Sandstone Insights: BHP's upgrade to buy, fear meets China stimulus

ASX code: BHP

Suggestion: Buy (previously Hold)

Need to know

• Upgrade to Buy: we have upgraded our rating to Buy. The share price reflects overly bearish assumptions on iron ore prices and Chinese growth
• Iron ore prices: iron ore prices are trading at key cost curve support levels of $85.00-$90.00 per tonne. Policy changes should benefit miners. US Federal Reserve (Fed) interest rate cuts and new stimulus measures from China are expected to improve sentiment towards miners. We anticipate further measures in China before the end of the year
• BHP capital expenditures: risks around BHP's capital expenditures are reducing. We expect further progress towards a final settlement of the Brazil mining failure in 2015, following the in-principle agreement reached in July 2024.

China stimulus measures

This year's policy changes in China have primarily focused on monetary policy, while fiscal initiatives have been more modest. Overall, the policy response hasn't been sufficient to tackle decreasing demand and consumption, affecting investor sentiment towards the materials sector.

Latest policy measures – 24 September 2024:

• Lowered policy interest rates with more cuts signalled
• Reduced rates on over $5 trillion of housing mortgages
• Eased rules for second-home purchases
• Lowered the required reserve ratio for banks to inject fresh liquidity
• Pledged over $100 billion to support equity markets
• Announced research into a stock market stabilisation fund
• Proposed a $20 billion low-income cash relief, to be distributed by the end of September 2024.

These measures are mainly policy announcements for now, with more details expected in the coming weeks. Although these actions alone won't stabilise the underlying demand, they will boost investor sentiment, which has recently become overly bearish regarding China's growth outlook. The stimulus stands out for several reasons:

• Most significant in size and reach since 2020
• Further fiscal support
• Direct support for the housing sector, which has been under immense pressure
• Policy measures issued by People's Bank of China (PBOC) Governor Pan Gongsheng, ahead of the Politburo meeting at the end of the week. The Politburo is the key policy-setting division in the Chinese administration.

Iron ore prices

Iron ore prices have dipped below $100.00 per tonne in recent weeks. A combination of seasonal weakness and expectations of softening forward demand has weighed on prices. In our view, we are unlikely to see the iron ore price fall materially further. Iron ore has a well-established industry cost curve, which at $90.00 per tonne implies that producers in the bottom quartile are currently mining at a loss.

Iron ore price

We expect that current price levels will lead to a reduction in mine supply. Historically, cost curve support has been strong in years post-Covid-19, with the iron price bouncing off cost curve support levels.

Iron ore prices after the Covid-19 period

US Fed outlook

US Fed interest rate cuts should be considered bearish for the US dollar (USD). A falling USD is generally positive for commodity prices, including iron ore. The combination of China stimulus and US rate cuts clearly challenges bearish views towards mining equities.

Investment view

The market's outlook on Chinese and global growth is too pessimistic. Strong cost curve support for mining should keep the iron ore price at $90.00 per tonne.

BHP is focused on simplifying its operations and moving towards large-scale, long-life assets such as iron ore, copper, and metallurgical coal. Potash is also emerging as a significant resource, expected to contribute from fiscal year (FY) 2026 onwards.

BHP aims for industrial-like returns with a low-geared balance sheet and a disciplined approach to capital allocation, positioning it well for financial success.

While Chief Executive Officer (CEO) Mike Henry has simplified BHP, growth questions remain, particularly around the asset mix for 2030 and beyond. The unsuccessful merger attempt with Anglo American in mid-2024 highlights the challenge of effectively allocating capital amid difficult conditions for new mine development.

At an iron ore price of around $90.00 per tonne, BHP is positioned to deliver a 7-8% free cash flow (FCF) yield.

BHP next 12 months FCF yield

Risks to investment view

The mining sector is highly sensitive to changes in commodity prices and currency movements. Shifts in expectations regarding China's steel consumption can significantly impact share prices.

Steel production has remained weak through 2024. Global rate cuts and China stimulus could help underpin a recovery.

Chinese vs global steel production

Chinese steel prices remain sensitive to changes real estate activity, despite a large shift in steel consumption into fixed asset investment, and infrastructure activity.

Chinese steel price index

China residential activity remains significantly depressed. Further large scale fiscal stimulus will ultimately be required to change activity levels.

China's residential floor space

Risks to investment view

The mining sector is highly sensitive to changes in commodity prices and currency movements. Shifts in expectations regarding China's steel consumption can significantly impact share prices. Political, financial, and operational risks are also key factors.

BHP continues to manage the financial consequences of the 2015 Brazil dam failure, with a $6.6 billion provision. However, there is a risk that this may not be sufficient. Additionally, key projects such as Escondida (South America), Olympic Dam (Australia), and Jansen (Canada) potash could fall short of expectations.

Chinese vs US equites

(Rebased 1 Jan 2020)

• _{The information provided by Sandstone Insights does not constitute investment advice and does not have regard to the specific needs of any person who may receive it. No warranty is given as to the accuracy or completeness of the information and any person acting on it does so entirely at their own risk.}

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