Iron ore supercycle over – implications for mining stocks
When the Financial Times of London gets its teeth into a subject, you can be sure the result will be of the highest quality. In this brilliant analysis, two of the newspaper’s mining writers take a close look at what they see as the ending of the iron ore supercycle. The implication for most diversified mining majors (BHP, Anglo American, Vale, Rio Tinto) is distressing. Their reliance on iron ore has grown to between 50% and 90% of profit. Only Glencore, which has no iron ore in its portfolio, is immune. Further down the pipe, Patrice Motsepe’s ARM, Des Sacco’s Assore and, obviously, Kumba Iron Ore are also significant. – AH
Iron is one of the most abundant elements on earth but pulling it out of the ground efficiently can be a daunting undertaking. Snaking through the low, green hills of southern Brazil is a 530km pipeline, the decisive link in Anglo American’s $8.2bn Minas-Rio project to extract iron ore in the Brazilian interior and ship it from a new Atlantic port. Way over its original $3.6bn budget and two years late, Minas-Rio is finally close to the point of “first ore on ship”.
For years, huge mining projects such as these have formed the backbone of global economic expansion. The world’s most important commodity after crude oil, iron ore has been devoured by Chinese steel mills, emerging as the raw material for an infrastructure-led growth spurt.
But Minas-Rio is about to deliver its first ore into a much less welcoming world. The price of iron ore has plunged more than 40 per cent this year, the worst performance across metals and bulk commodities in 2014. From an average price of $135 per tonne last year, the benchmark iron ore contract sank last week to less than $80 for the first time since the global financial crisis.
“The iron ore market is in the midst of a transition without precedent in recent commodity history,” says Macquarie, the Australian bank.
Behind the change is a big increase in iron ore exports – and not just the 26.5m tonnes that Minas-Rio will bring to market when fully operational in 2016. Vale, Rio Tinto and BHP Billiton, the world’s dominant three producers, have collectively raised output from below 700m tonnes three years ago to well over 800m tonnes and have plans to push supply past 1bn tonnes within a few years. Fortescue, the number four producer, has gone from 41m to 124m tonnes in the same period and expects to pump out 155m tonnes this year. Hancock Prospecting expects its new 55m tonne per annum Roy Hill mine in Australia to start loading ore next year.
Mark Cutifani, chief executive of Anglo American, says miners have “overbaked the supply pie” in the commodities boom – and iron ore is the most telling example.
The supply tsunami is not the only factor weighing on prices. Concerns about a slowdown in demand from China, the world’s biggest steelmaker and consumer of seaborne iron ore, have also taken hold. “Given that two-thirds of traded iron ore ends up in China, Chinese demand for ore and Chinese domestic production are important determinants of the global price,” says CRU, a consultancy in London.
A slowdown in China’s residential property sector, where the construction boom has saddled many areas with oversupply and falling prices, has led to weakening steel demand. Unlike the big iron ore sell-off in 2012, when government stimulus helped prices rebound, Beijing is unlikely to alter its policy dramatically this time.
“If supply was the driver of iron ore weakness in the first half of the year, demand is now the problem,” says Colin Hamilton, head of commodities research at Macquarie.
A recent Goldman Sachs report warned of the potential for a long trend of declining prices. It said 2014 was “an inflection point where new production capacity finally catches up with demand growth, and profit margins begin their reversion to the historical mean . . . the end of the Iron Age is here”.
Given that iron ore accounts for between 50 and 90 per cent of profits at the world’s three largest miners, a price collapse would be alarming for shareholders clamouring for better returns from the underperforming sector. BHP held off on an expected share buyback in August, citing the deteriorating outlook for commodity prices.
For smaller, emerging producers, the problems are existential and a shakeout, with ownership changes, is on the cards. In west Africa, some of the world’s poorest countries have pinned development hopes partly on iron ore. But in Sierra Leone and Liberia, smaller miners including African Minerals and London Mining are scrambling for cash to stave off collapse. Yesterday shares in UK-listed London Mining fell by more than 60 per cent after the miner said it needed more funds and was talking to an investor about a capital injection.
That miners have done so much to bring down prices by pushing supply is, for some, a perfect example of the industry’s cyclical ability to aim for the stars only to shoot itself in the foot. Ivan Glasenberg, chief executive of Glencore, the largest miner without iron ore mines, says: “Iron ore growth is good but you’ve got to look at supply. Iron ore is under pressure because everyone is adding growth.”
Evy Hambro, head of the natural resources equity team at BlackRock, says: “The majors have been showing greater capital discipline but they need to keep on this path. The iron ore market is already in surplus, so miners need to decide if it is wise to spend more money adding additional tonnes or not.”
Haul trucks are seen at Kumba Iron Ore, the world’s largest iron ore mines in Khathu, Northern Cape Province November 15, 2011. REUTERS/Siphiwe Sibeko Haul trucks are seen at Kumba Iron Ore, the world’s largest iron ore mines in Khathu, Northern Cape Province November 15, 2011. REUTERS/Siphiwe Sibeko
Bigger producers argue they are acting logically. As the lowest-cost producers running vast operations, they assume they can withstand lower prices while rivals fall out of the market.
Sam Walsh, chief executive of Rio, insists that this is working. Mr Walsh says 85m tonnes of iron ore has already been driven out of the market because it is no longer competitive and he expects 125m tonnes to be withdrawn by the end of the year. “An adjustment is obviously taking place . . . All of that is supply and demand at work,” he says. Mr Walsh believes the market presents miners with a prisoners’ dilemma. No one company can refrain from production: others will fill the gap and the price will still adjust. Rivals would get a “free kick”.
