Iron ore's downpour intensifies

It didn’t require a degree in advanced financial analysis to predict last year what’s happening to the iron ore price this year, which is what I did in early October in a story headed Readying for iron’s fall.

The missing link back then was the time of the fall, with participants in both the iron ore market and the stockmarket clinging grimly to a hope that the flood of fresh ore, which everyone in the industry could see building up, would not actually hit China’s steel mills, forcing them to cut orders.

The flood has arrived, and the challenge now is for investors to judge how quickly it will either subside, or when steel producers will be required to boost their demand for ore – a function directly linked to global steel demand, which is weak.

Unfortunately, the process started by the fall in the iron ore price will lead to a result as predictable as the fall itself – a crop of failures among Australia’s higher-cost producers.

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Yesterday’s announcement that Termite Resources, operator of the Cairn Hill iron ore mine in South Australia, had collapsed into the hands of administrators was an event that any visitor to the mine could see as being inevitable as long as 12 months ago, which is what I told South Australian government officers during a site visit in July.

Cairn Hill suffers from a number of problems. It is a small mine with limited resources. It is in a remote location, which is poorly served by rail and port systems with its ore requiring a number of different handling stages. Not even a high copper content, which boosted the sale price of Cairn Hill material, could compensate for falling commodity prices.

The net result of the Cairn Hill collapse is that its parent company, IMX Resources (IXR), has suffered a sharp share price fall, down 35% yesterday and down 50% since the start of June.

Who’s next?

That’s the question investors want answered, and that’s when analysis becomes tricky because no Australian iron ore producer, from the biggest to the smallest, is completely open about what it really costs to produce a tonne of ore – or what it is sold for.

Numbers are provided, but in most cases they are of little value because the company’s treat their true cost of production, and the true price received, as commercial secrets – and that’s before getting to the problem of the iron ore price most commonly quoted, a price based on ore assaying 62% iron as landed in China.

One of the best guides to true iron ore production costs was contained in a second story published in Eureka Report earlier this year, which covered the start of the current price slide (Not so fine … behind the iron ore price crunch.

In that story I attempted to cut through the mystery of iron ore costs, a procedure which allows for ore-grade differences (very few Australian mines produce 62% ore), discounts for impurities (most mines incur penalties for unwanted elements such as phosphorous), and some earn a price-premium for high-grade, low-impurity, material.

Using research produced by the investment bank, UBS, and Eureka Report’s own estimates, a list was compiled showing the iron ore price per tonne for eight producers to break even on a cash basis.

The lowest-cost Australian producers are the big two, Rio Tinto and BHP Billiton, which are believed to require an iron ore price of $US43 a tonne and $US45/t respectively to break even. The third-biggest producer, Fortescue Metals, was estimated to require price of $US72/t to break even.

The highest break-even costs were estimated to be those of Grange and Gindalbie at $US87/t and $US91/t respectively. Other break-even costs were: Atlas $US82/t. BC Iron $US70/t and Mt Gibson $US75/t.

The first important point from those cost estimates is that they are for cash costs. They do not take into account other costs and charges.

It is possible, not that the companies are declaring their positions yet (but they will have to when compiling their June 30 accounts), that some of Australia’s better-known iron ore miners are already trading at a loss if the current iron ore price of around $US91/t for 62% material is assumed to be the average for the year.

The latest attempt to work out exactly what an iron ore producer receives for its product was made this week by analysts at the investment bank, Morgan Stanley, in a report on Fortescue.

In a study which noted the extent of the price discounting in the market, presumably caused by supply exceeding demand, Morgan Stanley noted reports circulating in the iron ore trade that Fortescue was offering discounts of up to 15% on shipments of ore.

“SSB Steel Markets Daily (June 16) reported that Fortescue has offered further discount to some July cargoes, with some 56.7% iron Super Special Fines offered at a 15% discount on Monday compared to 14% on Thursday, and some 58.3% iron Fortescue Blend fines at a 9% discount on Monday compared to 8% on Thursday,” Morgan Stanley told clients in a note dated June 17.

It is difficult to calculate the impact of the discounting because the iron ore price (using the widely quoted 62% iron content measure) has been falling at the same time as the discounting has been rising.

But, as a rough guide for investors, Morgan Stanley estimated that last Monday the 62% material iron ore price at the Chinese port of Tianjin was $US89/t, and that Fortescue’s offer of a 15% discount meant it realised a price of $US75.7/t on Super Special Fines and $US81/t on Fortescue Blend material.

If the Morgan Stanley numbers are accurate, and if the earlier UBS numbers were also accurate, then Fortescue is close to its $US72/t cash-cost break-even point on some shipments.

More importantly, and once again assuming the investment banks are correct in their assessments, some Australian iron ore miners are already operating at, or below, their cash break-even point.

Termite Resources, the company running South Australia’s Cairn Hill mine, was obviously below its break-even point, which is why it was tipped into the hands of an administrator.

Knowing which other companies are on the edge is a guessing game, which is more than annoying and something that market regulators should consider cleaning up, in the same way gold producers have been forced to clean up their nonsense reporting of cash costs by adopting an “all in” cost reporting system.

Until the clean-up in reporting on the cost of iron ore production, and the true price received, all investors in iron ore stocks are being forced to trade on substandard information, and the best guesses of outside observers such as investment banks and Eureka Report.