Follow the money in iron ore

The surge in the iron ore price has divided the experts into two camps. First are the fundamentalists who are sticking to the view that Chinese seasonal demand will fall and knock the iron ore price back down to where, in theory, it should be. The second group has already revised up their price forecasts for the remainder of the year.

One camp will ultimately be proved wrong and will wear the heat from clients and their own organisations. The sharemarket is following the iron ore bulls.

The bottom line is that the iron ore price is meant to be weakening at this point in the calendar year. We are moving into the traditional third-quarter soft period where demand from the Chinese steel makers shrinks.

But strong steel production during July seems to have interrupted the usual market dynamics, at the very least moving timing or any correction in the iron ore price back a couple of months.

Morgan Stanley notes iron ore imports into China during July were strong given the elevated steel production and were not the result of stockpiling. The question now exercising commodities analysts is whether from its current price perch of close to $US140 a tonne iron ore will fall to levels of an average of $US100 in the third quarter (the fundamentalist view) or sustain a more gentle decline to around $US$125.

Already this year the iron ore price has broken from its theoretical script. It fell more than was expected in first half of the calendar year. Iron ore is a commodity that doesn't have a long history of being traded on a spot market. Until only five years ago most of the pricing was set among the major suppliers and customers after annual negotiations.

Even now as a hangover from those days (and because of a small number of market participants) the movements in the price can be a bit lumpy compared with other commodities. It could be that those anticipating a slump in the iron ore price over the next couple of months due to last year's experience are placing too much stock in an unreliable history. At this point the iron ore bears are under plenty of pressure. In the third quarter last year Chinese steel production slumped at the same time supply was ramping up.

There is a general consensus that additional supply will come on as this year progresses. The additional tonnage from Rio, Fortescue and BHP has been well documented. And this will continue through 2014. But will China slam the brakes on liquidity as it did last year? The jury is still out and there are many that are anticipating a softer landing. At this stage Chinese steel mills and steel traders are still restocking.

Merrill Lynch this week provided one of the more bullish outlooks. "We raise our 2013 iron ore price forecast by 9 per cent to $US131 as we incorporate higher realised prices in [the first half of 2013] and raise our [second half]."

Meanwhile, the sharemarket has already cast a vote. Pure-play iron ore producers like Fortescue and Atlas Iron have experienced huge share price gains over the past six weeks. Diversified miners including Rio and BHP have also felt a positive change in sentiment.

In part these stocks were oversold earlier in the year and the revival represents some compensation. The earnings uplift all these companies could experience (if the current iron ore spot price remains) is substantial.

Running these prices through the Rio model for 2014 would result in a 15 per cent improvement in calendar year earnings. Fortescue's profit would be up about 50 per cent in fiscal 2014, while Atlas would receive an earnings boost of as much as 100 per cent. But while some commodity analysts have been revising iron ore pricing the equities analysts that cover iron ore stocks have not dipped their toes into their models.

To the extent new iron ore prices are factored into corporate earnings it won't (typically) happen until the end of the September quarter.