Fortescue Metals Group (ASX: FMG) chairman Andrew Forrest has received a lot of criticism after suggesting the big four iron ore miners – FMG, BHP Billiton (ASX: BHP), Rio Tinto (ASX: RIO) and Vale (BOVESPA: VALE5) – cap their production in an effort to force the price of iron ore higher.
Yet in Forrest’s corner is Ivan Glasenberg, head of Glencore (LSE: GLEN) and one of the smartest operators in the mining world.
With the iron ore market already oversupplied, Glasenberg has been highly critical of continued expansion by the big four, suggesting they instead keep their ore in the ground until demand and supply become more evenly balanced.
To show how miners should act in a rational market, Glasenberg shut down Glencore’s Australian coal operations for three weeks in December 2014. The result was a higher coal price.
For similar reasons, Glencore will now cut 15m tonnes of coal from its 2015 production. Cannibalising the company’s total 150m tonnes of production doesn’t seem like good business to Glasenberg.
He believes the lost profits from these 15m tonnes – and the higher costs per tonne on the remaining production that will result from lower economies of scale – will be more than made up for by a higher coal price. Importantly, he doesn’t believe the lost production will be replaced by other coal producers.
BHP, Rio and Vale clearly aren’t of the same view. Their expansion projects generate high returns on the incremental capital investment required and allow them to keep lowering costs per tonne by spreading their expenses over greater volumes. By pursuing this strategy, they believe they can increase market share and quickly push out the higher cost, more marginal producers.
The suspension of Atlas Iron’s (ASX: AGO) shares from the ASX, Arrium’s (ASX: ARI) recent decision to shut down one of its mines and various Chinese mines ceasing production suggest the strategy may be starting to work.
Trouble is, the big four have pushed the iron ore price down so far that their overall returns on invested capital have declined from being extraordinary to merely very high.
That begs the question: If BHP, Rio and Vale’s iron ore market research departments believe that the long-term price of iron ore should be higher than its current, sub-US$50 value, why don’t they manage their production to get the price closer to this figure?
This would generate higher returns but still run the higher cost miners out of business. Compared with the current strategy they get the same result, but with more profit.
If Glencore can influence the coal price with just 15% of the seaborne coal market, imagine what the big four’s 70% control could do?
That issue will be even more pertinent when Gina Rinehart’s Roy Hill operations adds a further 55m tonnes to supply later this year. Vale’s $20bn expansion in the Carajas region of Brazil, adding another 90m tonnes in 2017, will press it even harder.
In the face of such profit-damaging obstinacy by the big four, investors should steer clear of the sector. In fact, we’ve been wary of the companies’ expansionary instincts for many years, warning in 2010 that high prices would fall sharply as the inevitable new supply they encouraged was developed.
The fallout may include Fortescue encountering difficulties in the next few years but will also create opportunities. If BHP and Rio start managing their assets – including iron ore – for high returns rather than engaging in reckless bouts of expansion, they might be two of them.