Is the spike closer than we thought?

iron

Typically during a period of sustained commodity price falls, miners typically implement production cuts in order to reduce supply overhang and to try and bring demand and supply back into balance over time, inevitably leading to stabilisation and eventual recovery in commodity prices.

A good example at present is thermal coal, where a massive ramp-up in production since 2000 led to an oversupply situation, exacerbated by prices falls and lower demand in the post-GFC period. While price and demand recovery is still a couple of years away, the world’s major thermal coal producers have implemented production cuts over the past three years that have led to a stabilisation in prices and ultimately will lead to modest price recovery.

The situation in the iron ore industry is vastly different. Rather than reacting to plummeting prices with significant supply cuts, Rio Tinto and BHP Billiton have continued with their implementation of new mine expansions, further dampening prices.

The rationale for this is threefold: firstly, they can weather the iron ore price downturn because they’re used to operating at even lower price levels (as evidenced by the price chart below); secondly, it’s a great opportunity to drive competitors to the wall; and thirdly there’d be a huge loss of face in reducing output after hundreds of millions of dollars have been spent on expanding infrastructure over recent years.

iron_ore_prices

The lower prices of iron ore have appeared to be inevitable for much of 2014. Supply side growth has looked likely to outpace demand growth in China, and steel production has been slowed as the government looked to tackle over capacity in the industry.

So the medium-term outlook for iron ore producers isn’t hugely appealing. Chinese steel production is expected to moderate due to a combination of slower macroeconomic growth rates and transitioning away from investment-led growth to consumption-led growth. All of this will coincide with a sizeable growth in world iron ore supply between 2014 and 2018.

Global iron ore exports are expected to increase by 10% (or 144 Mt) during 2014, whilst the period from 2015 – 2018 is also expected to generate continued strong growth, with annual supply increasing by 5.7% (or 88 Mt). This growth will essentially be led by the Big Four miners, which are expected to average 85 Mt of annual production increases for 2013 – 2015, compared to 45 Mt average annual growth during the course of the previous decade. The chart below highlights the location of new sources of iron ore supply:

Wendt2

In terms of the pricing outlook, iron ore prices are likely to trade between $140 on the upside and $110 on the downside, but with an overall weakening of prices. The reason is that supply is growing to meet demand, meaning the iron ore market surplus will most likely expand. This surplus is forecast to persist during 2015 and 2016, driven by continued large supply increases out of Australia and Brazil combined with slower steel production growth in China.

wendt3

The iron ore business has for decades been dominated by three major players – Rio, BHP and Vale – which together have accounted for as much as 80% of the world’s seaborne iron ore trade. There’s a simple reason for this – iron ore is a bulk commodity, which means it’s typically a low-margin business, requiring mining and movement in enormous volumes to generate a reasonable profit. Being a bulk commodity, infrastructure costs are huge, with returns typically generated over a significant period of time.

The fundamental characteristics of the iron ore business – high capex/ low-margins/large volumes/massive funding requirements/medium to long-term pay-back – are not features that typically attract smaller players into the industry. The ultra-high pricing environment of the past decade or so that encouraged smaller hopefuls into the sector is in no way typical. Prices leveled off and have since receded sharply as supply catches up with demand.

As a result, iron ore is predominantly the domain of mining heavyweights that can utilise their sizeable balance sheets to minimize exposure to potentially crippling debt levels and periods of price volatility.

The big miners however appear to have badly miscalculated in terms of future iron ore demand. As Richard Knights, a mining analyst at Liberum Capital Ltd told Bloomberg this week: “I’ve always taken the view that the miners had the best intelligence on this as large investment decisions are based on it. But if they get it wrong by a just a small margin, that has major implications for profitability and the share price for years to come.”

What he’s referring to are predictions by the Big Three that China’s demand for iron ore wouldn’t peak until around 2025 – 2030. However, Wolfgang Eder (Chairman of the World Steel Association and chief executive officer of Voestalpine AG, Austria’s biggest steelmaker) this week commented that China’s steel output would peak in as little as three years, prompting plant closures rather than expansions.

“There has to be a restructuring of the Chinese steel industry,” Eder said. “The iron-ore producers are getting more and more aware that their growth expectations have to be redefined. There are enormous over-capacities and more is coming on stream. This will increase the pressure,” he said.

To put things into perspective, every year for the past decade, China has added new mills with the capacity to exceed the annual production of Germany, the largest steelmaker in Europe.

But iron ore production has risen at an even faster rate, to the point where the market shifted to a point of structural surplus during the middle of this year. Citigroup forecasts that this surplus will widen to almost 300 million tons by 2017. Against such a background of excess supply, it is difficult to see a significant and sustained recovery in iron ore prices, particularly if Chinese demand is set to peak and residential construction growth continues to cool.

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