Iron ore surprises

Summary: The fortunes have changed for Australian iron ore miners on the back of the Chinese Government cleaning up the local industry. To the shock of global investment banks, a supply surplus has suddenly morphed into a supply deficit. 

Key take-out: Investors could note Atlas Iron has come back from the brink thanks to changing demand in China, with the potential to gear up from survival mode if prices stay elevated. Investment bank Credit Suisse thinks the story will continue unfolding until well into the next year, with the scene now set for prices to stay above $US60/t.

Few companies survive a near-death experience like that suffered by Atlas Iron.

But when it reported on Tuesday, 29 August it had turned a loss into a profit, and a large portion of debt had been repaid, Atlas sent the market a signal that concern about an imminent iron ore price fall might have been an exaggeration.

Higher-than-expected iron ore prices have been the key factor in Atlas defying predictions of its collapse, and if the price stays up for another 12 months, the company could switch from survival mode back to growth.

Very few forecasters expected iron ore to remain above $US70 a tonne for as long as it has with most investment banks tipping a slide back to around $US50/t, or less.

What appears to have changed in the iron ore market is a variation in the way China's steel industry is working with older, more polluting furnaces being forced by the Chinese Government to close. Meanwhile, bigger mills have been switching from local-mined low-grade ore to higher-quality imported ore, generating less air population as well as less residual slag.

For iron ore miners in Australia and Brazil the change in China has been an unexpected bonus. This is being reflected in the strong profits of companies such as BHP, Rio Tinto and Fortescue Metals.

Whether the change in China's iron ore appetite is a short or long-term event might not be known for some time but at least one investment bank, Credit Suisse, expects higher prices to remain well into next year.

The event that alerted the bank's analysts to the change was a decline in iron ore stockpiles at China's ports. Until June, stockpiles of ore imported from countries such as Brazil and Australia had been rising, pointing to a surplus of around 30 million tonnes of ore.

“But it reversed in late June, port stocks have since tumbled by 9m/t,” Credit Suisse said in a research note. “Off-take from ports has accelerated and in July was running at an annualised rate of 100 million tonnes faster than last year.”

That 100m/t increase is an important number. It represents enough ore to make about 60 million tonnes of steel – the same amount traditionally supplied by induction furnaces which use scrap steel as their feedstock, and many of these have been deemed illegal by the Chinese Government.

In other words, a government crackdown on illegal induction furnaces as part of China's environmental clean-up has seen conventional blast furnace operators boost output to make up the shortfall with imported, high-grade iron ore, their preferred raw material.

“We think the scene is set for iron ore prices to be strong (above $US60/t) in the first half of 2018 at least,” Credit Suisse said. But the investment bank added a caveat – a potential contraction to $US55/ towards the end of the current calendar year as steel production is curtailed because of winter and other seasonal factors.

What the bank sees in China is a fundamental change in the structure of the iron ore business with a supply surplus morphing into a supply deficit. Steel demand is increasing and Chinese economic growth is accelerating.

“It is probably fair to say that almost every commodity analyst looking at the seaborne iron ore market over the last few years has calculated that the market is in over-supply and getting worse,” Credit Suisse said.

“But we have all been wrong, that is not what is happening at all since mid-year.

“Iron ore is in deficit. Supply has been trailing demand and the under-supply seems to be worsening.”

Fortescue Metals was an early example of how the higher-than-expected iron ore price (and lower operating costs) could boost the profits of producers. Its earnings for the 2017 financial year more than doubled to $US2.1 billion from sales of 170.4 million tonnes of ore.

And if Fortescue is an early example, Atlas is a rare example. It's one of the few remaining small iron ore miners left in the local business, and thanks to a high iron ore price and cost cuts, its share price has appreciated, albeit modestly, in recent months.

A loss of $159 million in the 2016 financial year has been flipped into a profit of $48 million in the 12 months to June 30 for Atlas. This is in spite of the company producing almost the same amount of iron ore: 14.5 million tonnes in 2016 and 14.4m/t last year. Repayment of $79 million of secured debt means Atlas now owes $103 million, almost totally offset by cash in hand of $81 million, plus $20 million in a reserve account.

Until recently mining analysts shared a common view that the 2017 financial year was “as good as it gets” for the iron ore industry.

Credit Suisse has broken ranks with the other banks with its latest view of a price-pause towards the end of 2017, followed by a fresh surge higher in 2018.