A growing shadow over the iron ore age

For the past couple of years there has been a rough consensus that the iron ore market would swing into surplus around 2015 or 2016. That point where the market is oversupplied now, however, appears somewhat closer.

The conventional wisdom was that while there have been quite a few short-term fluctuations in the price over the past year (the price tumbled below $US90 a tonne last September before recovering to levels above $US150 a tonne) more controlled growth in China in the near to medium term and a slowing of the growth rate in the intensity of steel usage in China as its infrastructure investment boom wanes would dampen the demand side of the supply-demand equation.

On the supply side there would be a continuing surge in new production as new mines and the massive expansion of production from existing mines began to enter the market in a financial crisis-delayed response to China’s previously soaring demand. It would now appear that a significant amount of that new supply will come on later this year and early next year even as the growth in demand slows.

Over the past month the share prices of the iron ore producers have taken something of a beating as the dawning realisation that the moment where the enlarged supply surpasses demand is rapidly drawing closer.

For seasonal reasons, and because the Chinese steels mills overdid their destocking as China’s growth slowed last year, the price has bounced back strongly so far this year. Most in the market, however, appear to believe that it will fall back significantly in the second half.

Another piece of conventional wisdom was that there is a floor under the price provided by the marginal costs of China’s domestic iron ore producers, estimated at around $US120 a tonne.

That is, however, being challenged by a piece of Goldman Sachs research this week that has rattled the market.

On the demand side it believes the growth in demand for iron ore will be below GDP growth as China’s economy matures and that the global seaborne iron ore demand will eventually revert to its historic growth rate of about 2 per cent a year – a long, long way short of recent experience.

That’s partly a function of the change in the composition of China’s growth away from infrastructure spending that is occurring but also because Goldman believes that some primary steel production will be displaced by steel scrap, another manifestation of a maturing of China’s economy.

It also believes China’s domestic producers will prove more resilient than previously thought, with investment occurring in larger and more efficient mines which will displace the marginal low-grade producers that now account for about a quarter of China’s production. That larger than expected domestic production will mean fewer tonnes of seaborne iron ore will be bought.

Goldman’s conclusion is that the market will be in surplus next year and by 2015 about 200 million tonnes of seaborne supply will need to be ‘’rationed’’ out of the market.

If that estimate of the surplus supply is broadly right, it would, of course, have a depressing impact on the iron ore price until those tonnes disappeared – Goldman believes the price could fall through this year and continue to slide until it is below $US88 a tonne in 2018.

Once the surplus is cleared the price would be set by the marginal seaborne producers with low-grade haematite and magnetite deposits in Australia and Brazil. Goldman estimates their production costs at around $US70 to $US75 a tonne, so it is conceivable that prices could get down to about half current levels until the market finds a better balance.

Much of the new supply will come from the industry heavyweights – Vale, Rio Tinto and BHP, as well as the new and higher-cost Fortescue – with a big surge in supply from the first half of 2014.

As we saw when the price slumped last year, a big fall in price does impact the profitability of the big miners. Rio, despite significantly increasing iron ore production volumes, earned $US4 billion less last year because of the lower price. As the price trends back toward historical norms, the super profitability of iron ore producers during the period when producers were playing catch up with China’s demand will evaporate.

Nevertheless, the big three established producers are still at the low end of the industry cost curve and Fortescue will also be a relatively low cost producer once its current expansion program ends, albeit a financially leveraged one. They will still generate good margins and profits, albeit not the exceptional profits they have reported in the past several years.

It is likely to be the smaller and newer producers and prospective producers, with higher costs and lower quality orebodies, that get pushed out of the market as the new supply pours in. It is also likely that any big new projects, like Rio’s Simandou project in Guinea, will be mothballed for the foreseeable future.

The big iron ore producers knew there would be a moment later this decade when supply caught up with demand but thought they had a bit more time – and a lot more profit – before that moment arrived.

If Goldman is right – and it isn’t the only investment bank, analyst or miner reading that outcome from the changing nature of China’s economy and the shifting balance of demand and supply – that moment is now in sight.