Follow the money in iron ore
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.
Frequently Asked Questions about this Article…
The iron ore price has jumped recently, splitting analysts into two camps. Some 'fundamentalists' expect seasonal Chinese demand to fall and push prices down toward about US$100/tonne in the third quarter, while others have revised forecasts higher (some forecasting gentler falls to around US$125/tonne). Brokers like Merrill Lynch have also raised their 2013 forecasts, reflecting stronger realised prices earlier in the year.
There’s disagreement. Historically the third quarter is a softer period as Chinese steel demand eases, which supports the view of a fall toward roughly US$100/tonne. But stronger-than-expected Chinese steel production in July and continued restocking by mills/traders have interrupted that pattern, so prices near US$140/tonne could decline only gently to around US$125/tonne instead.
Chinese steel production and import levels are key drivers. Strong steel output increases demand for iron ore, and Morgan Stanley noted July imports were strong and not just stockpiling. If Chinese mills and traders continue restocking, that supports prices; if China slows liquidity like it did last year, prices could weaken.
The article notes additional tonnage is expected from major producers including Rio Tinto, Fortescue and BHP through 2014. More supply generally puts downward pressure on prices, but the timing and scale of Chinese demand will determine the net effect.
The sharemarket has responded positively: pure-play iron ore producers like Fortescue and Atlas Iron experienced large gains over a recent six-week period, and diversified miners such as Rio and BHP have also seen improved sentiment. Part of this reflects a rebound from earlier oversold levels.
If the current spot iron ore price holds, the earnings uplift could be substantial. Running those prices through Rio’s model suggests about a 15% improvement in calendar 2014 earnings, Fortescue’s profit could be up roughly 50% in fiscal 2014, and Atlas Iron might see an earnings boost of up to 100%.
Iron ore historically wasn’t widely traded on a spot market until about five years ago; pricing used to be set by negotiations among a small number of major suppliers and customers. Because there are still relatively few market participants, price moves can be uneven or 'lumpy' compared with more liquid commodity markets.
Equities analysts covering iron ore stocks had largely not yet updated their models at the time of the article. Typically, new iron ore prices are factored into corporate earnings forecasts around the end of the September quarter, when companies and analysts update their numbers.
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