The fine line in iron's decline

You know what has been missing from this rally? Any affection for our iron ore miners. Since the beginning of the year , the All Ord’s is up some 6% (10% at the peak), while our big miners hit a peak of about 4% and are currently 12% lower year-to-date. Outside of our behemoths, Fortescue is 15% lower (although it was up 18% at the peak). Now we know the story – the hunt for yield, our banks are doing marvellously and the like. We also know why our resources are being hit and why iron ore in particular is out of fashion – China slowing, steel demand slowing and a huge supply of iron ore coming on board.

All three of these are widely proclaimed as fact and many talk as if there was no debate. Goldman Sachs adds to that case a forecast that high-cost Chinese producers probably won’t close down as everyone expects them to, while demand slows and prices fall.

The large miners themselves expect prices to decline to something in $US130 per tonne range for the remainder of this year and 2014, before falling to $US80-$US90 in 2015. The Bureau of Resource and Energy Economics (BREE) for its part expects prices around the $US120 mark this year and sub $US120 next (hitting $US100 in 2015).

The problem I have with this view is threefold.

1. I see no signs of slowing Chinese economic growth more broadly.
2. There is no sign of slowing steel demand more specifically.
3. No one is actually forecasting a supply surge.

Now data on China is hard to find, and plenty of people don’t believe it when it comes out. I’m not going to defend it and say you should take it as gospel. But, that being the situation, how can anyone make the case the Chinese economy is slowing if they don’t believe the data? Gut feel? For what it’s worth, the data indicators actually show growth, at a more moderate pace than we’ve become accustomed to over the last decade, sure, but not too different from growth rates we saw last year of around the 7.5-8%. Don’t forget also that these forecasts on Chinese growth were made toward the end of last year and early this. The mood since has improved markedly, and there will likely be upgrades to something over 8%. Think of recent global indicators picking up.

More specifically I see no sign of, or expectation, that either steel demand or supply is going to decline – in China or elsewhere. Take a look at table 1.

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Australia’s expert forecaster BREE expects global steel demand to rise on average by 3.3%. This isn’t a slowing or some decline in demand. Demand for steel continues to grow. So too does production, albeit at a slightly more modest pace of 2.8%. This is expected to lead to a modest net excess demand position by 2015 (of -4 million tonnes). This should support prices and is far from a glut. Importantly for our iron ore miners, Chinese steel production is forecast to rise on average by 3.8%. Note too that BREE is not alone in these forecasts; its view is similar to those provided by the World Steel Association for 2013.

Then what about that supposed iron ore supply surge? Here it is argued that so much iron ore is coming through the pipeline that this will lead to a glut – prices will tank. Take a look at table 2:

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The table shows forecasts (by BREE) of iron ore imports and exports, which I use in the absence of firmer production and consumption numbers, as a proxy for demand and supply. Imports being demand and exports supply.

You can see from the table that world demand for iron ore grows at an average of almost 4% to 2015. It’s true to say that iron ore supply exceeds that growth, which is expected to rise on average by 7%. This isn’t a surge though. There is a surge on one year – 2014 – but even with this, no one is looking for a glut of iron ore. Instead, the large excess demand that has prevailed for some-time gets whittled away – but that’s not until 2015 and, even then, excess demand remains. So the fact is, iron ore production capacity is still not sufficient to meet demand.

I would also point out that most of these demand assumptions are based on the more modest Chinese growth profile of 7.5% and trend global growth. Indeed the World Steel Association made its forecast for 3.2% steel demand growth back in October 2012. The world is looking much better since. In other words, there is a lot of upside to all of those demand forecasts if, as has been the case consistently since the recovery from the GFC, the underlying growth assumptions surprise on the upside. This is highly likely when no allowance is made, or very little allowance for:

1. A pick-up in the global construction cycle, which is still currently very weak.
2. A lift in European growth.

So to put in another way, I see no basis in these quite significant downgrades from official forecasters or even large companies like Rio and BHP. Each premise is false the way I see it.

The other side arguments are as easy to dismiss. So, firstly, the view that increasing scrap usage within China will see steel production fall. Consider instead that scrap use is such a small percentage of crude steel production (about 13%-14% of crude production, which has been consistent for many years) this isn’t likely. Nor is the view that China will be compelled to keep high-cost iron ore producers operating for fear of rising unemployment. There are two problems with this view:

1. The last time iron ore prices fell, Chinese iron ore producers actually cut production significantly – by about 20%. Some regions stopped all production and others cut it by 60%.
2. There is almost no chance that the Chinese government, with an unemployment rate of 4% or so, will feel compelled to keep higher-cost producers in operation when they can command that labour into higher-growth sectors. More to the point, high-cost iron ore makes steel producers less profitable, affecting employment there.

Of course, even if I’m wrong, much of the bad news is priced in already. Rio, for instance, is trading at a price earnings ratio (trailing) of just under 12. That may not look cheap when you consider that the five-year average is 11. But then the one and two-year forward P/Es are between nine and 10, which puts it firmly in cheap territory. It’s the same for BHP – currently at a P/E of about 10.5 – below the five-year average of 13ish and the forward P/Es of between 11-12. Relative cheapness is even starker for the smaller iron ore plays like Fortescue, Atlas Iron and Mt Gibson Iron (forward P/Es of around four to eight).

While many may argue that their higher costs of production warrant a smaller multiple, I would disagree. Estimates vary, but the while the cost of production for Rio and BHP is around $34-$39, production costs for Fortescue and Mount Gibson are still well below the current spot or projected spot price at $53-63 per tonne. Current low P/Es don’t reflect this fact.