Iron ore: It's (not) different this time

A Faustian bargain has been made in China. In return for legitimising the authoritarian rule of the Communist Party, the people of China have been wrenched from grinding poverty and heaved towards a prosperous new future.

At the heart of this exchange lies steel. For the technocrats who command the heights of the Chinese economy, steel isn’t just another metal; it is a strategic asset—the key to modernisation. For that reason, China has thrown itself into the production of steel; China now accounts for about 50% of global output (see Chart 1).

That makes the ingredients that make steel—coking coal, manganese and most crucially, iron ore—of particular interest to Chinese state-owned enterprises, which form the backbone of this new economic giant.

In recent years, however, the giant has been crying foul. Ten years ago, iron ore prices were stable at less than $30 a tonne. Today, they are closer to $150. At the height of the boom, they approached $200 a tonne. Expensive steel threatens the modernisation of China and hence the rule of the Party, which is why China has been doing all it can to promote new supplies around the globe.

Yet China has been throwing money at projects for years and has had nothing but triple figure iron ore prices to show for its efforts. This has led to claims that iron ore has settled on a new paradigm of permanently higher prices (heard that one before?). Or in the language of the cynic; this time it’s different. Let’s put this claim to the test.

Why sky high?

Last year about 2.5bn tonnes of iron ore was produced globally. It’s a tightly controlled activity; four countries account for three quarters of production (see Table 1).

The big three iron ore producers – Brazilian giant Vale, Rio Tinto and BHP Billiton  – account for over 60% of the world’s traded iron ore supply. This concentration has been an important part of the growth in iron ore prices over the past five years (see Chart 2).

The dominance of these three leviathans can be explained by an essential truth: iron ore is really logistical science masquerading as mining.

Vast quantities of earth – billions of tonnes – need to be moved from distant deposits to ports and shipped to steel mills. To do this two things are needed: a spaghetti bowl of railway lines and port routes as well as giant deposits to feed these transportation machines. The great iron ore basins of the world, the Carajas in Brazil and the Pilbara in Western Australia, are already well endowed with both ore and logistics. Hence most of the world’s iron ore comes from these regions and, historically at least, incremental increases in supply have been sourced from these basins. But as prices rise, new things become possible.

Enter the dragon

Iron ore from Brazil and Australia is the world’s most coveted. The important differentiator is grade. As iron ore approaches 60% iron, it can simply be dug, crushed and shipped. Mining doesn’t get much easier. Rio Tinto and BHP’s enormous iron ore margins are testimony to that.

Whereas in the Pilbara and Carajas, producers do not bother with grades less than 55% iron, in China, miners work laboriously, with just a shovel and sweat, to recover grades as low as 20%.

This has become such a popular activity that the North Koreans have guards on their Chinese border to stop incursions from solitary miners seeking new resources. Despite a modest geological endowment, China has thus become the world’s single largest supplier of iron ore. It is thought almost 1bn tonnes of iron ore per annum originate in China, made possible by higher prices.

For China, this isn’t simply an economic activity, it is of prime strategic importance without which its continued industrialisation may be put at risk.

Chinese authorities understand what many iron ore investors don’t: that there is a finite ceiling to how high iron ore prices can go before plentiful low grade resources become viable. We believe we are now at such a threshold. The only thing standing between hungry steel mills and a flood of new supply are the logistics to get the lower-grade ore into the mills.

All aboard

The emergence of Fortescue Metals from an exploration minnow to a mighty $16bn miner is a fine example of how the industry has changed. Fortescue was in the position of many prospective miners – it had resources but no way of moving them to ports. Raising the billions of dollars needed to build the requisite infrastructure is a big task for a minnow. At least in normal times it is.

In a world of $150 a tonne prices and generous state sponsored financiers, asking the impossible ain’t what it used to be. At no other time in history would a project like Fortescue’s receive the necessary funding so quickly and so easily.

Now it is common place, with tiny companies sitting on massive loans provided by drooling state sponsored firms. The Chinese, tired of paying exorbitant prices for their push into modernity, are pushing back.

The industry’s cost curve is well below current prices (see Chart 3). Estimates of Chinese extraction costs indicate that almost all Chinese producers are profitable at prices above $100 a tonne. Below about $60 a tonne, a majority of Chinese producers are forced from their operations. This suggest that the days of $20-30 iron ore are over but also that today’s prices of over $150 a tonne are also probably unsustainable.

As lower grade ores are mined and as new railway lines are built to accommodate new sources of supply, iron ore prices will fall. But where will this supply come from?

Iron clad

About $60bn worth of projects are planned before the decade is out – and that is in the Pilbara alone. Vale is also spending vast amounts of money in the Carajas and, in Mauritania, Vale and Rio have uncovered a massive new iron ore province that looks a lot like the Pilbara did 40 years ago; it is perhaps the world’s largest deposit.

On top of this large scale supply, Chinese firms are funding infrastructure all over Africa to ensure that over the next two years, a total of 700m tonnes of iron ore will be added to global supply, the equivalent of two new Pilbaras. And much more thereafter is planned.

Fortescue alone has ambitions to increase production beyond 300 millions of tonnes per annum (mtpa). Ultimately, Rio plans to produce more than 400mtpa. And BHP is concentrating its enormous firepower on increasing its footprint in the Pilbara.

It is a rare and happy industry that can boast both record production and record prices. We believe that the new supply miners are boasting of will ultimately be the undoing of the great iron ore boom.

Portfolio rust

If you are heavily exposed to the iron ore sector, your portfolio should take this possibility into account.
Exposure to smaller producers, such as Sundance Resources, BC Iron, Gindalbie Metals, and Iron Ore Holdings should be limited or avoided altogether.

Fortescue has grown to operate excellent, high quality assets, but its balance sheet isn’t in the same shape. Sharply lower prices would wreak havoc on the business.

BHP and Rio rank among the finest operators in the world. They will not disappear, but risk significantly lower margins. BHP’s splendid diversification offers some protection, but Rio, which is heavily reliant on its iron ore division, remains vulnerable. We will be reviewing our recommendation on Rio over the coming weeks.

Two higher quality producers, Atlas Iron and Mt Gibson Iron, may be candidates for an upgrade should prices become attractive enough, but we don’t recommend them at this stage.

For now, we recommend limiting your exposure to the iron ore sector and taking profits where you have made them.

Iron ore will still be a profitable industry, but despite the bravado of the optimistic, elevated prices never last forever. It’s not different this time.