Iron ore: the bubble and our budget

As iron ore becomes a casino chip for Chinese speculators, budget forecasts might not hold and miners are in for a bumpy ride.

Summary: Falls of iron ore on Asian commodity exchanges are a warning sign as the Australian government’s federal budget pencils in an assumption of a $US55/t forecast. The share price of miners BHP, Rio and Fortescue were hit shortly after iron ore fell to $US63/t yesterday, and should the price continue to weaken then the budget will be under pressure – every $10/t change in price results in a $6 billion change to overall GDP.

Key take out: While executives do not have price tips, big miners are tipping softer prices later in the year, and are taking advantage of current prices now to pay down debt significant debts.

Key beneficiaries: General investors. Category: Commodities.

The great Chinese iron ore bubble of 2016 has been pricked and Australian investors risk becoming collateral damage, as does the Australian government.

Yesterday’s seven per cent fall in the iron ore price on Asian commodity exchanges to around $US63 a tonne was a hint of what might be coming, with the share prices of local miners taking a battering.

At its latest price, high-grade (62 per cent) ore has fallen by 10 per cent in a week – from its recent peak of $US70/t to be within $US8 of the $US55/t that was used to structure last night’s federal budget.

If the price falls below $US55/t, which looks likely, the budget might have to be amended within weeks of being delivered, and possibly during an election campaign.

The impact of the iron ore price fall can already be seen in the share prices of miners.

BHP Billiton, which was also hit yesterday with a $US43 billion damages claim over the Samarco dam disaster in Brazil, saw its share price fall by 8.8 per cent in the first few hours of trading earlier today, before closing at $18.79, down 9.36 per cent.

Rio Tinto lost 5.5 per cent in early trade to $48.70 before closing at $47.85, down 7.54 per cent on the day.

Fortescue Metals did best at the opening, with a fall of 3.6 per cent to $3.17 before closing at $3.13, down 4.86 per cent.

The iron ore price fall over the past few days is likely to be the first move in a downward spiral which could see a retreat back to the mid-$US40/t range – and the budget will be in trouble if that happens because of its heavy reliance on tax income from iron ore production.

As Australia’s biggest single export every, $US10/t change in the iron ore price means a $A1.4 billion rise or fall in tax receipts, and a $A6bn change to gross domestic product.

Five months ago the problem was not quite so obvious because in its Mid-Year Economic and Fiscal Outlook (MYEFO) delivered on December 15, the government assumed an iron ore price for the 2016-17 financial year of $US39/t.

Unfortunately for the government its budgeting rules require an assumption to be made about the future value of key commodities and currencies and while iron ore once had a relatively stable price structure it has more recently become a casino chip for Chinese speculators.

The popularity of exchange-traded iron ore products in China has occurred at the same time as the physical market for the material has recovered from a seasonal slump.

Stronger real demand for steel in China has been fuelled by an easing of credit restrictions, especially for construction projects which, when compounded by speculative trading has created an iron ore bubble.

The government’s $US55/t iron ore price assumption was based on the price on the price on the day that a decision had to be made for budgeting purposes. It was right at the time, but wrong on the upside within days and could be wrong on the downside in a matter of weeks.

A correction in the iron ore price has looked inevitable ever since it started a dash up from $US39/t at the time the MYEFO was delivered to the recent peak of slightly more than $US70/t.

The real problem for the government and investors is that control of the iron ore market has passed from miners and their major customers, Asian steel mills, to commodity-trading speculators active on markets such as the Dalian Commodity Exchange in the Chinese port city of Dalian.

The size of the commodity-speculating business can be seen in the whopping $US26bn in contracts for an assortment of materials traded in a single day on Chinese commodity exchanges.

This a country mile from a time when miners and mills met in secret price-setting conferences where agreements where made on tonnages to be delivered, by which miner, and at what price for at least the following 12-months.

No-one is happy with what’s happening today.

The Chinese government has been forced to tighten trading rules to try and regain control of commodity markets. Commodity exchanges have also tried to stamp out speculative trading.

Mining companies have been pushed into a position where they cannot make financial (or mine development) plans with confidence, and steel mills have lost control of the raw material purchasing process.

Australian investors are probably in the worst situation because what’s happening is a Chinese phenomenon but one which has a direct effect on the price of ASX-listed mining companies.

Ironically, the situation is further clouded by what seems to be the only issue on which most mining industry leaders, and seasoned commodity-market watchers agree – that’s the inevitability of iron ore retreat to a long-term price below $US50/t.

Goldman Sachs, a perennial iron ore bear, is sticking to its forecast of a price fall back to $US35/t while one of Brazil’s biggest bank, Itau, has told clients that iron ore will probably end 2016 at $US42/t.

Rio Tinto’s outgoing chief executive, Sam Walsh, and BHP Billiton’s new head of its iron ore division, Mike Henry, avoid given a price tip but both are predicting softer prices later this year.

Fortescue chief executive Nev Power believes the iron ore price will stabilise as the Chinese Government cracks down on speculators.

In the meantime, Fortescue is taking full advantage of the current high price using spare cash to further reduce its debts, this time with a $US650m repayment to holders of its senior secured term loans, the second recent pre-payment after a $US577m repayment last week.

Fortescue has now made early debt repayments of $US2.3bn, resulting an annual saving on its interest bill of $US164m.

More debt repayments are possible, along with what Fortescue terms “alternative refinancing options”, a hint that the company is preparing now for a lower iron ore price by the end of the year.

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