FIGURE 1. EXPORTS OF BULK COMMODITIES, CONTRIBUTION TO GROWTH

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1 ANZ RESEARCH AUSTRALIAN ECONOMICS PHASE III OF AUSTRALIA S MINING BOOM 1 JULY 214 CONTRIBUTORS Felicity Emmett Senior Economist Felicity.Emmett@anz.com Daniel Been Senior FX Strategist Daniel.Been@anz.com Cherelle Murphy Senior Economist Cherelle.Murphy@anz.com Justin Fabo Senior Economist, Corporate and Commercial Justin.Fabo@anz.com Dylan Eades Economist Dylan Eades@anz.com PUMP UP THE VOLUMES Over the next three to five years, the production phase of the AUD45bn mining investment boom comes on line. ANZ Research expects: iron ore export volumes to increase from 49mt in 212 to 87mt in 22. With the AUD/USD forecast to depreciate to around USD.84 and iron ore prices to decline to USD95 per tonne, iron ore exports values are set to rise from AUD55bn in 212 to AUD75bn by 22; LNG exports to rise from 23mt in 213 to nearly 88mt in 22. This will see Australia become the largest exporter of LNG in the world by 219, eclipsing Qatar, the current number one. LNG exports are estimated to be worth AUD67bn in 22, compared with AUD15bn in 213; resource exports to contribute around 1 percentage point to Australian GDP growth in each of the next three years; Australia s trade balance to improve from a deficit of 1½% of GDP in 212 to a surplus of more than 2% of GDP over the next three years, lifting the current account deficit to around 1½% of GDP. This should help solidify Australia s AAA credit rating; no significant new net demand for the Australian dollar (AUD) until at least 218. New sources of demand will manifest as onshore operating costs rise alongside profits. However, ownership structures, cost dynamics, and the fact that the mining companies operate in USD makes this a far more nuanced story. Overall, the impact from the rise in trade volumes will not be large enough to determine the broader direction of the AUD. The key domestic determinant will remain the terms of trade; FIGURE 1. EXPORTS OF BULK COMMODITIES, CONTRIBUTION TO GROWTH Contribution to annual GDP growth, ppts forecasts Thermal coal Coking coal Iron ore LNG Total

2 Phase III of Australia s Mining Boom / 1 July 214 / 2 of 25 the Commonwealth Government to benefit from additional company tax revenue. This phase of the mining boom, however, will not be as lucrative as Phase I when export prices and government revenues surged, given that higher operating costs and lower commodity prices will erode company taxes. Resource rent taxes are marginal additions for the Commonwealth, but will only deliver a fraction of original expectations while the Abbott Government has chosen to repeal altogether the minerals resources rent tax; the Western Australia government, and to a lesser extent the Queensland Government, to benefit from increased royalty payments. However these are very sensitive to commodity price and AUD/USD movements. We do not see any positive credit rating implications for these states from windfall royalties. At best there would be a faster rate of debt reduction in these two states if commodity prices were to surprise on the upside or the AUD/USD on the low side; and a fall in mining-investment related employment (as resources investment falls from a peak of around 8% of GDP to close to 3% of GDP) to be partly offset by a ramp up in operational mining jobs, but in net terms we expect at most another 5-75K jobs to be lost in the mining sector over the next couple of years. THE DETAILS The mining boom is transitioning into the third phase: the production phase. As is well documented, the boom has been driven by surging demand for Australia s commodities - particularly from China, where the rapid rate of urbanisation and industrialisation has substantially raised the consumption of steel making and energy producing commodities. The first phase of the boom was characterised by sharply rising commodity prices, including iron ore and coal (the bulk commodities), which drove a sharp lift in Australia s terms of trade. The second phase, the investment phase, saw an enormous expansion in production capacity of these commodities, as well as in LNG. The third phase is just beginning, as the extra capacity from the investment boom boosts the production and exports of Australia s key commodities. PHASE I: COMMODITY PRICES RISE In the first stage of the boom, Australia experienced the largest terms of trade gain in its history (+86% from the average level seen between 2 and 25 to the peak in 211). Coal prices more than doubled and iron ore prices quadrupled. The surge in prices flowed straight through to the bottom line for mining companies and, apart from a brief period in 29, company profits rose substantially. While mining companies are around 8% foreign owned, the benefits of this early stage were distributed widely through the recycling of company taxation into income tax cuts by the Howard and Rudd governments. More generally, the impact is clearly evident in the much stronger growth in Australia s national income (which captures the effect from the terms of trade) compared with GDP.

3 Phase III of Australia s Mining Boom / 1 July 214 / 3 of 25 FIGURE 2. PRICES FOR KEY AUSTRALIAN BULK COMMODITIES RAMP UP 3 Average Australian export prices, USD/tonne Coking coal Iron ore Thermal coal FIGURE 3. THE TERMS OF TRADE RISES SHARPLY Index Terms of trade FIGURE 4. GROSS DOMESTIC INCOME GROWTH OUTSTRIPS GDP GROWTH % ch y/y Real Gross Domestic Income Real GDP

