With iron ore prices already nearly 40 per cent lower than last year’s average you don’t have to be a rocket scientist to work out that there is worse to come.
Even if the tide of new supply that has poured into the market in the past few years were to displace marginal high-cost production, which isn’t a given, the current surplus of supply over demand is likely to swell dramatically over the next few years as even more supply comes on stream.
Brazil’s Vale is in the midst of an expansion program that will see another 130 million tonnes a year of ore enter the market between now and 2018.
Anglo American’s Minas Rio mine is on the verge of first production and has a planned initial capacity of nearly 27 million tonnes.
Gina Rinehart’s Roy Hill project will add up to 55 million tonnes a year once it is up-and-running in the second half of next year.
Rio Tinto and BHP Billiton could add another 135 million tonnes a year to their already greatly increased output if they press ahead with their next foreshadowed expansions in the Pilbara.
Those projects alone would add close to 350 million tonnes a year of supply into a market that former BHP senior executive, Alberto Calderon, yesterday estimated was already oversupplied to the tune of about 100 million tonnes. His estimate that the excess of supply would be about 340 million tonnes in 2016 may underestimate the sector’s prospective position.
Calderon also said something that Rio and BHP, at least, had been saying privately for some time.
The theory behind the continued increase in supply from the low-cost, high-grade producers such as Vale, Rio and BHP is that their ore will displace higher-cost and lower-quality production, particularly the high-cost and low-quality Chinese domestic production.
Calderon, however, said China’s iron ore output would remain at about 400 million tonnes, perhaps dropping to about 360 million tonnes, but remaining at about those levels over the next few years.
Rio and BHP have assumed that for both strategic and social reasons there will be a core of China’s production that will be maintained regardless of whether the mines are operating at a loss. In effect, there is a big base of high-cost production that has to be considered as if it were at the bottom of the cost curve.
As has occurred in other commodities, there has also been a shift in the profile of China’s domestic industry away from the very small mines to larger and more efficient projects.
Even if China’s production were to fall by 40 million tonnes it would meaningless in the context of the avalanche of new supply ahead.
That raises the prospect, articulated by Goldman Sachs’ Christian Lelong in research published today, that with supply growth outpacing demand growth 3:1 the sector may face long-term price deflation. He pointed out that between 1983 and 2003 the price was steady in nominal terms, equivalent to an annual deflation rate of about 3 per cent in real terms.
Miners used to operate on the basis of an assumption that the real prices of commodities would decline over the longer term. They may have to make that same assumption for the foreseeable future.
Calderon appears to believe China will actually engineer an oversupply to drive down prices to its own benefit. It doesn’t need to because the seaborne producers are doing that to themselves and will ultimately have to bear the major share of the production cutbacks, with second-tier producers most obviously at near-term risk.
With the price, even before the big bulge in oversupply arrives, already heading south -- it was $US83.20 a tonne yesterday, a five-year low -- there is a real question mark about how far it may yet fall.
Goldman had previously forecast a 2015 price of $US80 a tonne. Now it believes the price may dip below $US80 a tonne in 2016 and 2017.
At those sort of prices only Rio and BHP among Australian producers would be making meaningful profits (they both breakeven at prices of less than $US50 a tonne, which explains why they keeping expanding their output despite the oversupplied state of the market) while Fortescue Metals Group would be marginally in the black. All the smaller mines would probably be haemorrhaging.
Calderon likened the looming plight of the sector to the experience the aluminium industry has gone through as China’s domestic sector increased supply and depressed prices. There have been massive capacity reductions in the aluminium sector in the past couple of years; Alcoa alone has taken about one million tonnes of capacity out of the market, as the Western producers try to better balance supply with demand.
Something similar, and similarly wrenching, appears destined to happen in iron ore.