Iron Ore - stronger for longer or is it a bubble?

With some again calling for the re-introduction of a mining tax, does this signal the top of the iron ore price cycle?

Three of the largest 20 companies on the ASX are iron ore miners, so Australian investors need to be across the iron ore price.

For most of its traded life, iron ore was sold on a contracted basis and sales were direct between two parties.  This was a stable period for prices where they averaged between US $20-30 per ton until a spot market with daily pricing was introduced in the mid 2000’s.

Since this period, the spot price has probably averaged US$50 – 70 per ton according to Gaurav Sodhi (Deputy Head of Research, InvestSmart).  Today it trades at over US$200 per ton.  Sodhi says that this is an extremely unusual event to see iron ore at over US$100 per ton and has only happened once before.

 

The current high price is a result of rising iron ore demand from China, Australian miners operating at capacity and supply constraints from Brazil who is the second largest iron ore producer according to Hugh Dive (Atlas Funds Management).  The dam collapses in 2019 and COVID in 2020 removed around 85 million metric tons (MT) from Brazil’s annual production to around 300MT.  For perspective, China currently imports around 1bn MT per year.

The similarities to 2011, the last time the iron ore was very high, are that demand is being driven by a US$506bn stimulus plan announced by the Chinese Government in May 2020.  This is slightly smaller than the US$586bn package announced during GFC which saw the building of steel intensive bridges, rail lines and airports.  The difference to 2011 so far is that the supply response this time is slower.

During a boom though it is usually difficult to see what will bring it to an end.  Sodhi highlights producers in the Pilbara are currently trucking iron ore hundreds of km’s to port at a cost of US$100 per tonne and still making a very high margin.  

Dive believes that there are 5 events that could lead to lower iron ore prices.  He says that the period between 2012 and 2016 provides a good road map as to how the ‘air’ gets taken out of the iron ore price, though the situation is likely to unravel faster in late 2021/22.  

  1. Brazil moves back to full production of around 380MT pa with goals to increase to 400MT.  Current annual production is forecast to be around 335MT this year, and appears to be rising
  2. Chinese consumption of iron ore slows as the impact of stimulus measures fade
  3. High prices incentivise production.  Mt Gibson Iron recently opened up closed mines that had been flooded.
  4. New entrants into the market such as Mineral Resources expand from contract mining and mining services to producing their own iron ore
  5. In the medium term, China naturally shift to using electric arc furnaces (EAF).  EAF utilises scrap steel and electricity rather than iron ore and coking coal to produce steel.  As an economy matures it starts to generate scrap steel from things including buildings that are torn down and cars that are recycled.  In the USA, 70% of steel is produced by EAF, whereas in China, it is only 15%.

Should the iron ore price fall, all iron ore miners profits would be impacted, however Sodhi says that the most exposed are high cost producers who have entered the market to exploit current conditions.  He says that small producers like Fenix won’t be able to sustain operations in a ‘normal’ environment.

Dive highlights that iron ore accounts for 100% of earnings for Fortescue while only 79% for Rio and 69% for BHP.  Mt Gibson Iron generate all of their earnings from iron ore.

Low cost producers such as BHP are likely to be less impacted as they can still make healthy margins even when iron ore is US$50 - $70 per ton, but investors should ‘google’ BHP’s price chart during the 2012 – 2016 iron ore collapse.

Iron ore investors who are enjoying high share prices and dividends, should ask themselves whether the current iron ore prices will hold forever and, (here are the 4 most dangerous words for investors), whether ‘it’s different this time’.

 

This article was written by Mark Draper (GEM Capital) and was featured in the Australian Financial Review on Wednesday 16th June 2021