Why China will drive the iron ore price lower

Australia's mining boom is well and truly over, with iron ore the latest commodity to nose-dive. News to nobody, the insatiable demand for iron ore from China, which buys most of the world’s seaborne iron ore, has moderated. But the real issue, at least from an Australian perspective, has been the huge amount of new supply added to the market over the course of the decade-long boom. Majors BHP Billiton (BHP), Rio Tinto (RIO), Fortescue Metals (FMG) and Brazil’s Vale S.A. have all expanded operations and are producing record volumes.

The weight of all this supply has unsurprisingly pushed the price of iron ore lower, and the share prices of iron ore producers with it. But although the majors added most to supply, they have low-cost operations which afford some protection. Higher cost, marginal producers are the ones to suffer disproportionately. Northern Territory miner Western Desert Resources (WDR) recently went into receivership, and Chart 1 shows how Gindalbie Metals (GBG) has suffered more than Fortescue, which itself suffered more than Rio Tinto, one of the lowest-cost miners in the world.

Perhaps there’s one more ace in the Chinese stimulus pack in the short-term but the long-term outlook is decidedly grim. And, just as has happened in the coal industry, the response to lower prices could prove counterintuitive. Rather than immediate withdrawal of supply, some miners might increase production to try to reduce costs per ton and stay solvent. Smaller miners in particular are likely to produce as long as they have some cash, even at a loss, in the hope the market rebounds. This compounds oversupply. It could take decades for the market to rebalance.

The salvation many are hoping for is that higher cost Chinese producers will disappear from the market, relieving the pressure on price. Chart 2 shows the marginal cost of supply to China from both domestic supply and imports from Brazil and Australia (it excludes ‘sunk’ capital costs and makes no allowance for a return on investors’ capital). In other words, it’s an estimation of the additional cost to extract iron ore from the ground, ignoring the cost of infrastructure already in place. It’s clear that China does indeed have higher cost mines (mainly because of poorer quality deposits).

If China had demand of 1.1 billion tonnes next year, the cost curve suggests a marginal price of around US$76 would clear the market. That makes most of China’s domestic supply uneconomic. But, whilst a private company might respond to big losses by closing down, the Chinese government has different incentives. It is the major consumer of iron ore and can benefit from tipping the market into oversupply, at least in the short-to-medium term.

As an example, suppose China commits to continue producing 135 million tonnes, despite incurring costs of $110/t to extract it. If we move this supply to the front of the cost curve, you can see in Chart 3 that the new marginal price slips to US$65. The benefit to China through reduced prices is US$12bn (US$11 per tonne for the full 1.1 billion tonnes of demand), while the cost is just US$6bn on the loss making-supply (US$30 per tonne for 135 million tonnes of domestic production).

What would you do if you were China? Australian miners banking on the withdrawal of Chinese competitors might be clutching at straws.

This article is an extract from the Forager Funds September 2014 Quarterly Report. Download the full report to read more on China and the latest additions and movements in the Australian and International portfolios.