Rusting out: Iron ore at a crossroads

The iron ore sector has been beset by price discounting, and now “high-grading” is taking hold.

Summary: For junior iron ore miners, the rust has finally set in. Some producers have been forced into heavy price discounting to shift lower-grade material, and others are resorting to “high-grading” – choosing to extract and sell their higher quality ore while leaving their lower-grade material in the ground. But doing this can dramatically shorten a mine’s life.
Key take-out: After a decade in charge, Australia’s iron ore miners are being forced accept the best price they can. For investors, the trick now is to assess factors that go beyond simply looking at the price of iron ore.
Key beneficiaries: General investors. Category: Commodities.

What you see is never quite what you get with iron ore, a function of it being ore of variable grade and not metal. But two recent additions to an already complex pricing structure spell more bad news for small miners: discounting and high-grading.

The discounting problem is getting some air time, courtesy of the biggest iron ore miners emptying a bucket on smaller rivals, with Rio Tinto boss, Sam Walsh, and BHP Billiton marketing president, Mike Henry, doing the tipping this week.

Walsh warned at the The Australian & Deutsche Bank Business Leaders Forum in Perth on Wednesday that small miners producing low-grade ore will have to offer increasingly heavy discounts to shift their material. Henry said on Tuesday that discounts are “here to stay”.

Smaller miners, such as Atlas Iron, dismiss those attacks as the big boys of mining protecting their patch, perhaps in the hope of pushing more of them out of the industry, in the same way IMX Resources stopped iron ore mining last month, Sherwin Iron descended into insolvency and Pluton Resources is scrambling to organise a cash injection.

Unfortunately for Atlas, it shot down its own argument in yesterday’s June quarter report when it admitted selling ore at a substantial discount to the benchmark price for high-quality material (ore assaying 62% iron), and was effectively ending production of low-grade material known as “value fines”.
Graph for Rusting out: Iron ore at a crossroads

In the 12 months to June 30 Atlas produced 10.9 million tonnes of ore, 9.6m/t rated as standard fines and 1.3m/t as value fines. In the current 12 months it expects to produce between 12.2m/t and 12.8m/t of ore, with the lion’s share being standard fines and the values fines component dropping to between 0.2m/t and 0.6m/t.

Focussing on the highest-grade material is a common move by miners under price pressure, (hence its nickname of high grading) even though extracting the best material and leaving the worst can shorten a mine’s life – unless there is a future price boom and material of any quality can be sold.

With iron ore today there is no sign of a return to boom conditions, because what’s happening to iron ore is much the same as what happened to coal three years ago when a flood of material hit the market, killing the price.

Coal has been under additional environmental pressure but the real problem has been as simple as supply exceeding demand, with coal still the world’s number one energy source (and growing, not shrinking), a situation which has triggered a boom in mine developments.

Iron ore is now tracking the same value-destroying path, as was first warned here last year (Readying for iron’s fall, October 4), a story which annoyed some readers but might have also saved others from paper losses if they had stuck with their favoured small iron ore miner.

Back on the day that warning was published Atlas was trading at 86.5c. It went on to hit a 12-month high of $1.24 in early December before wheels fell off with latest trades close to a 12-month low of 58c, either down 33% from its early October price, or 53% from its peak.

BC Iron and Mt Gibson Iron have suffered similar falls. Sherwin is in the hands of receivers. Pluton is suspended as it seeks fresh funds, and IMX has plunged by 72% from 7.3c to 2c after its iron ore subsidiary, Termite Resources, appointed an administrator.

The common thread linking all of those developments is the 41% fall in the benchmark ore price from $US160 a tonne early last year to its latest price of $US94.50/t, a drop compounded by heavy discounts on lower-grade ores, and material high in impurities such as silica, alumina and phosphorous.

In the case of Atlas, its “standard fines” in the June quarter had an average iron content of 56.6%. Its second-tier “value fines” had an iron content of 53.31% iron.

The price received for standard fines in the June quarter was $US78/t, well below the benchmark price. The price for value fines was $US63/t, 19% less than the already discounted standard fines.

Atlas has countered the price falls by cost cutting and expects to report a pre-tax profit of between $240 million and $260 million for the year just ended. Profits are likely to be harder to earn in the current financial year.

Rio Tinto’s Walsh and BHP Billiton’s Henry are undoubtedly “talking their own books” as part of a concerted push to squeeze their smaller rivals, which is standard practice in all business and a pressure Rio Tinto itself once felt when the world’s diamond-mining giant, De Beers, squeezed Rio Tinto’s Argyle diamond mine which mainly produces low-grade gems.

For investors the trick now is to assess factors that go beyond simply looking at the price of iron ore with ore quality of increased importance, along with impurities, to arrive at a new term for the industry: “realised price”.

Just as the gold-mining industry has been forced by institutional investors to declare their “all in” costs and to not bamboozle investors by only referring to their cash cost, so too will iron ore miners be forced to declare the true price received, and the discounts being applied. (See Cost changes raise gold bar).

Price-cuts are being felt across the industry with even producers of top grade material, such as the part-processed iron ore pellets from the Tasmanian mine of Grange Resources, being hit by a loss of their price premiums.

Still the highest-priced material because most impurities have been removed, Grange pellets in the June quarter fetched $111/t, down 20% on the price received in the March quarter, and down even further than the 14% fall recorded by the benchmark price.

Walsh said Rio Tinto was “easily selling” all the iron ore it produced, while smaller miners were being hit by a push in China to clean up the country’s environment with higher-quality ores producing less air pollution during the steel-making process.

“I think China’s commitment to tackle pollution is a major factor (in the increased discounting of lower quality iron ore), plus the fact that there’s a lot of the low-grade ore coming into the market and it’s flooded that segment of the market,” Walsh said.

“So the juniors are having to discount to physically move their product. That’s the only way the steel mills will take it.”

Henry said that lower-grade ores have traditionally sold for between 93% and 87% of the benchmark ore price.

However, in their June-quarter reports the juniors have revealed price discounts of up to 20%, which means they’re getting closer to 80% of the benchmark price.

The challenge now is to assess when the sell-off in junior iron ore stocks reaches a point where they represent value buying, a job made harder by the additional uncertainties introduced by discounting, and high-grading – with high-grading potentially leading to a reduction in the estimated value of ore in the ground, which could trigger balance sheet write-downs.

Of even greater importance is the change in overall market dynamics, which has seen iron ore shift from being a seller’s market to a buyer’s market.

After a decade in charge, Australia’s iron ore miners are being forced accept the best price they can because Asian steel mills are asserting their power as the customer – and in business the customer is always right.