4 Phase III of Australia s Mining Boom / 1 July 214 / 4 of 25 PHASE II: MINING INVESTMENT BOOMS In response to the large lift in prices, mining companies embarked on an unprecedented expansion of capacity. Investment in iron ore, coal, and particularly LNG lifted sharply, with the spending concentrated in a small number of mega projects. Investment in the mining sector rose from less than 2% of GDP in 24 to a peak of over 8% in late 212. While this lifted overall investment in the economy and was an important driver of growth over the period, to an extent it appears to have come at the expense of investment in the non-mining sector with the higher AUD also dampening business conditions in other parts of the economy. Employment and wages grew strongly in mining and related sectors, while employment growth slowed in other parts of the economy. Given the import-intensive nature of the mining investment (on average around 5% of the recent boost in mining investment is estimated to have been imported 1, with import intensity in the LNG sector even higher) imports also grew strongly. The winding down of the investment phase of the mining boom will impact the Australian economy primarily over , with the main impact over H2 214 and 215 as the large Queensland LNG projects come to completion. Investment is set to fall from the peak of 8% to around 3% by end 216. This impact is clearly factored into the RBA s current very expansionary interest rate settings. FIGURE 5. MINING INVESTMENT 12 1 Investment pipeline excluding projects that have been either cancelled or indefinitely delayed since July 212 Investment pipeline for projects that are either under construction or committed ANZ profile 8 AUDbn Under construction Committed Under consideration Possible Cancelled/Indefinitely delayed 1 See Connolly and Orsmond (211), The Mining Industry: From Bust to Boom, RBA RDP 211-8

5 Phase III of Australia s Mining Boom / 1 July 214 / 5 of 25 FIGURE 6. TOP 2 MINING PROJECTS Project Commodity Company Capital expenditure (AUD) Initial production State Stage capacity per year Details Gorgon LNG Chevron (47.3%)/Shell (25%)/Exxon Mobil (25%)/Osaka Gas (1.25%)/ Chubu Electric (.4%) 56bn 15.6 Mt WA Under Construction Production is expected to start in mid 215 Ichthys LNG Inpex (66.1%)/Total (3%)/Tokyo Gas (1.6%)/Osaka Gas (1.2%)/Chubu Electric (.7%)/Toho Gas (.4%) 34bn 8.4 Mt NT Under Construction Production is expected to start in early 217 Wheatstone LNG Chevron (64.1%)/Apache 29bn 8.9 Mt WA Under Construction Production expected to start (13%)/PE Wheatstone (8%)/KUFPEC (7%)/Shell (6.4%) Kyushu Electric (1.5%) in mid 216 Australia Pacific LNG LNG Origin (37.5%)/ConocoPhillips (37.5%)/Sinopec (25%) 24.7bn 9 Mt QLD Under Construction Production is expected to start in mid 215 Queensland Curtis LNG LNG BG Group 2bn 8.5 Mt QLD Under Construction Production is expected to start (73.8%)/CNOOC in Q4 214 (25%)/Tokyo Gas (1.3%) Gladstone LNG LNG Santos (3%)/Petronas (27.5%)/Total (27.5%)/Kogas (15%) 18.5bn 7.8 Mt QLD Under Construction Production is expected to start in 215 Pluto LNG Woodside (9%)/Kansai Electric (5%)/Tokyo Gas (5%) Mt WA Completed Pluto started production in April 212, with the first LNG shipment occurring in May 212 Prelude (Floating LNG) LNG Shell (67.5%)/Inpex 12.6bn 3.6 Mt WA Under Construction Production is expected to start (17.5%)/ KOGAS (1%)/ in 217 CPC (5%) Roy Hill Iron ore Hancock Prospecting (7%)/ Marubeni (15%)/POSCO (12.5%) China Steel (2.5%) 9.5bn 55 Mt WA Under Construction Production is expected to start in Q4 215 Sino Iron Iron ore CITIC Pacific 8.4bn 24 Mt WA Completed Production started in Q4 213 Rapid Growth Project 5 Iron ore BHP Billiton 5.6bn 5 Mt WA Completed Production started in 211 Jimblebar Mine & Rail Iron ore BHP Billiton 5.2bn 35. Mt WA Completed Production started in 213 Cape Lambert port and rail expansion North West Shelf Expansion - North Rankin B Iron ore Natural gas Rio Tinto/Hancock Prospecting Woodside (16.7%)/BHP Billiton (16.7%)/BP (16.7%)/Chevron (16.7%)/MIMI(16.7%)/S hell (16.7%) 5.2bn n/a WA Completed Project completed in bn 967 Pj WA Completed Production started in late 213 Rail & Port (55-155mt) Iron ore Fortescue 4.6bn n/a WA Completed Project completed in 214 Kipper Turrum Oil, Natural Gas ExxonMobil (5%)/BHP Billiton (5%) 4.5bn 11 kbpd, 77 PJ pa VIC Completed Production started in 213 Caval Ridge Coking coal BMA 4.2bn 8. QLD Completed Production started in 214 Solomon Hub Iron Ore Project Iron ore Fortescue 3.1bn 6. WA Under Construction Production started in 213 Hay Point Coal Terminal Expansion Coal BMA 3.1bn n/a QLD Under Construction Project expected to be completed in 215 Karara Project Iron ore Gindalbie Metals (48%)/Ansteel (52%) 2.4bn 1. WA Completed Production started in 211 Source: Deloitte Access Economics, BREE, ANZ Research

