With the iron ore price down by almost a third this year and now at much the same level it was four years ago, is there an opportunity in the sector? The answer depends on the enduring strengths of each of the cycles that drove the boom in the first place and then, the individual cost bases of iron ore producers.
Let’s deal with the macro issues first.
Cycle 1: Chinese catch-up growth and urbanisation
Over the past two decades, China steadily opened its markets and generated productivity-driven growth. With the public and private sectors at full tilt, it built-out a modern economy for 1.3bn people astonishingly quickly.
The country’s urban population grew from 26% in 1990 to 53% in 2012. Current projections suggest that by 2030 70% of Chinese will live in cities. The issue is that the industrial capacity required to cope with this additional influx is already in place, lessening demand for iron ore.
There’s another problem. Even China’s pool of genuinely productive investments is limited, so the growth in debt availability delivered investments at diminishing rates of return. The situation is now so bad that new investments can no longer be financed at all and productivity growth has stalled.
So the country must now re-orient its resource allocation to higher yielding outcomes. That means higher interest rates, reduced but higher quality investment and more consumption. In short, China’s building boom is over.
Cycle 2: An unprecedented steel boom
Whilst urbanisation is the key driver of steel demand, as it slows so too does steel output. In the first five months of this year, which included a 34% jump in steel exports, output grew by just 2.7%. Remove the export growth and Chinese steel demand actually fell 1%. Chinese steel consumption is peaking and the country is burdened by vast overcapacity.
Cycle 3: Massive supply expansion
The amplifying steel boom took in iron ore miners. They invested on the basis of endlessly soaring demand but right at the time when demand is stalling the industry is in the midst of a huge growth in capacity.
Rio Tinto has another 90mtpa to deliver in the next 18 months. Roy Hill will add 50mtpa next year. Vale will add 90mtpa the year after. These are all unstoppable, sunk cost investments.
These figures can change but the coming glut is so massive that precision doesn’t matter. The coking coal business, which has been through this process of rationalisation over the past two years, is an indicator of what happens next.
The current market surplus of about 7% (25mtpa) caused the coking coal price to fall 70%. In iron ore, the surplus is around the same levels and the price has already halved. Trouble is, next year the forecast surplus is set to double or more. Further downwards pressure on the iron ore price is on its way.
Iron ore producers have more pricing power than coking coal producers but again, the vast surplus renders any market structure benefits all but immaterial. The iron ore price will fall until it hits the price of marginal production.
The question is where that might be. The junior miners with cost bases above about US$80/dmt, representing a combined total output of around 100mtpa, are dead men walking. That number includes Grange Resources, Gindalbie Metals and Atlas Iron.
Fortescue Metals Group represents another 150mtpa, so the total coming surplus is around 250mtpa. In the long term FMG represents the iron ore price floor of around $70-80 - the price of marginal production.
But that doesn’t make those companies with lower cost production a buy. As the shakeout gathers pace, iron ore prices are likely to fall lower as producers hang on for their lives. The juniors will quickly disappear but larger producers have sunk costs to write off. As they do so, they will continue to pump out product, putting further pressure on an already-stretched sector.
The shakeout will be an irrational, epic scramble to survive. The major miners, given they produce iron ore at breakeven costs of $40-$50, will emerge victorious and at some point they’ll be worth buying, but not yet. The iron ore price could fall a lot more yet.