Hammer to fall on an iron spike

Beyond the current high iron ore price is a longer-term shift to diminished demand and growing supply. Miners will increasingly need to focus on costs and volumes.

Within a couple of days first Fortescue Metals’ Nev Power and then Rio Tinto’s Sam Walsh have warned that the remarkable rebound in iron ore prices won’t last. Others aren’t as sure.

Earlier this week Power attributed the sharp rise in iron ore prices above $US140 a tonne to supply shortages as a result of the northern winter and China’s new leadership’s pledge late last year that stable and relatively fast economic growth was its objective for 2013.

Walsh followed up in an interview with The Australian today by saying the price spike was likely to be temporary. His explanation for the recent rise was that it was due to short-term factors like re-stocking and nervousness among the steel mills about the imminent cyclone season and its potential impact on Pilbara production.

That the mills would be restocking now would make some sense, given that it was destocking that helped drive the price down below $US88 a tonne in September last year. For the miners, and the Australian economy, however, what matters more than short-term shifts in demand is the medium to longer-term supply and demand equation.

There are conflicting views about how that might play out, with some analysts very optimistic about the strength of demand through this year and the price expectations that could generate and others far more pessimistic. The range of price forecasts starts below $US80 a tonne and tops out at around $US170 a tonne.

The key is obviously China’s economy, where the policymakers have targeted growth of around 8 per cent this year. They have, importantly, approved significant steel-intensive infrastructure spending as part of the growth agenda and there are also signs that China’s manufacturing sector is again growing.

But with the eurozone in recession and riddled with severe structural challenges that will take years, if not decades, to resolve (even if its policymakers can keep the fissures within the eurozone economies from widening further), the US this week deferring rather than addressing its own fundamental fiscal challenges and Japan still flat-lining, it is unlikely China’s economy could return to the levels of growth experienced pre-crisis.

China’s demand is, of course, only half of the equation. The probably more telling aspect is supply.

The financial crisis dampened the supply-side response to the heady growth in China’s demand for steelmaking materials, hence the extraordinary surge in iron ore prices to around $US190 a tonne at its peak. A massive structural surge in production was well underway when the price started tumbling last year, stranding a lot of prospective new production.

There has still, however, been a vast increase in production and there is a lot more to come.

Rio Tinto will increase production from 230 million tonnes to 290 million tonnes this year on its way to 360 million tonnes by 2015. BHP Billiton is producing ore at a rate of more than 170 million tonnes a year on its way to 220 million tonnes per annum by 2015. Fortescue has re-started its momentarily suspended Kings expansion project as part of a 60 mtpa expansion to lift production to a rate of 155 million tonnes a year. Brazil’s Vale, despite cutting back heavily on capital expenditures, is still in the midst of the biggest expansion program in its history.

What that says is that despite the impact of last year’s price falls on emerging producers (like those in the mid-west of Western Australia whose projects have been stranded) there is a vast amount of new supply coming into the market progressively over the next few years.

The supply shortfalls that helped push the price up to stratospheric levels are being steadily filled in and, while the price remains above $US120 a tonne, will also be swollen by otherwise marginal Chinese domestic production.

Recognition that, despite short-term fluctuations driven by seasonal influences or inventory cycles, the structural change in the supply/demand equation has occurred and the supply-side is still adding capacity has led Rio, BHP, Fortescue, Vale et al to the same conclusion.

The future will be about volume and costs rather than prices, which is why they are all racing to strip operating and capital costs out of their operations – Rio is targeting $US5 billion of cost reductions by 2014 to protect its margins and its status as the low-cost producer.

That longer-term picture of rising supply and global demand that is, relative to the pre-crisis environment, subdued demand would suggest that the current rebound in prices, however long it persists, is a temporary departure from a steady retreat towards iron ore’s long-term norms.