With the iron ore price now down more than 20 per cent from where it started the year, two Goldman Sachs research reports issued this week provide both a context for what’s occurring and a perspective into what it means for iron ore producers.
With the price now below $US105 a tonne compared with its starting point this year and last year’s average of around $US135 a tonne it would appear that the anticipated shift towards a surplus in the seaborne trade is emerging faster than had previously been anticipated.
The early part of each calendar year normally sees the price firm as the cyclone season impacts the Pilbara producers and production rates at Chinese steel mills peak ahead of a seasonal downturn in winter.
Instead production continues to rise as the vastly-expanded capacity of the big producers in Western Australia and Brazil continues to come onstream and the stocks of iron ore at Chinese ports continues to rise. At the moment there is an overhang of inventory at the ports of more than 100 million tonnes.
That has led Goldman’s analysts to conclude that the market is finally edging into structural surplus, somewhat ahead of schedule. The more bearish of analysts had forecast that a structural surplus could emerge towards the latter part of this year but the combination of strongly rising supply and China’s efforts to rebalance its economy may have brought that moment forward.
The analysts see a surplus of seaborne iron ore approaching 80 million tonnes this year, rising to 145 million tonnes next year and continuing to rise through to more than 280 million tonnes in 2018.
That rising curve of over-supply would have obvious implications for iron ore prices and the Goldman team, like many others, see it falling back to around $US80 a tonne next year – and staying there as the expansion in production capacity continues.
A separate piece of research focused on the “extraordinary fixed cost leverage” of Australian producers. While the thrust of the analysis was on the impact of lower iron ore prices on the tax base and broader economy (a loss of $7 billion of federal tax revenue over the two years to 2015) it also provides an insight into the impact for the producers themselves.
While Goldman says iron ore exports will continue to rise strongly – 19 per cent this year and another 9 per cent off that expanded base in 2015 – it says the lower prices will lead to a $US4 billion decline in revenue.
The fixed cost leverage that the report is focused on shows up in a $US10 billion dive in pre-tax earnings.
“It is the inability for the resource sector to alter its cost base as quickly as its revenue stream moves that drives compression in profitability,” the report said. It forecasts a $A7 billion decline in earnings for the Australian producers this year and $17 billion in 2015.
What the reports highlight is the extent to which the producers allowed costs to blow out and their productivity to decline during the boom years and the consequent leveraged impact on profitability as prices fall at a greater rate than costs.
Goldman says productivity in the sector fell 48 per cent between 2003 and 2012 as, compelled by the high margins available, the producers focused on rapid growth at the expense of efficiency and productivity within their existing operations.
Obviously the miners – most notably Rio Tinto and BHP Billiton – are addressing the productivity challenge and the compression of their margins by making massive and continuing reductions in their cost bases while still lifting their output. Their starting point was still at the low end of the industry cost curve and the upper tier of product quality.
Rio’s chairman, Jan du Plessis, was right yesterday when he said volatility favours groups like Rio (and BHP and Brazil’s Vale), although that advantage is a relative one – the big lower-cost and higher-quality producers will remain solidly profitable but at $US80 a tonne for iron ore, their iron ore margins and profits would be substantially lower than during the boom, even with the higher volumes.
The challenge is somewhat more acute for smaller players and even more acute for aspiring producers. At $US80 a tonne one wonders whether the $7 billion investment that Baosteel and Aurizon would need to make in the western Pilbara if their bid for Aquila Steel succeeds could be justified.
In theory lower iron ore prices would drive out the highest cost production and the marginal low-grade Chinese domestic producers that account for about 25 per cent of its production would be displaced first, benefitting the lower-cost and higher-quality seaborne producers.
There is, however, increasing scepticism that the theory will play out perfectly, with new, larger and more efficient iron ore mines being opened in China, some less-efficient mines integrated with adjacent steelworks (about half the key mills have their own domestic iron ore supply) and some continuing social pressures to maintain otherwise uncompetitive production.