Don’t believe the iron ore conspiracy theory

Are the big iron ore guys really conspiring to put the small producers out of business? The short answer is ‘no’, and here’s why.

It’s curious how people prefer to choose a conspiracy theory over obvious logic, with Rio Tinto’s Sam Walsh having to again deny that the big iron ore miners are co-ordinating their expansions to drive out competitors and regain control of the iron ore market.

As Walsh said in an interview with the Wall Street Journal at the weekend, that’s “absolute nonsense”.

With iron ore prices still falling -- the price is below $US76 a tonne -- there are those, including Western Australian premier Colin Barnett -- who don’t, or don’t want to, understand why the big producers like Rio, BHP Billiton and Vale are continuing to expand their production bases.

Rio, for instance, is nearing the end of its latest expansion program that will see its annual iron ore output rise from about 290 million tonnes a year to 360 million tonnes. BHP is in the process of lifting its annual output from 225 million tonnes to 290 million tonnes. Vale has a number of big expansion programs underway or on the drawing board. All up, if Gina Rinehart’s Roy Hill project is included, there is more than 350 million tonnes of extra production in the pipeline.

While it might appear counterintuitive that producers should aggressively lift production even as the price tumbles -- in the June half of this year Rio’s average realised price was $US103 a tonne and in 2013 the average price was about $US135 a tonne -- the big producers are acting rationally.

As Walsh said to the Journal, Rio is the sector’s lowest-cost producer. Its cash costs are around $US20 a tonne, its “all-in” costs are just above $US40 a tonne, and it can expand capacity with very low levels of capital intensity.

If you can produce a commodity at $US40 a tonne and sell it at $US76 a tonne, or even $US70 a tonne, the obvious incentive is to produce more of it, which is what Rio and BHP are doing.

Even with the volume increases -- and the very significant cost reductions the big producers have achieved in the past two years -- they may not be as profitable as they might have been had the price held at the boom levels achieved in 2011, when the price peaked above $US180 a tonne. They will still, however, be significantly more profitable than they would have been had they not increased production.

With the market already in oversupply -- the best guesstimates are around 80 million to 100 million tonnes of overcapacity despite some reduced production from higher-cost producers -- the increased output of the big low-cost producers will obviously impact prices and competitors.

In the absence of a sharp pick-up in China’s demand, which is improbable, the continuing expansion of the majors will drive smaller second and third tier producers with higher-cost and lower-quality product out of the market. But that is a rational development and the illustration of the market at work, not the intended result of some conspiracy.

The major iron ore miners don’t have to conspire to conclude that their individual interests are best served by increasing their volumes; the impact on smaller and higher-cost competitors is an outcome, not their objective.

It is an absolute article of faith in the resources sector that the low-cost producer remains profitable and survives despite the market circumstances.

As long as the Rios and BHPs continue to ramp up their production, as the surplus in the iron ore market continues to build and as the price continues to slide, the flow-on effects of that conviction on their own operations and strategies and on their competitors will continue to play out in a very visible, and often (for the competitors) painful fashion. It’s the market at work, not a conspiracy.

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