The iron ore price continues to sink under the weight of two reinforcing influences, neither of which appears likely to abate any time soon.
The original crack in the price two years ago was due to softening demand for China as its authorities wrestled with an over-heated economy and financial sector.
That slowing rate of growth in China, which accounts for two-thirds of seaborne iron ore demand, has continued and is continuing. The latest HSBC purchasing managers’ index showed a slight easing, with the domestic economy weakening.
There’s no reason to believe China is going to bounce back to double-digit-growth rates, with the authorities determined to pursue more stable and higher quality growth, so the demand side of the iron ore equation is unlikely to change dramatically in the foreseeable future.
As we know from the major iron ore producers’ production reports, their supply has increased dramatically and will continue to increase dramatically as they look to higher volumes and lower costs to offset price declines.
The recent Rio Tinto half-year results and BHP Billiton’s full-year results show that the strategy is working, with earnings from iron ore rising despite significantly lower prices. BHP is looking to expand its output further, from 225 million tonnes a year to 290 million tonnes, while Rio wants to lift its production from about 290 million tonnes a year to 360 million tonnes. Brazil’s Vale is pursuing a similar strategy.
It’s not surprising that, with weak demand and soaring volumes from the three big seaborne iron ore producers, the price has been sliding. Overnight it reached a new low in this price cycle of $US87.10 a tonne.
It may well go lower over the next year or so as the additional volumes enter the market. Rio, BHP and Vale aren’t going to be overly concerned, given that their cost bases are already at the lower end of the sector’s cost curve and are still reducing. Everyone else, however, is going to be worried.
The second and third-tier Pilbara producers, for instance, have far higher production costs and lesser quality ore that attracts a 10 per cent to 20 per cent discount relative to the prices that Rio and BHP achieve, so their realised prices are probably already falling below $US80 a tonne.
China’s domestic iron ore producers are even higher cost and lower quality and would be under severe pressure from the current conditions. However, the Pilbara producers have always factored in an element of 'social' factors within China to conclude that there will continue to be significant sub-economic or even uneconomic production within China.
While there are some conspiracy theories that have been built around the drive for far greater production by the 'big three' seaborne producers -- there’s a view that they want to drive their competitors out of the market by driving prices down in order to regain oligopoly control over the market and its pricing -- that would be a consequence rather than the motivation. Increased volumes are their only way to counter the decline in prices.
China’s steel industry appears to be getting nervous, however, about that prospect. There are reports that industry officials want to change the industry pricing model imposed on the sector by former BHP chief executive Marius Kloppers.
While the shift towards more market-based and index-based pricing and away from the annual contract negotiations and its benchmark prices is immature and therefore perhaps not as transparent as it might ultimately be, it is doubtful that Rio, Vale or BHP would contemplate a return to the old system or anything that resembled it.
The Chinese might worry about the major producers regaining their dominance of supply and destroying the wave of new smaller producers that emerged during the commodity price boom, but the big producers won’t forget how the Chinese steel mills acted when the commodity price slide began.
While the mills were only too happy to accept the benefits of the old annual contract pricing arrangements when iron ore spot prices were soaring, they reneged on the contracts when prices began falling in order to get access to the lower prices. That was a very one-sided 'heads I win, tails you lose' type of arrangement.
In the medium term, in any event, the mills will benefit from the big increase in volumes.
If the market entered over-supply earlier this year, the degree to which it is over-supplied (and therefore the continued downward pressure on the price) can only increase. The pressure on smaller producers can only become more acute as Rio, BHP and Vale continue to ramp up their production despite softer demand.