Iron ore's dead cat bounce

PORTFOLIO POINT: Iron ore hit the pavement and rebounded, but an oversupply of ore and falling demand add up to a looming price slump and pure-play stocks will suffer accordingly.

If you have ever wondered what is meant by the expression “dead-cat bounce”, take a look at iron ore – and then consider whether you are over-exposed to an industry where there is too much supply and not enough demand.

Over the past six weeks the iron ore price has risen by more than 30%, which has encouraged miners to claim that the worst of a price collapse that started late last year is over.

Shares in iron ore companies have responded accordingly, with Fortescue Metals Group leading the way by rising 54% between early September and early last week with a run from $2.81, when the company was under financing pressure, to $4.33.

Some of the steam in the stock started to escape on Friday as cooler heads considered whether the iron ore price recovery from a three-year low of US$86.70 a tonne in early September to more than US$120/t last week was an example of a dead-cat bounce.

Unfortunately, the answer is yes, because that 38% rise from iron ore’s September low point is probably its peak for some time. In effect iron ore has bounced just as a cat bounces after falling from a 10-storey building – but it’s still dead, and it will fall back again.

What that tells investors is that:

• Now is a good time to sell shares in iron ore producers and explorers.
• The best exposure to iron ore will come from the lowest-cost producers, and that essentially means the diversified leaders BHP Billiton and Rio Tinto.
• Next year, when the iron ore price settles at a level where supply and demand are in better balance, it will be time to re-enter the market.

What’s been happening recently is that Chinese steel mills have exerted their buying power in the iron ore market, devoting much of the past year to running down high-priced stocks of iron ore which, in some cases, meant withdrawing completely from the market.

Having achieved their objective for reducing high-priced stockpiles, which include some acquired at more than US$180/t, they returned earlier this month to replenish at sharply lower prices.

Left unanswered from this de-stocking/re-stocking process is the question of the real level of demand for iron ore in China, and the answer seems to be a lot less than was expected as recently as a few months ago.

Leading Chinese economist Andy Xie put a humorous spin on the Chinese steel industry in a talk at the Mines and Money conference in Sydney two weeks ago.

A former chief economist for the Asia-Pacific region with the investment bank, Morgan Stanley, Xie said demand for steel in China seemed to be coming mainly from “building more steel mills”.

“From what I see factories have been in trouble for a year,” Xie said. “Steel inventories are way up, with over-capacity of up to 300 million tonnes”.

The problem for investors is that China’s harder-than-predicted economic slowdown, and over-production of steel, has hit just as additional iron ore arrives in the market from the expansion of existing mines, and the start of new mines constructed during the boom.

BHP Billiton, Rio Tinto and FMG are all persevering with expansion projects, albeit at a slower pace than last year, and mainly in the hope of lowering their overall costs by extracting premium grade ore, a process called “high-grading” that miners traditionally follow when commodity prices fall.

Brazil’s iron ore giant, Vale, is following a similar path, mothballing a proposed new mine in the African country of Guinea, while expanding production in its Brazilian backyard.

New sources of supply will add to the congestion with two ambitious iron ore processing projects scheduled to start exports from WA in the next two months. Gindalbie Metals and the Chinese-owned Sino Iron are set to load their first shipments of magnetite concentrate, a premium product produced from low-grade ore.

Planned new mines, such as the Roy Hill project led by multi-billionaire, Gina Rinehart, are struggling to secure orders at a price that will underpin their costs.

BHP Billiton chief executive, Marius Kloppers, told analysts last week that he expects 100 million tonnes of new iron ore supply to hit the market in 2013, a 10% increase in the roughly one billion tonnes of seaborne iron ore shipped mainly from Australia and Brazil to Asia and Europe.

But offset against the rising tide of iron ore exports is a rapid slowdown in the production of steel.

Two weeks ago, the World Steel Association, the primary lobby group of the industry, lowered its forecast for annual growth in global steel production to just 2.6%. Last year, steel production rose by 6.2%.

Given that iron ore has only one use, the production of steel, there is an obvious decoupling looming as expansion of iron ore mining significantly outstrips modest growth in steel production.

Such a dislocation will lead to significant changes in the iron ore and steel industries, with the first major change already detected in the steel sector – there is a flood of Chinese exports starting to reach the market, potentially driving down further the price of steel.

In September, exports of steel from China reached five million tonnes, up 22% on exports in September last year, and the highest level for two years.

On Friday, the ANZ Bank joined the dots that connect falling steel output with rising iron ore exports, to ask the question: “is iron ore running out of steam?”.

The bank used two graphs to illustrate its key point, that “iron ore price gains look led by restocking rather than an underlying improvement in demand suggesting profit taking could kick in near-term”.

The first graph showed the Chinese domestic iron ore price and the seaborne iron ore price, and the second the cost of renting a Cape-sized (200,000 tonne) iron ore carrier with rising rental charges ending suddenly last week.

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On the iron ore price, ANZ said: “Many Chinese steel mills heavily ran down their iron ore stockpile over the past three months in a bid to punch seaborne prices lower.

“They got the desired effect, with prices plunging 25% over August/September to US$86.70/t. Those same mills are now restocking, taking advantage of a not-so-common positive import arbitrage (when imported iron ore is cheaper than domestic iron ore) – which is now closing.”

On shipping costs, ANZ said the cost of a Cape-size ship had risen by 50% since the start of October, a good sign that Chinese steel mills were buying.

“However, the 6% decline in the index in the past two days suggests a restocking phase may be ending.”

Click to enlarge

For investors who are being jerked up and down by the fall, rise, and looming fall again in the iron price, that challenge is knowing when will it stabilise, and at what price.

ANZ believes that the consolidation price will be between US$110/t and US$120/t for the rest of 2012, before returning to a range of US$120/t to US$130/t in the second half of 2013 “as China demand improves”.

That forecast could prove to be optimistic if China does not stage a rapid recovery, and even then there is the longer-term trend in iron ore prices which analysts at the investment bank, Goldman Sachs, maintain will be around US$70/t from 2016.

Whichever way the iron ore market is analysed, the boom of the past 10 years is dead. The future is all about survival of the lowest-cost producers, the exit of high-cost producers and a search for market-price equilibrium.

In other words, the cat has bounced and will now return to the pavement – and lie there for some time.