Iron ore prices soar 58% in three months. Here are Citi's top picks

This article was first published for Livewire Markets on Thursday 2 February 2023

Despite all the hullabaloo about negative earnings for iron ore miners on the horizon, locally listed plays have performed extremely well over the past three months. 

Take Fortescue Metals Group (ASX: FMG), for example, which has seen its share price skyrocket more than 50% since hitting a low on October 28, or Rio Tinto (ASX: RIO), which has rebounded around 42% over that same time period. BHP Group (ASX: BHP), in the meantime, has lifted 30%. 

Ah, retrospect is a fickle thing. 

Why the stellar share price recoveries? Well, Citi puts it down to two main factors. 

One, the China reopening - which investors seem to have hitched their hopes and dreams to. And two, these iron ore exposures were "oversold" six months ago. 

In this wire, I'll outline the brokers' thinking around iron ore at the moment, as well as their top exposures to outperform over the months ahead. 

The price of Iron Ore - currently at US$126.33/ton. It has lifted 57.85% over the past three months. (Source: Market Index)

Iron ore prices to moderate 

Citi isn't as bullish as many fund managers on the China re-opening trade. As part of our Outlook Series, experts like Platinum's Andrew Clifford, Tribeca's Jun Bei Liu and Alphinity's Mary Manning all argued the reopening was creating compelling opportunities for China-based and locally listed stocks alike. Meanwhile, Marcus Today's Henry Jennings recently argued it was the biggest event of the year, dubbing the reopening a "game changer". 

While that may be true for other sectors, Citi believes it's time to "step off the China re-opening trade in iron ore", as the value of China's Dalian Commodity Exchange (DCE) open interest has reached Shanghai lockdown peaks. 

With this in mind, Citi's commodities team believes prices will moderate to US$120 a ton over the next three months. 

But what about listed iron ore companies? 

While the risk-on iron ore trade has been "robust", as Citi aptly put it, earnings per share (EPS) revisions for some of the country's favourite exposures to this commodity have been resoundingly negative (since mid-2022).  

This includes BHP, Rio Tinto and Fortescue, with only Champion Iron (ASX: CIA) recording positive EPS momentum from December 2022. 

"Generally, negative EPS revisions correlate with share price underperformance," Citi analysts explained. 

"However, bellwether BHP is up 31% in the last six months. Expectations around China's re-opening have been a powerful sentiment driver with risk appetite (defined as the six-month move in iron ore versus six month move in share price) strongly positive for all the iron ore names over this period." 

That said, there could be some upside to EPS at current spot prices, the broker explained. 

"Running spot commodity prices and FX through our models for 2H FY23 results in approximately 80% of our mining coverage with EPS upgrades, with iron ore EPS up approximately 30% (spot vs base)," Citi analysts wrote. 

"No doubt the risk-on trade that’s been evident is in part reflection of upside EPS risk at spot commodity pricing. BHP FY23 PE contracts to 8.7 times using spot prices versus a base case of 11.3 times."

A valuation sense check 

Citi noted that Rio Tinto's price-to-book is currently trading in line with its long-term average, while BHP is trading slightly higher. 

Return on equity is running at higher levels than usual, with BHP and Rio Tinto's return on equity in FY25 currently at 31% and 22% respectively at US$90 a ton. 

Meanwhile, the broker believes that Fortescue Metals Group is currently trading at an approximately 17% premium, while Champion Iron is at a 24% discount.

Preferred plays (and less so)

(Source: Livewire Markets)

Citi prefers BHP as its large-cap exposure to iron ore, noting it boasts "stronger organic growth options", despite the weaker outlook for the commodity. Meanwhile, it believes Deterra Royalties (ASX: DRR) could outperform given it offers "low volatility exposure to iron ore via its royalty derived from BHP’s production at Mining Area C, which is tracking ahead of schedule". 

It really is only positive on Mineral Resources thanks to its strong outlook on lithium. 

However, with spot prices currently trading above Citi's short-term forecasts, the broker believes that iron ore miners, particularly smaller players which are more leveraged to prices, could enjoy earnings upside over the short to medium-term. 

"BHP has an earnings upside of 13% for FY23E which increases to 26% in FY24E. RIO enjoys an earnings upside of 18% in FY23E, and the upside increases to 39% in FY24E. FMG boasts great upside for FY24E-FY26E at 75%-120%," analysts wrote. 

Two bar graphs based on combined Bloomberg and Macquarie research looking at iron ore price impacts on company performance

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