Digging for meaning

Getting to the bottom of the iron ore price.

Summary: For all the attention, the iron ore price seems to confound the so-called market experts. The current market price is holding up despite bearish future price expectations  –  thanks to slowing Chinese steel production. We explain why.
Key take-out: The market tends to understate demand and overstate the supply response.
Key beneficiaries: General investors. Category: Commodities.

The iron ore price, probably more than that of any other commodity in today’s global market, seems to captivate investor attention. At its simplest it is the price a buyer is willing to pay for a tonne of iron ore to be sent to its shores.  But is it so simple? The iron ore price hardly tells the full story.

The daily price of iron ore supposedly provides an insight into how the Chinese economy is travelling; and what the share price performance might be for major iron ore producers.

Certainly from a fundamental perspective, iron ore makes up an increasing composition of BHP and Rio Tinto’s underlying earnings making it a key driver for analysts’ valuation models and share price targets. Moreover, an outlandish, far-from-consensus price forecast can bring notoriety to an analyst or their firm and create unparalleled levels of debate and media coverage within the capital markets.

Confounding the experts

Yet for all the attention, the iron ore price seems to confound the so-called market experts, as evidenced by a healthy divergence of opinions over its future direction. For the most part future price predictions appear to be overwhelmingly bearish with analysts citing slowing steel production out of China as a major influence. Presently, the most dire predictions are for a short-term price correction to levels of around US$85 tonne.

So why then has the price remained stubbornly above US$115 tonne and in recent days hovered around US$130 tonne? Most likely because the market tends to understate the demand picture and overstate the supply response, giving little recognition to the downside protection mechanism offered by the cost curve. In a recent quarterly update on the iron ore market KPMG acknowledged that while demand growth was slowing in percentage terms, without new expansion projects currently being undertaken in Australia’s Pilbara and Brazil’s Minas Gerias, current known iron ore reserves would be exhausted by 2050. Furthermore, KPMG suggested “as low cost hematite deposits run out, sources of iron requiring greater capital investment and operating costs for infrastructure and/or processing will be needed and change the price point.”

Iron ore like all commodities is finite by nature. New discoveries and technologies come at a cost and these costs must eventually be absorbed in the cost curve meaning higher prices are now required to maintain profit margins. In the absence of prices covering costs, higher cost producers are shut down and intended supply is not forthcoming to the market. It is this shortfall in actual supply versus planned supply that underpins prices and goes to the essence of how the cost curve (theoretically) provides a natural support for prices. The practicalities of this explain why many of the predicted supply surpluses in the past failed to materialise. From an iron ore perspective it helps explain why last September’s dip in the iron ore price into the mid-US$80s was so short lived with the price rebounding back to US$120 in less than three months – quite simply a large portion of the industry’s production was underwater at those lowly levels.

Negative perspective

Evidence of the market’s default ‘glass half-empty’ perspective to Chinese data were the June import numbers released two weeks ago. While those numbers showed that China imported 384 million tonnes of iron ore in the first half of 2013, a 5.1% increase on the same period last year, the market chose to focus on the June import tonnage of 62.3 million tonnes, which was down 9.1% on the previous month.  Let’s not mention that this number was still 6.8% up on the June import numbers of a year ago. A prime example of long-term ongoing demand expansion painted in a negative light base on a single month’s data.

For something that is so closely analysed, the iron ore price, its future direction and the drivers that underpin it, remain some of the least understood topics in today’s global commodity markets. So next time you read about the topic or hear it being discussed on Sky Business or CNBC, think beyond the headline price and consider its wider ramifications.

Cameron Peacock is an investment analyst.

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