|Summary: The iron sector has been playing in tough conditions for some time, with lower demand from steel producers and a glut in supply depressing the spot ore price. The lower dollar has helped, but forecasts of a substantially lower long-term iron ore price mean that the game is turning in favour of the big, low-cost producers. For smaller players, the iron curtain is definitely closing.|
|Key take-out: Smaller producers are already operating on thin margins, and further falls in the iron price could make their operations unviable.|
|Key beneficiaries: General investors. Category: Commodities.|
Saved by the dollar. That’s the kindest comment that can be made about Australia’s iron ore industry, which is reverting to its traditional status as a business where only big, low-cost producers prosper – and the small are crushed.
The warning bells signalling the end of the iron ore boom have been ringing for more than a year (see Iron ore’s harder times), and will only grow louder as a once-in-a-lifetime global shortage of the steel-making material morphs into a glut.
For most Australian investors, exposure to iron ore is important because it is the country’s most valuable export.
But the days of riding the fortunes of small producers is over, unless they can demonstrate a cost of production well below the forecast long-term iron ore price of between $US80-and-$US90 a tonne.
The problem is two-fold. Firstly, very few miners actually get the widely quoted iron ore price which applies to low-impurity material assaying 62% iron and, secondly, few small miners publish their true cost per tonne, preferring to report a cash cost to which must be added other charges (financing is a big one).
On the ore quality question, steel mills apply discounts for impurities such as phosphorous, alumina and silica, and the average ore grade of most juniors is around 55% iron. Those two factors can trim between 10% and 15% off the widely quoted 62% price, so when a price of $100/t is quoted a small miner might only be getting $US85/t.
The second half of the squeeze on profits is when the true cost is worked out. A small miner claiming a cash cost of $US50/t might actually have a true cost of $US70/t, leaving a very skinny margin, or worse, should the 62% iron ore price fall below $US90/t.
Size, more than anything else, is the key to survival in the iron ore industry. It’s why the business has historically only supported a handful of mega-miners able to fund and operate high-tonnage railways and port systems.
Iron ore is not so much about mining as a game of transport economics, because it is a classic bulk commodity best suited to shifting by rail, and not by the high-cost trucking options favoured by some small miners that do not have access to rail.
The emerging trend of a global iron ore glut means that local production by small miners will dry up, leaving four or five major producers, led by BHP Billiton, Rio Tinto, Fortescue Metals and perhaps Hancock Prospecting, when it finalises funding and completes development of its world-class Roy Hill mine.
Some small miners might produce niche products, or have some other advantage, but most will not.
Last year’s shock crash in the price of premium quality (62% grade) iron ore to less than $US90 a tonne was an early warning of what happens when stockpiles at Asian steel mills over-flow and buyers exert their power over price.
Recovery back to this year’s peak price of $US158.90/t in February was largely in reaction to Chinese buyers re-entering the market after allowing their stockpiles to fall too far too quickly.
Since hitting that “rebound high” (see Iron ore’s dead cat bounce) iron ore has been in steady decline, generating telling statistics that show a rising volume and a falling value.
In the financial year which will end on Sunday, the total volume of iron ore shipped out of Australia is expected to be up 13% to around 533 million tonnes, while the value is tipped to have fallen by 9.4% to an estimated $57.3 billion, or roughly back to the same value as two years ago.
Higher iron ore exports
In 2013-14, the volume of Australian iron ore exports will rise even more sharply as big expansion projects undertaken by BHP Billiton, Rio Tinto and Fortescue hit the ports.
In its latest quarterly report, the Australian Government’s Bureau of Resources and Energy Economics (BREE) forecast that exports of iron ore and iron pellets (part-processed ore) will rise next financial year by another 14.5% to 610 million tonnes, meaning that the industry will have almost doubled by volume in roughly five years.
The value of those exports, according to BREE, will be up 16.4% to $66.7 billion, with the bigger increase in value compared with volume a direct result of the falling value of the Australian dollar.
But in making its prediction of the future iron ore price, BREE deviates noticeably from other forecasters.
While BREE is expecting an average price in the current calendar year of $US117/t, with a fall next year to $US112/t, there are more pessimistic forecasts being used in the private sector.
The investment bank Goldman Sachs, for example, expects an average iron ore price next year of $US115/t, falling sharply in 2015 to $US80/t, before recovering modestly to $US82/t in 2016 and then adjusting to a long-term average of around $US88/t.
Looming supply glut
A falling exchange rate against the US dollar will alleviate some of the pain inflicted on the iron ore miners, but the underlying reason for the pessimistic price projections is directly linked to the biggest challenge facing Australian iron ore –rising global supply and low growth in the steel industry, which is the only major consumer of iron ore.
With iron ore, Australia is not alone in bringing on big new export projects of the sort which earned Rio Tinto’s new chief executive, Sam Walsh, some sharp criticism earlier this year from his biggest shareholder, the investment manager, BlackRock World Mining Fund.
Evy Hambro, chief manager of the fund, said he was surprised that Rio Tinto was pushing ahead with a $5 billion expansion of the operations in WA’s Pilbara region.
“I think the markets were a little bit surprised by that,” Hambros is reported to have said, adding that pledges from Rio Tinto to pursue shareholder value and reduce costs were the “type of things that sat with cancelling or deferring projects”.
What Rio Tinto, BHP Billiton and FMG are doing is snatching as much of the market as possible in order to enjoy the benefits of their size advantage – so called economies of scale.
Unfortunately, Brazil’s biggest iron ore miner, Vale, is doing the same thing, with its iron ore exports tipped to rise by 10% next year. While less than Australia’s 16% increase, the result will be that the two countries will collectively be pushing an extra 127 million tonnes of iron ore into the global pipeline next year alone.
This extra material is schedule to reach steel mills in Asia and Europe as steel production grows at an anaemic 2.9% this year, and 3.2% next year, according to the World Steel Association.
Chinese steel mills, which have an interest in talking down the iron ore price, have been warning for the past 12 months that they are in dire financial trouble because of over-production and high raw material costs.
The steel trap
Three weeks ago the chairman of Anshan Iron and Steel, China’s fourth-biggest steelmaker, predicted a sharp fall in iron ore prices over the rest of 2013.
Zhang Xiaogang told London’s Financial Times newspaper that China’s steel mills faced “a long-term struggle” to return to profitability.
He added this warning: “Some people will collapse during this war of attrition if their cash flow dries up, or if they can’t make any money at all.”
Zhang said fat profits from steel making during China’s construction boom had led to a glut of steel-making capacity – what he could have added is that this also led to a glut in iron ore mining capacity.
“Those lucrative years are gone for good; they will never come back,” he said.
And in that comment can be found the core problem for Australian iron ore, and why it needs a low exchange rate to prosper.
It is difficult to see iron ore miners continuing to expand output (which they are) while their biggest customers operate at a loss (which they are). At some point, the customers will demand that their raw material suppliers share the pain and accept lower prices.
What is about to happen in iron ore is effectively a return to the conditions experienced in the 1980s, and at other times which might be called “after the boom”.
Investment advice: For iron ore exposure, stick to BHP Billiton and Rio Tinto. Sell small producers and explorers.