“People very simplistically say, ‘If you took off 100m tonnes wouldn’t we all be better off?’” he says. “The answer is no. Some of that capacity is going to come straight back on – from other people.”
Miners’ actions can also be viewed as an attempt to see off competitors. The trio of companies that dominated the market – Rio, BHP and Vale – have been joined by new producers: Fortescue will this year produce half as much as Vale, from a standing start in 2008.
Nev Power, Fortescue’s chief executive, says his company has helped bring “the iron ore price back from unsustainable peaks back to more long-term and sustainable competitive pricing”.
An executive at an African iron ore project says the largest miners “opened the door to Fortescue – the last thing they want to do is open the door to producers in west Africa. So they are ramping up the tonnage. They want to kill the other producers and give everyone the fright of their lives so no one builds another iron ore mine”.
But so far supply has not left the market as economic logic should dictate. Cuts have come from non-mainstream producers in countries such as Iran, Indonesia and Mexico, as well as high-cost privately owned mines in China itself. But other parts of the Chinese mining and steel industry are controlled by large, state-owned steel companies where jobs, not profits, are the priority.
“The response by high-cost producers . . . has been much slower than certainly what I thought and what most in the industry thought,” Mr Power says. “But inevitably that needs to happen . . . so the iron ore price will be low for long enough for that supply to exit the market. That’s an economic reality.”
Nor does it look as though demand will return to the buoyant levels of the past decade soon. The vice-chairman of the China Iron and Steel Association told a conference last week that China’s apparent crude steel consumption – that is excluding net exports – had fallen 1.9 per cent to 61.9m tonnes in August – the first decrease in 14 years.
Mr Hamilton says Chinese mills are cutting production heavily because demand is weak and they cannot sell more to a saturated export market. “In that environment they will want to hold less iron ore, particularly as steel prices are falling quicker than iron ore prices at the current time,” he says. The futures price of reinforcing bar, a steel product used in building, has hit a record low.
The low prices of iron ore were the “new status quo”, the president of Baoshan Iron & Steel, China’s second biggest steelmaker, told the conference.
Tim Murray of J Capital Research says a property market correction is under way in China, with new starts in construction negative for five consecutive months. “We will see a 20 per cent reduction in steel demand from construction over the next 12 months.”
Beyond shorter-term demand problems is a broader concern that China’s appetite for steel – and hence iron ore – will peak, although CRU, a consultancy, reckons that “peak steel” will not occur for at least another five years as the country continues to experience absolute growth in construction activity.
Miners identify longer-term growth prospects in other regions, such as India or Africa. But while they may eventually follow China’s trajectory, they may not do so with such concerted vigour.
Large iron ore miners are not consumed by panic yet. According to UBS analysts, Rio and BHP can break even by delivering ore from Australia to China at prices as low as $45 and $50 respectively. “Even at $80 iron ore is really good business,” says Chris LaFemina, an analyst at Jefferies.
But if the miners have misjudged, and iron ore prices are driven further down, the shakeout could hurt shareholders. Liberum, a UK broker, thinks that at current iron ore prices neither Rio nor BHP can deliver promised capital returns next year while holding to their targets for net debt, although other analysts are more confident miners can stick to their plans.
At Anglo American, there is no talk of Minas-Rio’s once-anticipated second phase – rather satisfaction that the miner’s other output, from diamonds to copper, offers some protection from the battle raging in iron ore. “I have nine other commodities that have a different prognosis,” says Mr Cutifani. “We will wait for the iron ore market to fall back into reasonable equilibrium.”
Market index: In search of a more realistic pricing system
What determines the iron ore price? As with most commodities the obvious answer is supply and demand but the market is not quite the clear arbiter that economic theory would suggest.
The mining and steelmaking industry used to set the price of iron ore through annual contracts. But as China overtook Japan as the biggest consumer of internationally traded “seaborne” iron ore, the system began to break down. Like oil, aluminium and coal before it, the iron ore industry ditched annual contacts in 2010 and moved to the new system, using a spot market index – usually the Platts Iron Ore Index – to set the price of quarterly contracts. The market has evolved further since then with a big move towards short-term contracts that are more reflective of market prices.
Critics of the index pricing system say it has increased volatility and reduced the visibility of earnings for big miners. Others say the spot market is not yet liquid enough to provide accurate price formation.
“Ten per cent or less of the world’s seaborne iron ore is traded on the spot market – and that sets the index price,” says one market participant. “We find a lot of the participants in the spot market are high-cost, low-grade suppliers or struggling steel mills, which may have difficulty obtaining letters of credit from Chinese banks to buy ore.”
He says the solution is for big producers to tip more ore into the spot market, which they are reluctant to do.
The benchmark price only partly reflects what a miner can expect to earn. Ore is sold in many forms and grades, with iron content of 62 per cent being the benchmark. Large miners and traders blend output. Some think China will increasingly want higher-grade ore to make steel, meaning this ore will attract a premium price.
As with many commodities, miners’ best protection against falling prices is to produce as cheaply as possible. They need precise knowledge of where they and rivals lie on the “cost curve”. If new competitive supply comes on line the price at which demand is met should fall. Mines further up the cost curve become uncompetitive and should cease output.