Iron ore under pressure

Summary: Political issues are looming large over Australia's iron ore sector, a sector already entangled with pricing problems.

Key take-out: Investors should be aware a dangerous game of diplomatic football has begun in the iron ore sector of the market, and low-grade ore producers are most likely to be caught up. 

Early signs of tougher times for Australia's biggest resource export, iron ore, are emerging at a commercial and political level, especially for companies producing low-grade material.

A wholesale downturn is unlikely but a squeeze on profit margins seems hard to avoid as iron ore reverts to a structure where a handful of mega-miners, such as BHP, Rio Tinto and Brazil's Vale, dominate production and deliver the quality demanded by Asian steel mills.

That long-term trend is meshing with short-term political and diplomatic issues which have seen Australia's relationship with China, the biggest buyer of iron ore, turn sour.

Among the developments causing concern for iron ore miners are:

• A continuation of significant discounting by steel mills for iron ore that doesn't meet the highest grades, a process which is forcing some mines out of business.
   
• Rising costs, especially for diesel and other fuels linked to the price of oil, which means profit margins are coming under pressure, and will come under more pressure if the oil price hits the $US90 a barrel (tipped by some investment banks).
   
• Plans by BHP and Rio Tinto to spend an estimated $US3 billion each on big new mines which will cement their status as the industry's low-cost leaders, piling pressure on smaller miners already being hit with price discounts and,
   
• Concern that diplomatic tensions between Australia and China could flow into iron ore because it represents a pressure point in the Australian economy for China to exploit.

On the diplomatic/political front, a recent exchange of sharp words between Australia's Foreign Minister, Julie Bishop, and a former Australian Ambassador to China, Geoff Raby, underline the high stakes in the iron ore sector.

Raby, who is also a former director of Fortescue Metals Group and now a Beijing-based trade consultant, called for Bishop to be sacked because of comments she made about China – an unusual stance for a former Australian Ambassador to take.

While a man undoubtedly well-qualified to comment on trade, diplomacy and Australia's relationship with China, it is Raby's once close links to Fortescue which have caused some observers to question whether he has a deeper understanding than most about China's use of iron ore as an economic weapon.

Fortescue, which is unable to match BHP and Rio Tinto on ore quality, has taken a painful beating on iron ore pricing. Fortescue management, led by founder and chairman, Andrew Forrest, has expressed confidence the discounting will come to an end, but there is no sign of that happening.

As these diplomatic games are played in Canberra and Beijing, the news from the iron ore market is that discounting of low-grade material is likely to continue for some time, with Fortescue the major Australian loser.

In its latest review of the iron ore sector, investment bank UBS said the discount for low-grade ore was “refusing to close”.

UBS said the March quarter results from major iron ore producers had been a mixed bag with some reporting lower costs and some higher.

Wood Mackenzie, a well-regarded consulting firm, echoed the UBS view on discounting. It said in a research note yesterday the widening price-spread was a result of structural changes in China's steel sector.

“In particular, steel capacity rationalisation has led to an increase in steel margins and steel mills are now focused on maximising productivity,” Wood Mackenzie said.

“This productivity focus favours suppliers of high-grade sinter fines and concentrate over suppliers of low-grade fines, causing price spreads to widen.”

Simply looking at cost per tonne does not reveal the full situation in iron ore where the key is the “realisation” price – the amount that a miner actually gets paid relative to the widely-quoted benchmark price for premium grade ore, material assaying 62 per cent iron and with low impurities.

In Fortescue's case, the realisation price has emerged as its Achilles Heel. In the March quarter, UBS said the Fortescue realisation price averaged 62 per cent of the benchmark price, meaning that if the biggest and best miners got $US100/t for their ore, then Fortescue got $US62/t.

UBS pointed out that Fortescue's 62 per cent realisation price was down from a realisation price of 66 per cent in the December quarter last year and 71 per cent in the September quarter.

According to a table produced by UBS, the iron ore pricing puzzle means that Rio Tinto, as the local low-cost leader, needs an iron ore price of $US30/t to break even. Next up, BHP needs $US32/t, and Fortescue $US47/t.

Given that the latest iron ore price for 62 per cent material is around $US65/t, and $US42/t for 58 per cent material, most of Australia's iron ore producers remain profitable. Exceptions include smaller miners such as Atlas Iron which needs $US66/t, Mt Gibson's older mines which need $US70, and Cliffs Natural Resources which needs $US66/t (and has already flagged that closure is being planned).

Wood Mackenzie said it did not expect the gap between high- and low-quality ores to return to levels last seen in 2016.

“Our view is that capacity rationalisation in China's steel sector will cause steel margins to remain higher than in the past,” Wood Mackenzie said.

“As a result, tiered pricing for iron ore is a structural change that will persist.

“The industry is responding to the reality of wide variations in realised prices and the impact on profitability. Numerous suppliers of low-grade [iron ore] have been forced to scale back production or withdraw from the market in response to margin compression. More casualties will follow in 2018-19 as low-grade fines continue to be heavily discounted.

“Some miners have flexibility – and finance – to respond to this changing market dynamic. For example, BHP is replacing the depleting Yandi with a higher-grade South Flank project; Fortescue's Eliwana project could lift the company's average ore grade; and Roy Hill is planning to install a beneficiation circuit to upgrade its ore.”

What makes the current situation difficult to predict is that none of the miners expected a sharp increase in their fuel costs because most oil price predictions were for long-term low prices.

Two problems have emerged with fuel, which is one of the biggest costs in mining and transporting a heavy material over long distances.

The oil price itself is obvious, but less obvious is an emerging crisis in a type of fuel called middle distillate, the stuff used to make diesel and jet fuel.

Morgan Stanley, another investment bank, said in a research note into the oil sector that much of the new oil being brought to market, such as natural gas liquids and US shale oil, is ultra-light, and no good for producing diesel.

Diesel might be a politically unpopular fuel, but among consumers and households it is enjoying a strong increase in demand from industries such as mining, farming and long-haul transport.

For iron ore miners the squeeze is slowly becoming more evident. Price discounts on low-grade ore are not fading and costs are rising, and fuel costs are rising too.

To cap it off, iron ore has become a diplomatic football being booted around by Australia and China, a game in which China is the favourite to win.