6 Phase III of Australia s Mining Boom / 1 July 214 / 6 of 25 PHASE III: EXPORT CAPACITY COMES ON STREAM The third phase of the mining boom, the production phase, will bring significant benefits to the Australian economy. Higher commodity export volumes will boost growth, while increased export revenue will improve Australia s external accounts. Notwithstanding high rates of foreign ownership, the lift in profits will flow through to the economy via higher dividend payments, higher company taxation, and increased royalties. The second stage the investment phase was both capital and labour intensive, so the transition to the third phase will see investment (and imports) fall sharply, and mining-related employment decline. EXPORT VOLUMES Export volumes are set to increase sharply as the capacity created by the boom in investment comes on stream. Over the next three years, Australia s export volumes will rise by around 6½% per annum, driven mainly by bulk commodities. Iron ore volumes have already picked up sharply and will continue expanding. By 216 LNG exports will take over as the key driver. Analysis from ANZ s Commodity Research team suggests: Iron ore export volumes, which already account for one third of resource exports, will almost double from 49mt in 212 to 87mt in 22. LNG exports are set to rise from 23mt in 213 to nearly 88mt in 22. Australia will become the largest exporter of LNG in the world by 219, eclipsing Qatar, the current number one. Coal volumes look set for more modest growth, averaging over 5% per annum over the next seven years. Resources exports will contribute around 1ppts to Australian GDP growth in each of the next three years. FIGURE 7. EXPORTS OF BULK COMMODITIES CONTRIBUTION TO GROWTH Contribution to annual GDP growth, ppts forecasts Thermal coal Coking coal Iron ore LNG Total

7 Phase III of Australia s Mining Boom / 1 July 214 / 7 of 25 FIGURE 8. EXPORTS OF COAL 35 Thermal coal Coking coal 3 ANZ million tonnes BREE BREE ANZ Source: ABS, BREE, ANZ Research FIGURE 9. IRON ORE AND LNG Iron ore BREE LNG BREE million tonnes ANZ ANZ million tonnes Source: ABS, BREE, ANZ Research An important question is how much the lift in bulk commodity exports offsets the drag on the national economy from the wind back in mining investment? Quite a bit, we expect. From 2-21, the average contribution to annual GDP growth from bulk commodities exports was just under ½ppt. This stepped up over the past two years, with bulk commodities contributing just under 1ppt to growth in 212 and 1¼ppts in 213. We expect this trend to continue as more bulk capacity comes on stream. We forecast bulk commodities will contribute close to 1ppt per annum to growth over the next three years. Iron ore will make the largest contribution in 214 and 215, and LNG will step up sharply through

8 Phase III of Australia s Mining Boom / 1 July 214 / 8 of 25 FIGURE 1. EXPORTS OF BULK COMMODITIES f 215f 216f Volumes (Mt) Iron ore LNG Coking coal Thermal coal Volumes (% ch y/y) Iron ore LNG Coking coal Thermal coal Contribution to GDP (ppt) Iron ore LNG Coking coal Thermal coal Total Exports/revenue (AUDbn) Iron ore LNG Coking coal Thermal coal Total % GDP Price assumptions (USD/t) Iron ore LNG Coking coal Thermal coal AUD/USD This large contribution to growth from mining exports will provide a solid offset to the drag from the wind back in mining capex on a pure national accounts basis, although other important considerations are the impacts on national income and employment. Mining investment looks to have peaked in late 212 and has fallen steadily since. This decline is set to continue, although the pace of the decline will steepen over the next two years as the AUD55bn Gorgon project and the large scale Queensland LNG projects move towards completion. We expect mining investment to fall 14% in 214, 22% in 215 and a further 22% in 216. This will subtract around 1ppt, 1¼ppt and 1ppt from GDP growth for those respective years. FIGURE 11. MINING INVESTMENT, EXPORTS AND NON-MINING 5 Contribution to annual GDP growth, ppts forecasts Net mining investment* Resource exports Non-mining GDP GDP growth * assumes a 5% import share for mining investment

9 Phase III of Australia s Mining Boom / 1 July 214 / 9 of 25 Adjusting for lower imports, however, suggests the net impact will only be around half of this. Roughly 5% of mining investment is assumed to be imported, and the sharp fall in capital imports over the coming period will provide a significant offset to the weakness in mining investment. Although higher resource exports will provide a solid offset to the drag from mining investment, the non-mining economy will need to pick up substantially for overall growth to recover. EXPORT REVENUES AND EXTERNAL BALANCES The lift in bulk commodity volumes will drive a strong improvement in export revenue growth and Australia s external accounts. The initial improvement was driven by higher iron ore receipts, while a lift in LNG revenues is expected from 215. Resources export revenue rose 6½% in 213, driven by a sharp increase in iron ore exports, while the further expansion in bulk commodities capacity will drive gains in resources exports of on average close to 7½% per annum in each of the next three years. Iron ore export receipts rose a substantial AUD15bn in 213 driven largely by higher volumes. We expect iron ore revenues to remain relatively stable at around AUD7bn over the forecast period as higher volumes are offset by lower prices. Coal revenues should rise by AUD5½bn in 215 and nearly AUD4bn in 216, as volumes grow and prices recover. A new wave of LNG exports begins to come on stream later this year, with exports receipts likely to rise around AUD6½bn in 215 and a further AUD11bn in 216. Revenues will continue to grow strongly through to 22 as further capacity is commissioned. This cumulative rise in export revenue will drive a marked improvement in Australia s external accounts. The sharp jump in the value of iron ore exports has already turned the trade balance around from a deficit of 1.5% of GDP in 212, to a small surplus in early 214. After broadly stabilising through 214, we expect the trade surplus to continue to widen, reaching around 2% of GDP by end 216. The sharp turnaround in the trade balance will not be fully reflected in the current account deficit because of the simultaneous widening in the net income deficit. The net income deficit is set to widen on two counts. The first is the anticipated rise in global interest rates over the next few years, which will drive interest payments on our foreign debt higher. We expect global bond yields to gradually increase over the next 2-3 years as central banks - particularly the US Federal Reserve - move to normalise monetary policy and withdraw monetary stimulus from the economy. We forecast that the weighted average bond yield (based on currency denominations and maturities of foreign assets) will increase from 2.6% currently to 3.7% by the end of 216. As a result, interest payments are likely to increase by around AUD4½bn over this time frame and rise from 2.5% of GDP currently to 3.2% of GDP. The second is the increasing flow of dividend payments to foreign owners. While the mining investment boom has generated a significant amount of foreign investment in Australia across the LNG, iron ore and coal sectors, much of this investment has been funded offshore. As a result, Australia s foreign liabilities in the mining and energy sectors have increased sharply in recent years. Indeed, it is estimated that the mining sector in Australia is around 8% foreign owned: ownership rates in the LNG sector are closer to 9%, while in the iron ore sector

