruptions in early 2019 have contributed to a decline in export volumes. Recently Rio downgraded its annual export volume with the miner on track to ship its lowest volume in three years.
Demand for high quality iron ore also looks to endure in the near term as China looks to increase infrastructure projects to boost its slowing economy. Chinese steel inventories are at their lowest levels since early 2017, with imported iron ore declining to 121.6 million tonnes due to reduced shipments. The lull in supply and high iron ore price may prompt Chinese steel mills to cut costs and buy lower grade ore, favouring the likes of Fortescue.
Should you buy?
In my opinion, one of the worst feelings as an investor is buying the top in any investment. Currently the parabolic iron ore price has overextended the share price of big miners on the ASX and many analysts seem to be bearish on the sector in the short term. However, I do think that there is still the potential for growth and value in the sector over the long term. Perhaps a more prudent strategy would be to wait for a pullback before buying shares in any of the big miners.
