Politburo pulls the floor from under iron ore
The continuation of loss-making iron ore and steel production in China has undermined the iron ore price floor – and any floor likely won't be reinstated until China's political nervousness eases post-handover.
The debate is between those who thought there was a floor and those who look to what has actually happened to the iron ore price as evidence that it doesn’t exist. In some respects it is an argument between optimists and pessimists that, for the moment at least, the pessimists are winning.
A year ago, when the iron ore price was touching $US190 a tonne, the notion that it might plummet through $US100 a tonne to now be a smidgeon above $US90 a tonne would have been inconceivable, even though the major miners were always aware that the "super-cycle" prices were an aberration that would disappear as new production, delayed by the financial crisis, came into the market.
There was, however, a thesis and a quite rational one, that there was a natural level of support for the price set by the costs of the marginal producer. While prices did fall well below the current levels during the financial crisis, that was thought to be around the $US120 to $US130 a tonne range at which the marginal producers in China would be losing money.
Hence, as the price keeps tumbling, the consternation and confusion.
There are some fundamental reasons for why the iron ore price (and the prices of other hard commodities) have crashed, and some behavioural reasons.
The core explanation is quite prosaic. Supply, ignited by the super-cycle prices, has been rising strongly while demand has been falling sharply.
Take a look at what’s happened (and is still happening) in the Pilbara.
Over the past two years BHP Billiton has increased its production 35 per cent and is now producing at an annualised rate of 179 million tonnes a year – 51 per cent higher than it achieved in 2009-10. Rio Tinto has lifted production 35 per cent since 2010 to an annualised rate of 230 million tonnes and is on track to lift that to 283 million tonnes by the end of next year. Fortescue is producing at a rate of 55 million tonnes a year but is on track to lift that to 155 million tonnes by the middle of next year. That’s just the Pilbara.
So supply has soared. What about demand? It was going along nicely until about September last year when the combination of the deepening troubles within the eurozone and China’s own internal attempt to stamp out a credit driven property bubble combined to slow its economy. It has kept slowing and, as Europe’s woes have worsened, China’s exports have fallen away sharply – with an obvious and intensifying impact on its steel mills.
Conventionally that would drive down steel prices, as it has, produce a significant increase in inventories, which it has, reduce demand for iron ore, which it has, but also lead to reduced steel and domestic iron ore production – which it hasn’t.
Steel and iron ore prices have fallen to levels last seen during the worst of the financial crisis but steel production has held up and, it appears, domestic iron ore production, while it has been cut back, hasn’t responded as completely to the price signals as it should have.
That’s why the iron ore floor price thesis has broken down.
With a majority of China’s steel mills reportedly losing money and, one would assume, just about all its iron ore producers (Chinese ore is low-quality and high-cost) one would expect that not to be a sustainable position.
The fact that the market hasn’t worked to drive out unprofitable steelmaking and shut down domestic iron ore production almost inevitably relates to social factors and the unwillingness of state-owned enterprises to shed activity and jobs. In the meantime stockpiles of steel and iron ore have been built.
China has been trying to manage a controlled reflation of its economic growth rate, including some targeted increases in infrastructure investment, but its policy measures have yet to produce a discernible positive impact. Its ability to act more decisively may be inhibited by the looming generational change in leadership.
In any event there is an expectation among China watchers that it may take until next year before any stimulus-generated uptick emerges.
In the meantime the supply of iron ore is rising inexorably at high single-digit percentage rates. In the absence of a return to the double-digit growth rates in China that the authorities, anxious to deflate a speculative bubble, hosed down last year, the rising supply will provide a ceiling on prices.
While it happened earlier than they had anticipated – both Rio and BHP thought they had a couple of years left where demand would outstrip supply and where the marginal producers’ cost of production would provide that floor – their longer term strategies don’t depend on a return to super-cycle pricing.
With cash costs below $US50 a tonne (in Rio’s case well below) the two big Pilbara producers can live with prices around the $US100 a tonne level, or lower, provided their rising volumes do displace higher-cost supply from within China and elsewhere. Fortescue also has cash costs below $US50 a tonne but carries a lot of financial leverage, which is still rising, into the new market circumstances.
With Europe likely to remain a basketcase longer term, and the US economy weak and confronting significant debt and deficit issues that will take a long time to bring under control, the global economy isn’t suddenly going to rekindle China’s growth rate and set hard commodity prices alight again anytime soon.
If there is to be any floor under the iron ore price (and other commodities) in the near term it will relate to China’s own ability and willingness to generate increased domestic activity and demand.
There is a floor of kinds under China’s demand for the commodities that have helped feed its spectacular growth over the past decade – its economy is nearly 50 per cent larger today that it was before the financial crisis – but that, for the moment at least (and it could be quite a lengthy moment) has more to do with volume than price.
That relatively abrupt shift from the emphasis in price to volume is why there’s now not just a debate about floor prices and their existence or otherwise, but about whether the boom itself has ended or simply shifted into a very different, and for the producers and producer nations, far less lucrative phase.