10 Phase III of Australia s Mining Boom / 1 July 214 / 1 of 25 they are lower than 8%. Consequently, as mining profits rise over the next few years a very significant income stream will flow offshore in the form of dividend payments. That said, dividend payments are likely to remain contained in the near-term given that LNG production and profitability does not ramp up in earnest until post-216. Overall, we would estimate that equity payments will add around AUD3bn to the net income deficit. Overall, this will see the net income deficit widen from close to 2½% of GDP in 213 to close to 3½% by the end of 216. The combination of the move to a substantial trade surplus and a wider net income deficit will see the current account deficit narrow to around 1½% of GDP in 216. FIGURE 12. THE TRADE BALANCE AND THE CURRENT ACCOUNT BALANCE 4 2 forecasts % GDP Trade balance Current account balance There is, however, considerable uncertainty over this outlook. We remain confident on the volume side with expansion in iron ore and LNG capacity underwritten in most cases by long-term supply agreements. Australia is also a very low cost producer of iron ore, and demand from China will remain strong. But the outlook for prices is much less certain. There remains a wide range of views on the degree of impact the very large increase in capacity in bulk commodities has on prices. ANZ price forecasts for iron ore, coking and steaming coal, and LNG are close to or slightly below consensus, but the risks to prices are skewed to the downside.

11 Phase III of Australia s Mining Boom / 1 July 214 / 11 of 25 FIGURE 13. EXPORTS OF BULK COMMODITIES LOW AND HIGH PRICE SCENARIOS f 215f 216f AUDbn Central case Export revenue Trade balance Current account deficit Low commodity price scenario* Export revenue Trade balance Current account deficit High commodity price scenario** Export revenue Trade balance Current account deficit % GDP Central case Export revenue Trade balance Current account deficit Low commodity price scenario Export revenue Trade balance Current account deficit High commodity price scenario Export revenue Trade balance Current account deficit * 1% lower than our current forecasts **1% higher than our current forecasts COMPANY PROFITS Resources profits have already risen strongly and are likely to continue to grow, particularly as LNG comes on stream. ABS data show that mining profits rose 12½% in 213, driven primarily by higher iron ore volumes. While iron ore shipments are expected to continue to grow strongly, lower prices will weigh on profit growth in the near-term. Broad-based cost pressures in the mining sector are also likely to crimp profit growth. Overall, we expect mining profit growth to slow in the near-term, and then pick up in 215 as exports of LNG ramp up. FIGURE 14. PRICES AND COSTS 12 Prices Costs 11 Index, 213 = Iron ore LNG Coking coal Thermal coal Coking coal

12 Phase III of Australia s Mining Boom / 1 July 214 / 12 of 25 While we forecast ongoing solid growth in company profits, the very strong earnings growth experienced over the second half of the last decade is not expected to be repeated. This was a period of very steep price gains, which fed straight through to the bottom line. The rise in revenues over the next few years will be driven by volume growth, which will be dragged back by an associated rise in costs and any further falls in prices. Iron ore prices are likely to grind lower as the new supply comes on stream. ANZ Commodity Research expects the iron ore price to average USD11/tonne in 214, nearly 2% lower than the average 213 price of USD135/tonne, with ongoing, albeit smaller declines in the coming years. This suggests iron ore profits likely peaked in 213 and will decline moderately over coming years. Australian coal mining companies have made substantial efficiency gains and cut costs sharply over the past two years, but remain high cost producers of both thermal and coking coal. While an expected improvement in coking coal prices in 215 should help to generate higher profits, further gains will be limited by the high cost base. LNG profits will be the key driver of mining profits in the future and should grow strongly from 216 as capacity ramps up. Around 9% of capacity is currently contracted out, so the revenue stream has a considerable degree of reliability around it. Overall, we expect mining profits to be broadly flat in 214, rise approximately 14% in 215, and then grow close to another 1% in 216. FIGURE 15. MINING PROFITS AND EXPORTS 12 1 forecasts 8 6 % ch y/y Resources exports Mining profits

