Readying for iron's fall

It was the economist, Lord Keynes, who warned investors that: “the market can remain irrational longer than you can remain solvent”.

And though he wasn’t thinking of iron ore at the time, the warning still applies. While iron ore company share prices are high today, the iron ore price is poised to fall.

The problem with that iron ore warning is that it’s been made many times over the past six months, and it has been wrong just as many.

The result is that people who can see an iron ore price fall on the horizon, like me, have been made to look out of touch and, in some cases, they have been unwilling to persevere with the argument that a disconnection has developed between share prices and the future iron ore price.

Some stockbrokers, who previously subscribed to the theory of an inevitable iron ore price fall, have recanted because the change has not occurred in the time they expected, which was in the September quarter.

Their problem is that clients who sold iron ore miners in June missed solid, and in some cases spectacular, capital gains. Fortescue Metals, for example, has risen by 57% since June 30. Mt Gibson is up by 52%, and BC Iron has risen by 41%.

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In my view, those rises, and the latest evidence from the iron ore market, are combining to point to an even more damaging correction when it occurs, which it will.

The issue is simply one of timing, because no-one who follows the iron ore sector doubts that a large amount of extra supply is heading for the world’s steel mills at a time when steel production is solid, but certainly not booming.

Over the past few days the iron ore warning bell has been rung at least four times by four separate organisations that watch the market closely.

• Citigroup Global Markets sees the price for best quality iron ore falling from its current $US131.80 a tonne to $US115/t over the next three months.
• J.P. Morgan sees the price starting a long-term fall soon, with next year’s average expected to be $US118/t, followed by $US110/t in 2015 and $US103/t in 2016.
• Bell Potter, one of the strongest “gold bulls”, sees the price holding up for longer, with an average next year of $US123/t before sliding to $US115/t in 2015.
• The Bureau of Resources and Energy Economics (BREE), an Australian government agency, sees the start of a long-term decline, which will culminate with a price of $US91/t in the year 2018.

Apart from the sub-$US100/t forecast in five years from BREE, none of the price predictions represent a threat to the survival of any Australian iron ore miner.

But that’s not the point, because all represent a squeeze on profit margins, with the next few years likely to see a race among producers to drive their costs down. Such a process can often involve increasing production in the pursuit of plant efficiency, thereby further boosting the growing iron ore glut.

The world’s three biggest suppliers of iron ore to the seaborne trade, Rio Tinto, BHP Billiton and Brazil’s Vale, are all racing to expand their operations, not so much because of an expected surge in demand, but more in the pursuit of lower costs on a per tonne basis.

While no-one is able to put a precise date on when the price slide will start, there is an inevitability contained in some of the production numbers that underpin the cautious outlook.

According to J.P. Morgan, Australia’s production of iron ore has increased by 17% this year and will rise by another 20% next year.

In tonnes, that means Australia’s miners will ship an extra 92 million tonnes this year, and an extra 130 million tonnes next year.

The problem with those extra tonnes is, who will buy them? According to J.P. Morgan, China’s steel production needs to grow by 9% to simply absorb Australia’s extra supply next year.

Steel output in China is highly unlikely to grow by that amount, so the only solutions to the glut are lower prices and/or the closure of high-cost Chinese iron ore mines.

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Citi comes closest to putting a time on the iron ore price fall: the December quarter, which is sometime between now and the end of the year.

Not only does it see a problem with a glut of production, but a secondary problem of tightening credit availability in China.

“Strong Chinese steel production and iron ore imports in recent months have masked weaker fundamentals,” Citi said.

“A surge in seaborne iron ore supply is expected over the coming months, driven by two primary factors:

• Strong increases in Australian exports from Rio Tinto, BHP Billiton, and Fortescue Metals leading to expectations that fourth-quarter production will increase by a record 34 million tonnes (year on year) and 12 million tonnes over the third quarter, and
• Large quantities of Brazilian ore currently on the water as a result of inventory drawdowns in Brazil following resolution of rail issues.

“Pricing and supply dynamics have shifted in recent weeks, and we expect weaker steel production and softer demand for imported ore in the fourth-quarter.”

Bell Potter is the most optimistic of the forecasters, but only to the point of shifting the time lines of the price correction.

In a review of the bulk commodity sector released on Wednesday, Bell Potter has increased its price estimate for 2014 from $US110/t to $123/t, and its estimates for the following year from $US110/t to $US115/t.

“Iron ore prices have surprised the market on the upside, with September-quarter prices averaging $US134/t,” Bell Potter said.

“To meet financial year 2014 broker consensus of $US115/t prices would have to average less than $US110/t over the October 2013 to June 2014 period.

“We think that this outcome is unlikely, and expected to see a round of broker upgrades over the next few months. Leveraged iron ore producers will benefit from those upgrades.”

From an investment perspective the scene appears to be set for one last iron ore hurrah before the long-term (and overdue) price correction starts.

That does not mean the iron ore sector should be abandoned. But it does mean that the next few months will be a good time to take some money off the table, with an eye to buying back after the correction.