Iron story is ore inspiring

The general investment community doesn’t appear to be having much luck forecasting the price of iron ore.

For such a critical component of the Australian economy, that’s a very serious problem. Iron ore comprises something like 30% of BHP’s revenue and 50% of Rio’s. Rightly or wrongly, it’s taken over as the bellwether for the country’s overall resources sector, which itself is something like 20% of the total market. Extending it even further, it’s a general pointer to our terms of trade, and so the overall health and wealth of the Australian economy.

From what I can tell, there’s been a fairly sizeable mind shift among investors on the prospects for the iron ore price compared to last year – when there was panic on the streets. Recall that the iron ore price had collapsed, and while some expected a near-term rebound, the broad consensus was that the downtrend would remain intact for some-time. Forecasts typically ranged from $US100 to $US80, and some were talking in the $US60s. Twelve months on, the iron ore price is around $US135 having hit a low, very briefly, of around $US110 in June. So, having been burnt before, the new consensus seems to be that there is short-term support for iron ore at this current level.

That’s all good and well, although for our purposes – investing for the medium-to-longer term – short-term price expectations don’t tell us very much. However, it is very positive to see more balance in the market rather than just frantic and unjustified calls for a price slump.

Forecasting uncertainty is compounded by the fact that there is (well it’s expected that there will be) a sharp rise in iron ore production over the next year. See Tim Treadgold's article Dust cloud over Fortescue. BHP’s latest production figures give us a taste of that, with the amount of iron ore mined up 23% over the year to the September quarter. More broadly, the Government’s Bureau of Resources and Energy Economics (BREE) reckons that iron ore exports, from the major producing countries, will rise just over 8% this year. Over the next two years, it’s set to rise around 20%. So the issue becomes, how readily can the global economy absorb this expected increase in supply?

Up until recently it had been thought that the prospects weren’t good. In particular, analysts at Goldman Sachs argued that weak demand, or weak steel consumption in particular, would allow the development of a supply glut. That expectation turned out to be wildly inaccurate, as I argued it would be at the time. Chinese steel production growth is looking like it will be four times what it was in 2012 – up 8% compared to a 2% increase last year. Back in April, apparent steel use in China was expected at 3.5%this year – still up from a comparatively soft 2012. In October that was upgraded to a 6% lift.

You get the gist. Demand is much stronger than expected, and you can see that manifesting very clearly in the chart below. Australia’s iron ore exports to China are booming – are at a record – and have accelerated sharply from this time last year, when people feared the end of the boom.

Click to enlarge

More importantly, I don’t see that momentum really unwinding much over the next 12 months. The bottom line is I don’t think a lack of demand is going to be an issue. Why?

1. The global economy is picking up. I realise that most of the large global financial institutions are becoming more bearish on global growth, and I have highlighted elsewhere why I don’t think this is right. Basically most of the important indicators point to accelerating growth not decelerating. Anyway, the exact point forecasts matter little at this point, because the fact is, even with recent downgrades to economic forecasts, most of those forecasters still actually look for growth to accelerate next year. The IMF, for instance, is looking for growth to increase to 3.6% from 2.9%. Growth forecasts for China vary widely – but they are all generally in the vicinity of 7-8%. Not too much different from this year.
2. Of particular importance, the global construction cycle is turning. This means much greater steel consumption (construction accounts for 51% of global steel use). Much greater production and, of course, more steel consumed means more iron ore demand. The good news is that we are at the embryonic phases of this construction rebound.

So the demand side is all good and I see few headwinds. This brings us back to this expected supply surge.

Exports are certainly expected to surge, 8% in 2013 alone, but the thing is BREE also reckon that imports will rise about the same for this year. That may in part explain this emerging consensus that the iron ore price will remain elevated for now. So far so good.

Click to enlarge

Looking beyond that though, a balance in world trade isn’t expected to be achieved until 2017 at the earliest – three years away. This would seem to support the expectation of Vale – the world’s largest iron ore producer –that any evidence of ‘excess’ supply won’t be evident for some years. This is important because, at the moment, the world’s largest consumer of iron ore, China, still relies on lower-quality, higher-cost domestic production of iron ore, for 40% of its needs.

China is, in fact, the world’s largest producer of iron ore, but they do it at a much higher cost. Estimates vary, but most seem to suggest that the cost of producing iron ore in China is $US140 or more. To my mind, that still heavy reliance on higher cost, lower quality domestic iron ore, ensures the Chinese will readily absorb growing global production increases at the expense of domestic production.

That’s a fact borne out by the surge in iron ore imports into China in recent months. More to the point, an absence of economies of scale (smaller mines), infrastructure bottlenecks and the like – not to mention rising wages in China – point to these costs rising over time, not falling. And this should support globally traded iron ore prices.

So yes, global iron ore supply is expected to grow strongly. Yet it seems quite clear that the rebound in the global construction cycle and China’s willingness to substitute domestic iron ore production with cheaper, higher-quality, imports will ensure this supply is readily absorbed. That doesn’t preclude ongoing price volatility, as we’ve witnessed over the years.

This year alone the price has fluctuated on a 30% range! But it does suggest that continued bearishness on the iron ore price is perhaps misplaced. For the foreseeable future at least, ongoing tight supply – the surge in supply is being met with a surge in demand – actually suggests some upside to the iron ore price. I think it more likely, on that basis, that iron ore will head beyond $US140 on a six-month view than spend too much time materially below – notwithstanding volatility.