13 Phase III of Australia s Mining Boom / 1 July 214 / 13 of 25 COMPANY TAXATION, RESOURCE RENT TAXES AND ROYALTIES Company tax Over the past decade, Commonwealth budget revenue has been affected by large swings in company tax revenue as rising and falling commodity prices have flowed through to company profits. The first phase of the mining boom drove a sharp lift in taxation revenue. This largely coincided with the last five years of the Howard Government and much of the proceeds were recycled through the economy in the form of income tax cuts. This spread the benefits of the mining boom across a wider population and lifted household spending and growth. Through Phase II of the mining boom, sharply higher capital investment resulted in higher depreciation expenses which meant corporate tax receipts did not rise in line with gross corporate profits. Moreover, lower commodity prices combined with the ongoing impact of the fall-out from the GFC have lowered taxes on capital 2 as a proportion of total Commonwealth receipts (and GDP) since Taxes on capital are, however, still above the proportions of GDP recorded in the 198s and 199s. The Commonwealth budget papers project total company tax growth of just 1.6% in , but growth of between 5.3% and 6.1% per annum is projected over the next four years. Forecasting taxation revenue is notoriously difficult, given the large influences of changing prices, costs, and interest and depreciation charges. That said, we expect taxation revenues to grow broadly in line with profits, slowing in the near-term and then picking up post-216 as profits in the LNG sector ramp up. Estimates from independent consultant Wood MacKenzie confirm this with their measure of iron ore taxation receipts peaking in 214 and then gradually declining, and LNG taxes picking up substantially in 218 and 219 as exports step up sharply. FIGURE 16. MINING TAXES AUDbn % total company tax AUDbn % total company tax Source: Australian Tax Office, ABS, ANZ Research These forecasts, as noted, are highly sensitive to changes in commodity prices. Treasury s sensitivity analysis showed that a fall in export commodity prices that causes a 4% fall in the terms of trade and a 1% fall in nominal GDP by would lower company profits by 3% in both and This would lower company tax revenue by 1.8bn (or 2.5%) in and 3.1bn (or 4.1%) in Lower company profits would also flow through to lower Australian equity prices, 2 Taxes on capital include company tax, resource rent taxes, superannuation earnings tax, and capital gains tax.

14 Phase III of Australia s Mining Boom / 1 July 214 / 14 of 25 and therefore reduce capital gains tax from individuals, companies and superannuation funds. Resource rent taxes Resource rent taxes in the past have been an important source of revenue for the Commonwealth Government, but have fallen substantially in line with lower offshore oil production over the last 3 years 3. Despite expectations to the contrary, they have not been an important source of revenue during Phase I and Phase II of the mining boom and therefore will not be a large source of volatility in the coming phase. In the petroleum resource rent tax (PRRT), which was first established in , was extended by the Labor Government to onshore oil and gas projects and the North West Shelf and a Minerals Resource Rent Tax (MRRT) was applied to profits from the extraction of iron ore, coal and some coal seam gas. These policy changes were designed to share the benefits with the wider economy much as the first stage of the mining boom did. But the MRRT only raised AUD2m (or 5% of the amount originally estimated) in and is estimated to raise just AUD1m in net terms in The current government is attempting to remove the MRRT altogether. The PRRT is expected to rise more strongly but raise only AUD1.4bn in and AUD1.95bn in (of a total Commonwealth revenue base of around AUD38bn). Forecasts of this revenue source were revised down in the May budget (compared to the December 213 mid-year budget update) reflecting lower expected profitability of the relevant companies. Royalties Royalties will add to selected state government revenues during the Phase III of the mining boom. Royalties are forecast by the various state governments to grow strongly over the next few years, with growth not surprisingly concentrated in Western Australia and Queensland (which together collect around 8% of the nation s total royalties - with around 54% collected by Western Australia.) As a share of state government revenue, royalties are expected to jump from around 4% currently to nearly 6% in To give some perspective to the size of royalty collections, in WA these are expected to be AUD5.9bn in , which is more than Tasmania, the Northern Territory, and the ACT each raise from all their revenue sources. WA s royalties are projected to rise to AUD6.8bn by and contribute 21.5% of WA s total revenue at this time. There are a number of determinants of royalties including production levels, the AUD/USD exchange rate, and commodity prices. Therefore, while royalties have been a great source of revenue upside for the WA and Queensland state governments, they are also a source of great volatility. Given these governments must make a best guess about the path of the prices of mainly iron ore (in the case of Western Australia) and coal (in the case of Queensland) and the AUD, their dependence on this source of revenue is a hindrance to the predictability of budgeting. Some of the volatility in royalty revenue is smoothed by the GST redistribution process, but its lagged nature means there are still forecasting difficulties, which makes budgeting complex. This has been identified as a hindrance to the resources states, especially WA, by credit rating agencies. In the most recent budgets, royalty revenue projections were revised marginally lower by both the WA and Queensland governments. In WA, over the four years to , royalties were expected to be AUD464m lower overall, compared 3 Trends in Australian government receipts, to , Jan 214, Parliamentary Budget Office, Commonwealth of Australia.

