Why iron ore prices will remain high

Australian miners are again looking at record iron ore prices even as the Chinese economy cools.

Increased supply and reduced demand usually make for a lethal combination.

For iron ore miners, that was the bleak outlook thrust in their faces earlier this year by some of the best and brightest analysts on the planet.

A cooling economy in China combined with a shift away from investment driven growth and towards greater domestic consumption was to be the catalyst for the end of the great resources super-cycle. That it was occurring simultaneously with a massive increase in mining and shipping capacity after years of investment would culminate in a price crash.

The most optimistic analysts had pencilled in $US120 a tonne for 2013. The bears were pointing to a repeat of last year’s events when prices slid below A$US90 a tonne.

Despite the overwhelming logic of the argument, the opposite is occurring, which Adam Carr flagged in The fine line in iron's decline back in April.  Rather than falling, iron ore prices have risen consistently for months. Last night it pushed even further to $US141 a tonne ($AUD158).

When combined with a weaker Australian dollar, local iron producers are raking in the cash with prices above $A154 a tonne approaching all time highs, forcing a complete rethink on the earnings outlook for Australian producers, particularly the pure iron ore plays such as Fortescue Metals (FMG), Rio Tinto (RIO), Atlas (AGO) and BC Iron (BCI).

How much longer can it continue?  At least for the next few months.

According to the official Chinese news agency Xinhua, stockpiles of imported iron ore at 25 major ports declined almost 3% in the first week of August, dropping to 72.83 million tonnes after declining in the latter half of July.

Given the reason cited for the steady lift in prices since June has been restocking, there appears plenty of scope for that to continue. And with September usually the peak season for consumption, demand for the key steelmaking ingredient is likely to remain hot at least until the end of this quarter.

An oft overlooked fact about China’s steel industry is that during the past decade and a half, it has evolved from a cottage industry with a large number of smallish mills into an industry that boasts some of the world’s largest facilities.

As the scale and size of the plants have lifted, the capacity to reduce steel output in response to reduced demand has diminished. Closing or even partially shutting down a mill is an expensive operation that could only be undertaken if the long term economic dynamics dictate such drastic action.

At various times, the industry has racked up large losses as iron ore prices have risen to record levels while steel prices have crashed.

About the only flexibility available to steelmakers is in the management of stockpiles, cutting back when steel demand falls. That, however, can only be employed as a short term strategy as witnessed in October last year.

It would appear iron ore prices are likely to remain elevated for quite some time, interspersed by periods of volatility as mills reduce or lift stockpiles.

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