A Chinese burn for Australian miners

The 22 per cent plunge in iron ore prices this year reflects a swirling mix of factors, with ‘creative’ financing and speculative activity over-laying some far more fundamental shifts in the supply and demand equation.

The flashpoint for Monday’s dramatic dive in the iron price below $US105 a tonne was provided by data released over the weekend showing an alarming and unexpected plunge in China’s exports last month, with exports falling more than 18 per cent compared to February 2013.

Concerns about the rate of China’s growth rising and a backdrop of China’s attempts to control its shadow financial system have weakened the near-term outlook for steel-making and iron ore demand -- even as supply keeps increasing.

BHP Billiton’s chief financial officer, Graham Kerr put the outlook for iron ore into perspective at a briefing that accompanied the release of the group’s first half results last month. He said BHP expected the growth in demand would be smaller than the growth in new low-cost supply.

China’s steel demand, he said, was expected to grow by just over 3 per cent, leading to iron ore demand growth of about 60 million tonnes. The growth in seaborne supply, however, would be more than 100 million tonnes.

While that’s a less sanguine outlook than those provided by Rio Tinto and Fortescue Metals, it is consistent with the forecasts of some investment banks that the market would move into oversupply in this quarter.

Output from the Pilbara and Brazil continues to rise as a result of the massive investments that have been made in expanding capacity over the past five years. The extent of that oversupply is almost certainly going to increase. Unless there is a massive and unlikely rebound in China’s growth rate and demand, there will be obvious implications for iron ore prices and for higher-cost producers.

With China trying to manage its growth rate and the composition of that growth to reduce its dependence on exports, the producers are unlikely to get much relief from a meaningful lift in demand. Predictions for an iron ore price trending towards $US80 a tonne over the next 12 to 18 months aren’t outlandish.

The extent of price gyrations over recent days could be explained simply by reference to the fundamentals, but there are some other influences.

As my colleague Robert Gottliebsen explains (The hidden crisis behind copper and iron ore price collapses, March 11) there has been some unusual activity in iron ore and copper markets.

In the copper market it has long been the case that traders have bought and stockpiled inventory purely as part of a financing strategy to get around China’s periodic attempts to control credit growth.

In recent months, analysts -- puzzled by the extent of the build-up in iron ore inventories at China’s ports -- have postulated that traders and cash-strapped steel mills have been doing something similar. It appears they were right.

With China’s growth spluttering, its exports falling and banks starting to call in loans to loss-making steel mills, the trading and financing games have stopped. The big iron ore miners have become obvious and compelling targets for hedge funds.

The miners are, to varying degrees, highly leveraged to the iron ore price, which averaged just over $US125 a tonne last year. Every 10 per cent movement in the price, for instance, adds or subtracts $US120 million from Rio’s earnings.

Rio, BHP and Vale are the low-cost producers in the industry, with Fortescue working hard to lower its costs. They are all expanding production to blunt the impact of price declines with greater volumes, although it has been quite obvious from their recent results and their stated sensitivities that price movements have a far, far greater impact than volume increases.

In theory, over time, their increased low-cost production will drive out higher-cost ore and bring the market back into balance.

That pre-supposes, however, that China’s domestic producers will shut down uncompetitive production. None of the miners expect the theory to play out perfectly (for social reasons), and where iron ore mines are co-located with steel mills, that production is expected to continue.

As China finally imposes some pressure on the steel industry to reduce excess capacity (China raises its iron ore fist, March 11) and the probable imperfect workings of the iron ore market, the medium-term outlook for the price and the sector is cloudy and volatile -- but clearly negative.

The only real surprise in what’s happened this week isn’t the break in the price, but that it happened so abruptly.