- The iron ore shakeout has only just begun
- There will be a time to buy but only when the blood is in the streets
- Focus on major, low-cost producers
As the primary driver of a 150-year boom in its terms of trade, iron ore has been good to Australia, the central pillar of our contemporary prosperity in fact. Once again, we got lucky, this time with unique convergence of three cycles: Chinese catch-up growth and urbanisation; an unprecedented steel boom; and a massive supply expansion.
Trouble is, all three cycles are in the process of either reversing or ending altogether, making the future of iron ore the bleakest of any global commodity.
But with the iron ore price down by almost a third this year and now at much the same level it was four years ago, investors are asking if there’s opportunity in the sector. The answer depends on the enduring strengths of each of the cycles that drove the boom in the first place and then, the individual cost bases of iron ore producers. Let’s deal with the macro issues first.
Cycle 1: Chinese catch-up growth and urbanisation
Over the past two decades, China steadily opened its markets and generated productivity-driven growth, taking advantage of a vast pool of cheap labour. Local savings rose fast enough to fuel enormous investment in the hard infrastructure of urbanisation. With the public and private sectors at full tilt, China built-out a modern economy for 1.3bn people astonishingly quickly.
The country’s urban population grew from 26% in 1990 to 53% in 2012. Current projections of 70% urbanisation by 2030 will mean 960m total urban residents. The numbers are huge but it’s the rate of change in growth that matters. The fact is the industrial capacity required to cope with this additional influx is already in place.
There’s another problem. The historic structural shift in Chinese growth to a modern economy enabled the rise of a huge construction-focused economy, from bricklaying to financing. Initially, each new investment drove a more efficient allocation of resources. Farmers used better roads, travellers enjoyed improved rail and everyone lived better, more productive lives.
But, while the pool of genuinely productive investments was limited, the growth in debt availability produced investments at diminishing rates of return. The situation is now so bad that new investments can no longer be financed at all and productivity growth has stalled.
This is the same conundrum confronting every developing economy when their catch-up growth phase ends. To avoid what is dubbed the ‘middle income trap’– in which declining productivity kills growth – China must now re-orient its resource allocation to higher yielding outcomes. That means higher interest rates, reduced but higher quality investment and more consumption. In short, the growth in China’s building boom is over.
Cycle 2: An unprecedented steel boom
The Chinese steel boom that fed the growth cycle was jaw-dropping. The growth in steel output needed to modernise an economy of its size, as Chart 1 shows, was huge.
From around 100 million tonnes per annum (mtpa) output at the turn of the millennium, Chinese steel raced to almost 800mtpa last year. Idle steel capacity is today some 200-300mtpa above that figure.
The proportion of steel used in Chinese urbanisation is massive. Estimates vary between 40% and 70% but whatever the figure, residential housing accounts for about two-thirds to three-quarters of it. Whichever figure you choose, urbanisation is the key driver of steel demand. As it slows, so does steel output.
In the first five months of this year, which included a 34% jump in steel exports, output grew just 2.7%. Remove the export growth and Chinese steel demand actually fell 1%. Chinese steel consumption is peaking and the country is burdened by vast steel overcapacity.
Steel booms are unique among commodities in that they generate their own demand; the furnaces, factories, railways, roads, ships, trucks and mines required to build steel, use steel in their construction. So there’s a natural amplification of the boom that’s mistaken for sustainable demand. But when the growth in real underlying demand starts to slow, the amplification suddenly reverses, leaving vast swathes of capacity standing idle. Such was the fate of US steel in the 1920s. Such is the fate enveloping Chinese steel today.
Cycle 3: Massive supply expansion
This amplifying boom took in iron ore miners. They invested on the basis of endlessly soaring demand but right at the time when demand is stalling the industry is in the midst of a huge growth in capacity. Rio Tinto has another 90mtpa to deliver in the next 18 months. Roy Hill will add 50mtpa next year. Vale will add 90mtpa the year after. These are all unstoppable, sunk cost investments.
Chart 2, showing broker forecasts for the seaborne iron ore market balance of supply and demand from 2008 to 2017, tells the story.
Of course, these figures can change but the coming glut is so massive that precision doesn’t matter. The coking coal business, which has been through this process of rationalisation over the past two years, is an indicator of what happens next. The current market surplus of about 7% (25mtpa) caused the coking coal price to fall 70%. In iron ore, the surplus is around the same levels and the price has already halved. Trouble is, next year the forecast surplus is set to roughly double or more. Further downwards pressure on the iron ore price is on its way.
Iron ore producers have more pricing power than coking coal producers but again, the vast suplus renders any market structure benefits all but immaterial. The iron ore price will fall until it hits the price of marginal production.
Buy iron ore miners?
Chart 3 shows the breakeven price of iron ore producers. The junior miners with cost bases above those of Fortescue Metals Group (FMG), representing a combined total ouput of around 100mtpa, are dead men walking. With FMG representing another 150mtpa, the total of the coming surplus is around 250mtpa.
In other words, in the long term FMG represents the iron ore price floor of around $70-80. But that doesn’t make those companies with lower cost production a buy. As the shakeout gathers pace, iron ore prices are likely to fall lower as producers hang on for their lives. Juniors like Atlas Iron will disappear quickly but larger producers have sunk costs to write off. As they do so, they will continue to pump out product.
Such is the nature of the iron ore cycle. Even if FMG entered administration, the mines would continue until the company can’t make a cent. The shakeout will be an irrational, epic scramble to survive. The major miners, given they produce iron ore at breakeven costs of $40-$50, will emerge victorious and at some point they’ll be worth buying, but not yet.
Sentiment will pulverise neat discounted cash flow models, crushing apparent value to dust. Before this is over we will see ruthless corporate action, sabre-rattling geo-political tensions and household names fall to earth. That will be the time to buy.
David Llewellyn-Smith is the founding publisher and former global economy editor of The Diplomat magazine, Asia Pacific’s leading geo-politics and economics website. He is also the co-author of The Great Crash of 2008 with Ross Garnaut and a regular economics and markets contributor for Fairfax and the ABC. David is the editor-in-chief and publisher of MacroBusiness.