15 Phase III of Australia s Mining Boom / 1 July 214 / 15 of 25 to the December mid-year budget update, with higher production levels expected to be offset by lower iron ore prices. Each US1 cent decrease/increase in the AUD is capable of moving WA revenues AUD8m higher/lower and each USD1 per tonne increase/decrease in the iron ore price is capable of moving revenues AUD49m higher/lower. FIGURE 17. ROYALTIES 7 6 forecasts 5 % total state revenue Source: Various state budgets, ANZ Research In Queensland, the Budget papers revised the coal price assumptions down again and so royalty forecasts, which contribute 4-6% of Queensland s total revenue, were also lowered by a substantial AUD22m in , AUD554m in and AUD331m in LNG royalties are expected to pick up substantially in Queensland from 215 onwards although these are expected to remain only a fraction of coal royalties. Despite the strength in forecast royalties we see no positive implications for the credit ratings of Queensland (AA+ with a stable outlook from Standard & Poor s and Aa1 with a negative outlook from Moody s) or Western Australia (AA+ with a stable outlook from Standard & Poor s and Aaa with a negative outlook from Moody s). The budgets (and therefore the credit rating agencies) have strong rises in royalties already factored into their projections over the coming four years. The risks to the forecasts are weighted to the downside due to the possibility of bigger falls in commodity prices than WA and Queensland are assuming. Already since the publication of the budgets, prices of iron ore and coal have moved lower, although these impacts will likely be cushioned by their relatively conservative AUD forecasts. Overall the implications of the third phase of the mining boom for the public sector are positive, with growing company taxes and royalties likely to boost both Commonwealth and state government revenues (although most of the latter benefits will be concentrated in Western Australia). The extent of the gains is dependent on prices for commodities, so there remains considerable uncertainty about how large the gains will be. For governments, this uncertainty prevents policy makers from tying these gains to expenditure that would share the benefits around the economy. However with the WA, Queensland and Commonwealth governments focussed on fiscal consolidation and debt repayment, we expect that any upside surprises from company taxes or royalties would probably be associated with faster repayment of debt, while downside surprises (which in our view are more likely) would slow debt retirement.

16 Phase III of Australia s Mining Boom / 1 July 214 / 16 of 25 EMPLOYMENT IMPLICATIONS The transition to the production phase of the mining boom from the investment phase will see employment in mining and mining-related jobs fall as the production/operational phase of the resources boom is less labour intensive than the (shorter) investment phase. For instance, the construction of a Western Australian iron ore mine, on average, requires two to three times as many workers as the operational stage of the mine. For LNG, the ratio is even higher: for Queensland's LNG projects, which use coal seam gas, it is about six or seven to one, while for a typical Western Australian LNG project the ratio is close to 1:1. Taking all these factors into account, our analysis suggests that at most a net 5-75K resourcerelated jobs are still to be shed over the next few years. FIGURE 18. RESOURCES INVESTMENT & RELATED EMPLOYMENT 8 7 ANZ forecasts Per cent of GDP Per cent of total employment Resources investment, % of GDP (LHS) Employment related to resources investment, % of total (RHS)* * ANZ estimates for Source: ABS, RBA, ANZ Research While the investment phase of the resources boom generated a large number of jobs, there are significant difficulties gauging its magnitude. RBA estimates suggest that between mid 25 and mid 212 employment grew by around 25K due to higher resources investment, and by roughly 23K due to higher resources production. Other analysis, which assumes that labour productivity associated with resources investment has been similar to that in the overall economy in recent years, points to a similar 23K rise in resources investment-related employment over the same period. Using the RBA s research, our forecasts for resources investment imply that investment-related employment could fall from its peak by around 13K persons by the end of 216. A key question is how much of this has occurred already? We estimate that resources investment has already fallen by more than 1% from its peak in late 212. Importantly, this decline has largely been in iron ore and coal investment, which has a greater drag on the domestic economy than lower LNG investment due to its higher domestic input content. One sign of the labour market impact to date is the fall in engineering services employment over the past year or so. Taken together, this suggests that employment related to resources investment has been falling for some time. We estimate that substantially fewer than 1K resourceinvestment-related jobs remain vulnerable.

17 Phase III of Australia s Mining Boom / 1 July 214 / 17 of 25 FIGURE 19. RESOURCE EXTRACTION & RELATED EMPLOYMENT 8 ANZ forecasts Per cent Per cent, nominal Resource extraction & related employment, % of total (LHS)* Resources exports, % of GDP (RHS) * ANZ estimates for Source: ABS, RBA, ANZ Research 5 The RBA s research can also be used to gauge the number of jobs created during the operational phase of the resources boom. Unsurprisingly, the Bank s estimates of employment due to resource extraction and the servicing of mines are correlated with resources exports. A literal reading of the chart above suggests the potential for sizeable job gains going forward associated with the operational phase. But several factors temper this expectation: both the volume and price of resources output can influence operational resources employment. Lower commodity prices will limit job gains associated with further volume increases. Additionally, the composition of resources employment could also increase its susceptibility to commodity price fluctuations, with a relatively small share in iron ore mining which is proportionately much lower cost than other parts of the industry; a rising share of resources exports will be LNG and, as discussed already, LNG production is less labour intensive than other resources production; a significant number of major non-lng projects are already operational, limiting the upside in terms of operational employment going forward; and hiring of operational employees for several of the large LNG projects has already ramped up due to the significant training required well before the construction phases ends. Given that employment growth from higher resource exports over the next few years could be significantly less than 5K, we conclude that at most around 5-75K jobs have yet to be lost across the economy over the next few years as resources investment winds down. Moreover, fewer workers in resources activity will have an outsized effect on household income and spending, as these workers tend to be paid well above the average wage.

