Not so fine… behind the iron ore crunch

Sharp price falls over the past month by iron ore miners might tempt speculators to buy what they believe are bargains, but cautious investors should hold back until a clearer picture emerges of a sea-change in Australia’s most important export industry.

Despite a fall of 33% by Fortescue Metals over the past 12 trading days, and 50% by Mt Gibson Iron, there could be worse to come.

The problem is five-fold.

• Australia’s iron ore stocks flew too high for too long, defying the evidence of declining steel demand in China and an over-supply of iron ore.
• Grave uncertainty about links between “shadow bank” financing deals in China and iron ore which could unleash a flood of stockpiled material.
• A crackdown by Chinese authorities on the most polluting steel mills, including the withdrawal of credit which could force widespread mill closures.
• Ongoing expansion by the world’s biggest iron ore miners which will dump more material onto an already saturated market, and
• Uncertainty about the precise cost per tonne of the smaller miners which generally do not get paid the widely-quoted price for premium quality (62% iron) ore.

What’s happened over the past few weeks was totally foreseeable, and indeed was predicted in a Eureka Report story late last year – “Readying for iron’s fall”.

Back then, I used the bluntest possible language when warning about what would eventually happen: “while iron ore company shares are high today, the iron ore price is poised to fall”.

As it turned out, the price of iron ore company shares continued to rise for another five months, until the wheels fell off last week as the price for premium-grade ore (the 62% material) dropped from $US120 a tonne to $104/t.

Small and high-cost producers in the spotlight

The overdue correction underway will not inflict significant damage on Australia’s leading miners, such as Rio Tinto and BHP Billiton, but it will have a major effect on smaller and higher-cost producers.

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The difference between the big and the small was on display yesterday and today at an iron ore and steel conference in Perth.

While senior executives from the big miners said they would ride out any price correction they did expect “low cost iron ore to displace high cost ore” – with the inference being that some Chinese mines will close and smaller Australian mines will be under pressure.

A snapshot of which companies will feel the most pain was contained in a recent analysis of costs by the investment bank, UBS:

In that March 10 report the bank pointed out that what you see with iron ore is not necessarily what you get because the price for 62% iron ore can be heavily discounted for lower grade material such as the 58% ore delivered by Fortescue, and discounted further if the ore has a high moisture content or is high in impurities such as phosphorous, silica or alumina.

Conversely, a premium to the 62% iron ore price is available for the best quality ores, sometimes referred to as lump, because it is easier to use in a steel-making blast furnace and generates less pollution.

The UBS analysis showed that after all costs, discounts and premiums there is a wide spread of break-even prices in the iron ore industry with Rio Tinto the low-cost leader at $US43 a tonne and Gindalbie the highest-cost producer at $US91/t.

Chinese steel mills to act on pollution

To add insult to injury, the biggest miners are cranking up production of lump ore to earn the price-premium on offer from steel mills under pressure to emit less pollution.

Until last month, even as the iron ore price fell from around $US135/t to $US120/t no Australian iron ore miner saw its profits threatened by the iron ore price.

That situation changed when the price dropped this week to around $US104/t and concern grew that the Chinese Government was serious about forcing a major restructure of its steel industry which has been producing more steel than the country requires as the construction phase of its economic growth cools.

The same pressure, which includes a reduction of the amount of credit available to the iron and steel industry by government-owned banks, is being applied to other raw materials, most notably copper which has also suffered a sharp price correction of 11% over the past two weeks, including a fall back through the $US3 per pound mark last night.

Of the multiple pressures bearing down on iron ore the easiest to understand is the over-supply which is a result of mining companies unleashing huge expansion projects at a time when the Chinese construction boom seemed to have no limit.

In simple terms it has been a classic case of supply chasing demand – only to have demand suddenly triggering what looks like a slow-motion train wreck.

Chinese credit crack-down

A more complex factor is the state of the credit market in China were two forces are at work, a credit crack-down to force high-cost and more polluting steel out of the industry, and a crack-down on “shadow banking” which has seen commodities such as copper and iron ore used as collateral for bank loans.

The Chinese Government attack on fringe dealers in its banking sector is forcing stockpiled commodities into the market as financing deals are hurriedly unwound with near-panic dumping of surplus material into the over-supplied market.

The financing crisis is even forcing some steel mills to request delays in iron ore shipments until stockpiles are cleared, a situation which mirrors what happened during the 2008 financial crisis when Chinese steel mills refused to accept, or pay for, contracted shipments.

In time, the current crisis will pass, just as it has on previous occasions when the supply demand balance of the iron ore industry tilts too far one way.

Unlike other minerals, such as nickel, zinc or aluminum, iron ore operates as a closed loop system when mines and mills are closely harmonised and stockpiling is difficult either at mines or in ports.

Once a stockpile is full, as is the case today, the system must slow-down, which is what’s happening today as Chinese steel production slows and fringe financiers are forced to dump the material they had been using to raise bank loans.

The chief executive of Rio Tinto’s iron ore division, Andrew Harding, told the Perth conference that there would be “short-term volatility” in the market, a point echoed by his opposite number at BHP Billiton, Jimmy Wilson.

While both men have the luxury of running the industry’s low cost operations which will comfortably ride out the crisis which is washing over the higher-cost producers there are reports of pressure on both BHP Billiton and Rio Tinto to help the over-supplied Chinese steel industry.

The point was made by a commodity trader in Singapore who told the Reuters news service yesterday that: “steel mills and traders are telling BHP Billiton and Rio Tinto to delay their shipments from April to May,” the unnamed trader is reported saying.

“The reason is all their financing (in the form of iron ore) is stuck at the port so they can’t open new letters of credit.”

For Australian investors with an interest in the iron ore sector that comment, and the other items of evidence emerging at the conference and from sources in China, points to the next few months being a tumultuous time.

There might be bargain-buying opportunities, but there is more potential for heavy losses as the iron ore price bounces around and miners start to consider two critical factors:

• what is the daily iron ore price doing to the cash flow? and
• what will a lower price in the long-term do to their balance sheet?

For the next few weeks the safest place to observer the iron ore sector will be the sidelines.

* For more on the iron ore crunch, see Eureka Report managing editor James Kirby's video on "Why the iron ore plunge matters".