Keep away from the edge as iron ore cracks

The latest crack in the iron ore price, below $US80 a tonne, doesn’t mean anything in itself other than that it sends a signal to the more optimistic in the sector that their hopes of the price stabilising at a higher level may be a tad too optimistic.

In an interview to be published on Business Spectator tomorrow, Fortescue Metals’ Nev Power admits he may have been a little too optimistic about the prospect of high-cost ore being withdrawn from the market in response to the dramatic fall in prices, although he still believes it is only a matter of timing before economic rationality prevails (KGB Interview: Fortescue's Nev Power).

What Power, most of the smaller miners and perhaps some of the bigger players believe -- or at least hope -- is that China’s domestic iron ore production of about 400 million tonnes a year will decline in the face of a continuing avalanche of lower cost supply that has already pushed the market into surplus.

There is a question mark, however, over whether China will behave rationally by Western standards given that there are strategic and social reasons for maintaining a core of domestic supply.

Power believes rationality will prevail because otherwise China’s steel industry will become progressively uncompetitive relative to other producers accessing lower-cost iron ore, but China could choose to subsidise its iron ore producers to maintain some security of supply and to constrain the power that would otherwise flow to the big seaborne iron ore producers.

Certainly Rio Tinto and BHP Billiton believe there is a large proportion of China’s output (which has, in any case, been migrating towards newer, larger and more efficient mines) that will keep producing virtually regardless of the price. If they are right, it would be other seaborne producers that would bear the brunt of the impact of the price declines.

Between them, Rio, BHP, Brazil’s Vale, Anglo American and Gina Rinehart are either in the process or have plans to add something approaching 350 million tonnes a year to supply over the next few years -- not far short of the 400 million tonnes or so that China produces.

With the growth in China’s demand slowing markedly, and perhaps plateauing at or just above its current level of about 800 million tonnes a year, that would ensure a substantial oversupply of iron ore for years to come.

Rio and BHP, as the low cost producers (BHP has all-in costs of around $US50 a tonne and Rio about $US45 a tonne) with high-quality ore, can sustain a sub-$US80 a tonne price and indeed still generate very handsome margins on their ore.

Of the other Australian producers, Fortescue has the next lowest costs. Power pointed to all-in costs of less than $US60 a tonne, although the market believes they are more likely to be in the low $US70 a tonne range. Vale’s costs, with shipping costs included, are higher again but it does have the advantage of being a diversifier of supply from China’s perspective.

Fortescue has dramatically reduced its costs and expanded its volumes since its wake-up call in September 2012, when the first crack in the price appeared. It has also repaid a lot of debt, rescheduled its remaining $US7.2 billion of debt so that none of it falls due in the next few years and, as Power pointed out, it owns all of its mines and its port and rail infrastructure.

It ought to have the capacity to continue to push its costs down and it could, if it needed to, re-visit the 2012 option of offering to sell equity in its core infrastructure if it needed to raise capital.

It may need to keep those options under continuing consideration because if the absence of any meaningful displacement of high-cost production persists, the price will continue to fall.

The emergence of China at a time of under-supply had a leveraged impact on an iron ore price that had, in real terms, been declining for decades.

While the entirety of the price hike might not be aberrational -- there are almost certainly many elements of the price being structural re-based at a higher level to reflect the emergence of a vast new source of demand -- the lagged supply-side response has been so substantial and is continuing at such a substantial rate that there is a realistic possibility that the price will significantly over-shoot in the other direction before finding a new equilibrium.

If most of the highest-cost production were ultimately forced from the market Fortescue might well find itself in the position of being the marginal producer and the price-setter, given that its 155 million tonnes a year of ore sits between Rio and BHP at the bottom of the cost curve and Vale at a step above its own costs.

That could suggest that the price might settle around the $US70 a tonne level in the long term, perhaps a touch higher, rather than around the $US100 a tonne-plus level at which the more optimistic/desperate producers have been hopeful of.

Certainly, that’s what the less competitive producers ought to be factoring into their modelling, along with the potential for periods where the price is volatile -- in both directions -- as the supply and demand equation itself keeps shifting.