18 Phase III of Australia s Mining Boom / 1 July 214 / 18 of 25 AUD IMPLICATIONS The improvement in Australia s trade position will be driven by rising export volumes of iron ore and liquefied natural gas (LNG), as the recent phase of heavy investment in capacity winds down and production at new facilities gears up. The nature of the shift (which is dominated by just two goods and controlled by a small number of predominantly public companies) makes it possible to delve into the details and gain an understanding as to whether this will mark a significant shift in demand for the AUD. The current account deficit has already begun to shrink as the intensive investment undertaken by the iron ore industry comes online. New mines from BHP, Rio Tinto, Fortescue, and more recently the Roy Hill project, have all increased production, and will continue to ramp up their output through until This ramp up in production has seen iron ore exports rise AUD4.4bn over the past year, and has been a key driver in the AUD6.7bn improvement in Australia s trade balance. In late 215/early 216 and beyond, the trade surplus will improve further as the new LNG projects begin to deliver their contracted gas to the world. The structure of Australia s current account is relatively unusual with two factors making the coming current account narrowing unique. First, Australia sells its resources on the international market in USD, not AUD, and second, the mining companies are primarily foreign owned and as such do not have a need to repatriate all of their profits into AUD. This means that not every transaction recorded in Australia s current account will actually create demand for AUD. While this has always been the case, the speed of the improvement, and the fact that it is concentrated in only a couple of components, makes this particularly relevant now. Therefore, determining the impact of the current account improvement on the AUD is not a straightforward issue. International companies, international markets, international prices Resource export sales are settled in a global market at a price determined in USD. Ownership structures of the resource companies mean that the retained profit from these transactions are also typically held in USD. Thus, one needs to understand how these companies interact with Australia to gain a real understanding of how their demand for AUD is set to evolve. In general terms, resource companies have three primary sources of demand for AUD. The first is to meet domestic costs, the second is to pay any profits/dividends to Australian owners, and third is to pay taxes and royalties to both state and federal governments. The path of each of these sources of AUD demand over the next few years will determine how the third phase of the mining boom will impact the trajectory of the AUD. The evolving cost structure Resource companies face three primary cost sources - capital expenditure (CAPEX) costs, operating (OPEX) costs, and the cost of financing. The interactions between all of these provide us with some clues as to whether there will be a significant rise in demand for the AUD as the current account narrows.

19 Phase III of Australia s Mining Boom / 1 July 214 / 19 of 25 CAPEX costs will plummet The recent investment boom was an enormous CAPEX cost for these companies. As the second phase of the mining boom comes to an end, this cost (and the resulting AUD demand) will decline significantly. ANZ Research estimates that these costs will decline from AUD1bn to AUD8bn in 215 and continue to decline until 218. The Australian Bureau of Statistics (ABS) CAPEX survey corroborates these estimates over the next year. FIGURE 2. MINING INVESTMENT 9 8 forecasts 7 6 % GDP Mining investment (%GDP) This is approximately an AUD2bn reduction in capital expenditure costs over the next 12 months. Though not all of these costs were denominated in AUD. Estimates that 5% of these costs were spent domestically means that there is an AUD1bn reduction in AUD denominated costs for the resource sector in just the next year. Given that the sector has been almost entirely financed through retained earnings (and to a small degree by debt raised in international markets), it is reasonable to assume that in aggregate, this reduction in costs will also deliver a reduction in demand for AUD. As such, at least an additional AUD1bn per annum worth of AUD demand must be found in order to match current levels. OPEX can t fill the gap The flip side of this decline will be the rise in OPEX that occurs as the new productive capacity becomes operational. Here, the dynamics for each of the commodities is quite different and as such they need to be looked at in turn. The ramp up in iron ore exports will have the larger impact on the current account in 214 and the first part of 215. ANZ Research is forecasting operating costs will average around USD55 per tonne in 214 and rise by less than 4% per annum thereafter. A significant portion of these costs are based in USD (eg tyres, fuel, etc.) and we estimate that on average only 5% of the costs are AUD-based. Furthermore, current efficiency trends suggest there is some downside risk to these estimates as mines continue to focus on cost cutting (over the last year, most major resource companies managed to reduce their cash costs through efficiency programs). As new infrastructure comes online, it is also possible that these costs will decline further.

20 Phase III of Australia s Mining Boom / 1 July 214 / 2 of 25 FIGURE 21. TIMING OF THE GEAR UP IN PRODUCTION million tonnes million tonnes F 215F 216F 217F 218F Iron Ore Supply (LHS) LNG Suppy (RHS) Source: Wood Mackenzie, Bloomberg, ANZ Research That aside, if we assumed that the above cost structure is realised, with volumes set to increase nearly 45% over the next five years according to the ANZ forecasts (which do not veer too far from those of the government s Bureau of Resources and Energy Economics (BREE)), this would imply approximately an USD2bn increase in domestic costs per annum between 214 and 218. While this is significant, it is dwarfed by the reduced demand for AUD that occurs because of the reduction in CAPEX. For example, Fortescue alone expects their capital expenditure to decline from AUD6.2bn to AUD1.9bn 4 over the next financial year, an amount equal to twice the increase in operating costs estimated for the whole industry. LNG exports only start in earnest in 215, and kick into top gear in This part of Phase III of the mining boom could be marginally more supportive of the AUD as a fresh source of AUD demand arises from the cost of extracting and processing the LNG. FIGURE 22. OPERATING COSTS FOR LNG PRODUCTION 6, 5, forecasts 4, AUD m 3, 2, 1, LNG Operating Costs Source: Wood Mackenzie, ANZ Research 4 Fortescue Interim results

