Iron ore in a steel trap

Squeezed operating margins are putting iron ore stocks under renewed pressure.

Summary: After a sharp fall last year, the price of iron ore staged a recovery as ore stockpiles were steadily reduced. But with demand for iron ore reducing in line with lower steel production, especially in China, the iron curtain may be falling again.
Key take-out: For iron ore miners operating on slim profit margins, a sharp deterioration in the ore price will have potentially devastating effects.
Key beneficiaries: General investors. Category: Commodities.

A crisis is building in Australia’s iron ore industry, with rising costs and falling prices squeezing profit margins in what could become a longer-lasting repeat of last year’s price crash that triggered an investor rush for the exits.

Adam Carr pointed to the prospect of a broad commodities price rebound on Monday in his article Can commodities stage a comeback?, but this article is specifically focused on iron ore.

Conditions are not as bad yet as the middle of last year, when the iron ore price fell from around $US150 a tonne to $US87 a tonne in a matter of weeks. But there is pressure building in the iron ore market as China’s rate of economic growth slows and demand for steel (the only end market for iron ore) declines sharply.

Over the past four-weeks the price of premium-grade ore (62% iron content) has fallen by around 9% to a recent low of $US144 a tonne, with one of China’s key economic agencies, the National Development and Reform Commission, demanding even lower prices as well as accusing the major international iron ore miners, including BHP Billiton and Rio Tinto, of price rigging.

First signs of what could happen over the next few months to Australia’s listed iron ore miners can be detected in some share prices, with Mt Gibson Iron (MGX) already back to a price seen in last year’s panic selling. At its latest price of 63c, Mt Gibson is down 29c (31.5%) in less than a month and only just above its 12-month low of 61.5c.

Other iron ore miners have not fallen as far, but there is a downward trend evident that should be a warning to investors that worse times are to come, especially if a number of recent price forecasts prove correct.

Fortescue Metals Group (FMG), the biggest of the pure-play iron ore miners, has fallen by $1.23 (22.5%) over the past month from an intra-day high of $5.47 on February 14 to recent trades at $4.24 – a price which is still comfortably above its 12-month low of $2.81 reached on September 6 when the company was under intense pressure to refinance its debts.

Atlas Iron (AGO) has fallen from by 57c (30.5%) since mid-February, a fall which has put it within sight of its 12-month low of $1.14 reached in early September.

(Source: Bloomberg)

BC iron (BCI) has held up best among the producers, shedding just 38c (9%) to $3.80 over the past two weeks to be well ahead of last year’s low of $2.24, while Iron Ore Holdings (IOH) has risen by 18c (18.7%) since mid-February after announcing plans to start its first mine.

Some of those price movements reflect the growing level of concern about the future profitability of the iron ore sector, which has enjoyed a 10-year boom. But that might be coming to an end, with last year’s sharp fall an early warning of a prolonged downturn.

The recent falls also reflect a warning in a story I wrote for Eureka Report last October (Iron ore’s dead cat bounce).

The argument in that report was that the sharp mid-year price fall was a warning of what lay ahead, with the October iron ore price recovery driven by short-term re-stocking by Chinese steel mills. This process lasted until early this year but has now ended, leaving the market exposed to more conventional supply-and-demand forces.

If that’s the case, and the boom which has driven double-digit growth in steel consumption in China has ended, then Australian iron ore producers will find themselves exposed to conventional 3% annual growth in steel consumption as forecast last week by the chief executive of China’s biggest steelmaker.

Baosteel boss, He Wenbo, described the outlook for steel as “a period of stability”, a change which will feel like a slowdown. “The steel industry had become used to rapid growth, so now that it slows down it will take time to get used to that,” he said.

Over the past three weeks changing market conditions have produced a flood of iron ore price tips, some of which have plunged to alarming levels. One particularly excitable economist has predicted a price of $US60 a tonne, a level which would see a number of higher-cost Australian miners go out of business.

The man responsible for the low-price forecast was Andy Xie, a former chief economist in Asia for the US investment bank, Morgan Stanley.

Always an entertaining speaker, Xie has a habit of adopting extreme positions, though his extensive Chinese connections and base in Shanghai means that his forecasts carry some weight.

Significantly, Xie is not alone in warning of tough times ahead for iron ore. Another economist who is even closer to the market is Vivek Tulpule, chief economist at Rio Tinto, Australia’s biggest iron ore producer.

Last week, Tulpule shocked his industry when he told a meeting of investment analysts in Sydney that the iron ore price was on its way to $US100 a tonne, down 33% on the recent high of around $US150 a tonne.

Price tipping is always tricky, but when people with the experience and connections of Xie and Tulpule forecast a big fall in iron ore it would be unwise to ignore them, especially as other experts can see the start of a significant and lasting slide in the price.

The investment bank Goldman Sachs has maintained a long-term bearish view of iron ore, with its latest forecasts for an average price this year of $US144 a tonne for ore with a 62% iron content falling next year to $US126 a tonne, and then down to $US90 a tonne in 2015.

For investors, there are two additional worries when it comes to assessing the future potential profitability of iron ore producers. They are:

  • The price of iron ore most commonly quoted is not what most miners get because very few mine ore with a 62% iron content, and
  • The cost per tonne generally quoted by the miners is not their true cost, with most using a cash cost which omits financing and other charges.

It was that pincer effect of producing a lower grade ore and having a higher true cost which crushed the Fortescue share price last year and raised doubts in the market about the long-term survival of the company unless it slashed costs and refinanced its debts – which it did.

But, nothing has really changed in the industry, as a few examples illustrated.

Mt Gibson, in its report for the six months to December 31, said the average industry-wide price in that period for 62% iron ore was $US117 a tonne, whereas it received an average of $US102 a tonne, roughly 90% of the generally quoted iron ore price. Mt Gibson’s total costs in the half year were $78.90 a tonne.

It’s not hard to work out that if Tulpule’s $US100 a tonne price forecast is correct then Mt Gibson will be under pressure because it will probably still be getting only 90% ($US90 a tonne) for its ore leaving a margin of less than $US12 a tonne unless production costs are cut.

If Goldman’s $US90 a tonne for 62% iron is accurate (and that infers a price of $US81 a tonne for Mt Gibson’s ore) then the profit margin effectively disappears.

In Fortescue’s case the equation is broadly similar with it reporting a cash cost in the December half-year of $US50 a tonne, with another $US18 a tonne added in operating costs to produce a real cost of $US68 a tonne.

(Source: Fortescue Metals Group)

Significantly, Fortescue received an even lower average selling price than Mt Gibson with its ore fetching just $US96 tonne, a function of Fortescue’s material having a lower iron content.

Fortescue’s December profit margin of $US28 a tonne would be under severe pressure if Tulpule’s $US100 a tonne forecast for ore at 62% iron proves to be correct because that could translate into a price of $US82 a tonne for Fortescue’s ore leaving a profit margin of just $US14 a tonne unless costs continue to be reduced.

Similar cost/price exercises can be run on all the Australian miners to demonstrate that they might be heading into tough times as the gap between the real price they receive their real costs narrows.