Iron ore: Grade is king

Summary: The ‘de-commoditisation' of iron ore has begun where the difference between ore quality-to-price must be paid more attention to than ever before.

Key take-out: Investors must better understand how iron ore is priced as low-grade ore receives a damaging discount.

Iron ore quality has emerged as a critical issue for Australian miners of the steel-making mineral. One producer of low-grade ore this week announced a premature mine closure and another revealed that it is being whacked with a massive discount by its customers.

Cliffs Natural Resources blamed a collapse in the price for its low-grade ore as a reason for planning the closure of its Koolyanobbing mine in Western Australia by the end of the year, five years ahead of the scheduled shutdown.

Fortescue Metals Group, one of Australia's iron ore majors, said it was only paid 68 per cent of the widely quoted reference price for high-grade ore in the half-year to December 31 but was expecting to receive between 70 per cent and 75 per cent of the reference price for the full-year.

Ore quality has always been an issue for miners to manage, but in the past the big quality issue has been impurities which can affect the strength of steel, with discounts applied for higher-than-average amounts of unwanted elements such as silica, alumina and phosphorous.

Those discounts are still being applied, but the much bigger issue today is the iron content in ore. Steel mills are demanding peak-quality material to maximise their profits, as well as in reducing pollution around steel mills, particularly in China.

What's happening is deeply significant for the Australian mining industry. Even though there is nothing new in the mining maxim that ‘grade is king', it is a comment normally applied to base metals such as copper and zinc, and precious metals, such as gold and silver.

Until recently bulk materials, such as iron ore, manganese and coal, were lumped together under the description of ‘commodity', with limited attention paid to quality.

That has changed. Whether it is a permanent or short-term change is not yet known, but it was enough for investment bank Credit Suisse to refer last week to the “de-commoditisation of iron ore and (iron ore) equities”.

The value in iron ore

The challenge for investors is in understanding how iron ore is priced, a process which starts with a reference price that is generally applied to ore assaying 62 per cent iron, with low impurities. Ore which meets that quality is currently selling for about $US74 a tonne.

Lower-grade ore, generally material assaying 58 per cent iron, is selling for about $US59/t, while 58 per cent ore high in impurities is selling for about $40/t.

In Fortescue's case, in its latest quarterly production report, it said it was paid an average of $US46.70/t in the December half, the so-called ‘realised price'.

What's happening to Cliffs, and is happening to Fortescue, is a warning shot that they will have to watch ore quality more closely than ever, especially as steel mills demand high-grade, low-impurity ore, and apply damaging discounts to substandard material.

Cliffs has been operating the BHP-built Koolyanobbing mine in the south of WA for the past decade. While it once provided high-grade feed for a blast furnace at Kwinana, south of Perth, and has been successfully exporting to Asia, the reserves of high-grade are running out.

Lourenco Goncalves, the outspoken chief executive of US-based Cliffs, said the discounting of low-grade ore was making it difficult for the mine to operate profitably.

“As the Chinese preference for higher grade ores has only increased over the past year, our non-core, low-grade operation in Australia has continued to refine its mine plan to the best of its ability,” Goncalves said. “That said, we will likely cease mining operations in Australia later this year.”

Fortescue's problem with low-grade ore has been widely reported but it is now starting to change the shape of the company as it hunts for higher-grade deposits to try and boost its average iron grade to more than 60 per cent, something that might be achieved when it develops the higher-grade Eliwana deposit.

Adding a new iron-ore mine to achieve a higher realised price is not all that Fortescue is doing to manage a problem that goes to the heart of the business which was founded on low-grade ore and which has survived (and prospered) by winning an industry-wide cost-cutting race.

A second move away from low-grade iron ore is to diversify, with Fortescue now looking for lithium in WA's Pilbara, copper and gold near Orange in NSW, and base metals (copper) in the South American countries of Ecuador and Columbia.

Since it reduced iron ore production costs to just $US12.08/t in the December quarter, the low realisation price could be comfortably managed. But, if the cost of production rises as new and higher-grade mines are developed, and the iron ore slips as forecast, Fortescue will be challenged.

A paradigm shift

In its “de-commoditisation” report, Credit Suisse said the change in what steel mills were demanding represented “a paradigm shift where product differentiation has become key” with every iron ore miner, including sector leaders such as Rio Tinto, BHP and Brazil's Vale, adjusting to the change.

Vale, which owns the world's highest-quality iron ore mines, has increased the amount of blending its various ores to achieve a more uniform product. While Vale has the capacity to produce 450 million tonnes of ore a year, it has indicated its target is to only produce 400m/t as it pursues a plan of “quality over quantity” to maximise profit.

The need to meet customer demands for higher-quality ore is well understood – but two things still remain unclear. Number one, how long will the trend continue, and two, what's really driving it?

Credit Suisse believes the quality issue could be a factor in the iron ore industry for several years with a wide price gap remaining between high-grade and low-grade ore. By the end of 2018, the bank expects 62 per cent ore to be selling for $US55/t, low-impurity 58 per cent ore to sell for $US46/t and high-impurity ore to sell for $US36/t.

Chinese steel mills, which have been reported as seeking higher-grade ore to comply with tougher environmental laws, might be making the shift for another reason – profit.

Credit Suisse said it had questioned a number of Chinese mills about whether they were using higher-grade ore to reduce pollution.

“The answer was unequivocally no, the choice of ore grade was purely about profit,” the bank said.

A representative of the China Iron and Steel Association said the mills had been forced to invest in pollution control equipment, and to turn it on, to keep their licence to operate.

“Now that they have this equipment operating the choice of ore makes no difference to pollution,” the CISA spokesman is reported to have said.

This de-commoditisation of a traditional commodity business, as Credit Suisse describes the situation, is a novel twist for the Australian mining industry and mining sector investors.