21 Phase III of Australia s Mining Boom / 1 July 214 / 21 of 25 Over the remainder of 214 Australia will open capacity to supply an additional 2.5mmtpa. This compares to the current output of about 2mmtpa supplied by the North West Shelf and Pluto fields. As such, the new capacity is minimal. The rampup will become marginally more impressive, rising by an additional 7mmtpa in 215, and by approximately 15mmtpa over the next three years. Wood Mackenzie estimates that the operating costs from these projects will be AUD2.7bn in 215, AUD1.3bn more than 214, and will rise around AUD9m more per annum until 218, when they start to taper. These numbers once again fall well short of what is necessary to make up the loss in AUD demand from the decline in CAPEX. In addition, domestic contracts for LNG will provide a small AUD income stream. Gorgon will supply Western Australia, while the Queensland Curtis and Gladstone LNG coal seam projects will supply the eastern seaboard with gas. This AUD revenue stream will act as a natural hedge for these companies and somewhat offset some of the domestic operational costs, thus reducing the cost-based AUD demand. Financial costs impact on profit repatriation While most mining companies have funded expansion through retained earnings, the major domestic players, Fortescue and Roy Hill (partly owned by Hancock) have also built up debt in foreign markets. These debts reduce the profit available for repatriation, and so act as a drain on demand for AUD. When they last reported, Fortescue was still prioritising the repayment of debt to reach their target leverage ratio 5, having already reduced debt significantly over the previous 12 months. Profit dynamics also fall short While in aggregate costs may fall, the higher volumes will also convert into higher profits and this also has the potential to create new AUD trading dynamics. That said, it is important to note that not all of this profit will be returned to Australia. The mining companies concerned are large global conglomerates which operate across the world, and as such there is a USD bias in their currency holdings. Most of the major global diversified miners in fact hold their retained earnings in USD and as such not all profits are converted into AUD. There are two major channels through which these profits are returned to Australia: dividend payments and taxes paid on profits. For the iron ore producers, profit is highly dependent on commodity prices achieved. Below is a table providing a rough estimate of export revenue growth for the iron ore industry, with varying price assumptions presented to gauge the impact of higher/lower prices. It highlights that by 217, a USD1 fall in iron ore prices will reduce revenues by AUD8bn (all else equal). FIGURE 23. IRON ORE REVENUE SCENARIOS AUDbn Volume (mt) USD/tonne * assuming AUD/USD.94 5 Media Interview with FMG CFO

22 Phase III of Australia s Mining Boom / 1 July 214 / 22 of 25 From the micro level, consensus earnings can also provide some independent guidance. Bloomberg publishes both estimated profit numbers 6 and payout ratios for these publically listed companies. According to these numbers, Fortescue is forecast to experience an earnings decline in each of the next two years (declining to AUD2.945bn in FY215, and then AUD2.478bn in 216). Though its dividend payout ratio is currently 16%, current company reports indicate it will look to raise this when its gearing ratio falls to 4%. On current estimates (which assume Fortescue will achieve prices above USD11), the payout ratio will rise to 35%, doubling the dividend payable by 215. The rise in the payout ratio will be more important than the headline profit numbers. However, the rise would only amount to an additional USD32m (16% of USD2bn) of AUD demand. From 215 analysts are expecting Rio Tinto s earnings to rise by 5-1% a year. Assuming a dividend payout ratio of 5%, this could equate to USD5bn in FY214, not a significant rise relative to recent payments. For BHP, analysts are less optimistic, forecasting a decline in profit over the next three years. Once again, this does not imply a large increase in AUD demand. The key risk to these numbers will be any potential share buybacks as companies focus their attention on shareholder return. This flow into AUD will also be tempered by company ownership structures. For Fortescue 7, foreign owners are likely to repatriate any dividends paid in AUD, while for Rio and BHP, profitability is shared more broadly given their dual listing. For both, the UK market cap is nearly equivalent to that in Australia, and so the benefits of an improvement in Australia s trade position again do not fully convert into an equal rise in demand for AUD. Finally, when the Roy Hill mine (7% Australian owned) comes into operation, it will also add to capacity. However, production at this facility only picks up in late 216, and early 217 (rising from 1m/tonnes to 5m/tonnes), at which time the Roy Hill Project will provide about 6% of Australia s iron ore production). For LNG, the profit dynamics are quite different. Very few of the companies have Australian shareholders and thus profit dispersion within Australia will be very limited as most will take their retained earnings (which are billed in USD and received in USD), and use them to pay dividends in whichever country they are listed. In addition, the more heavily Australian-owned projects will gear up much later. In 215, Gorgon and Queensland Curtis LNG come on stream, but these projects are both 1% foreign owned. Only in 216 will projects which provide a domestic profit stream emerge. Gladstone LNG and Australian Pacific LNG will collectively produce 5.3mmtpa (around a third of the total increase in LNG production), but only 35% of this production is Australian-owned. In 216 this will equate to a 4% share in the profits, while by the end of 218 these projects will represent almost 2% of production, and the AUD profit share will be just 7% of the total aggregate profit for the sector. According to Wood Mackenzie, this will see an additional USD6m potentially flowing into AUD demand in 215, rising to around USD2bn by the end of 217, where it will plateau. 6 All profit numbers mentioned below are Bloomberg consensus estimates (as of 13 June 214) of profit before extraordinary items (the profit line Bloomberg uses to calculate the dividend payout ratio). 7 ANZ Research does not produce equity research and all information concerning individual companies, including forecast earnings information, is from publically available sources as referenced.