Boom and bust in iron ore

You know the ore market is in trouble when contracts start to disintegrate. There’s a raft of reports indicating just that this morning. The pick is from the AFR (and is free) but owing to its archaic attitude to the internet, copy and paste is disabled, so I can’t provide any of it. Here’s an except from BS:

The combination of Chinese steel makers insisting on lower iron ore prices and Brazil accepting discounted prices to gain market share is putting significant pressure on Australian’s largest iron ore suppliers, according to a report by the Australian Financial Review.

Chinese steel mills are reportedly attempting to renegotiate quarterly prices to more closely track the spot price, which has fallen 15 per cent in the past five weeks.

Meanwhile, Brazilian miner Vale is adjusting its pricing model to meet reduced price demands by Chinese steel producers, which observers say will pressure Australian miners Rio Tinto Ltd, BHP Billiton Ltd and Fortescue Metals Group Ltd to do the same.

Ore got smacked another 2% yesterday and is now at $150. Meanwhile, the bottom has literally fallen out of the swaps market, down $10 or over 7% yesterday to $118:

There’s clearly a sudden and a rather dramatic oversupply of iron ore in the market. Interestingly, although steel prices are also falling, it is happening more slowly. Here’s Shanghai rebar:

The set up on the chart is also pretty ugly and I expect significant further falls. And perhaps it’s just that traders have managed to get a handle on iron ore swaps and are using that market to correct the steel/ore complex. But, there’s another chart I’ve been pointing to for months that suggests it’s more than that:

That’s China port ore stocks, which have been climbing to record levels all year. Now, they’re falling as mills turn to local supplies.

The iron ore market looks like its showing all the classic signs of a boom and bust. A tight market and slow supply response leading to a price bubble, hoarding and then crash.

I’m not saying it’s the end of the ore boom. But massive volatility is what you get in the conditions described above. Suggestions that ore will stabilise in the $140-150 range may prove foolhardy.

Houses and Holes
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      • So who at FMG, RIO and/or BHP has the contact at the Oz to continue writing those bullish iron ore articles?

        And, more importantly, what poor sucker has believed them?

        • Nothing is definitive yet. The IO price has made fools of those predicting a crash in the past, it could do so again after a breather. I personally don’t trust the derivatives market atm, or any market in general. Everything is being priced/traded on very short term time horizons.

          • I’ve been one of those fools from time to time. My point today is that iron ore not does look any differnt to the boom and bust dynqamics that have seized so many other commodities in recent years.

  1. There’s clearly a sudden and a rather dramatic oversupply of iron ore in the market.

    I’m not sure that the swaps chart is saying that. These are 12 month contracts (according to the chart) so ideally they should be reflecting price expectations of iron ore 12 months from now (i.e. oversupply in 12 months relative to now). As the largest steel producer China is the ultimate insider trader w.r.t. knowing future steel demand and therefore future iron ore demand. So you could argue that steel makers are seeing a drop in demand a year from now (which doesn’t preclude them seeing a drop in demand now by the way) and therefore we see the price fall. It would be interesting to think about who the counter parties to these swaps would be. For their part the iron ore miners have been pretty consistent in the public comments about expectation of strong demand. Are banks taking positions?

    What I’d like to see is the swaps chart overlayed with steel output (offset one year) to see how much of these price fluctuations might be tied to industry hedging and how much to punting.

    Getting back to the oversupply question, we’d need data on volumes being shipped, in addition to your stockpile chart, to assess the oversupply situation — assuming there is one.

    None of this means that I don’t think there is a drop in demand at the moment, because there clearly is. I guess I have a natural suspicion of whether derivatives act in the way textbooks imagine, i.e. whether they are being used to hedge or whether they are being used to punt (reflecting current data rather than the market in 12 months time).

    • Good points and I agree. My comment on oversupply currently was the result of all the circumstantial evidence – Chinese and Brazilian behaviour, ore stocks and market pricing. On whether the swaps are in overshoot, no doubt.

      But, I will add, that the iron ore swaps market has tracked the price pretty well, with the occasionl overshoots…

      • After I posted that comment it occurred to me that by definition there is probably an oversupply right now, hence the fall from 180 to 150 … and probably further. But there are oversupplys and there are oversupplys.

        The iron ore swaps have tracked spot prices pretty well — no doubt about that. And that is what bothers me. It all looks coincident to me rather than forward looking.

        (the 12 month swap price in Sept 2010 was 120. spot price in Sept 2011 was 180. Who were the counter parties in Sept 2010 that didn’t see the demand for ore in Sept 2011? etc. You’d think the steel producers would have had a handle on it. It is a shame we can’t get data on who are taking out swaps. It just looks like the swaps are reflecting current market conditions rather than forward ones)

  2. Ideally resources are a long term play.

    and a reminder that there is room to move for the majors

    If declines continued it would be of greater concern to marginal producers. The majors are not marginal. In this current market uncertainties abound, buyers no doubt attempting to better position themselves when negotiating forward contracts (now that spot has declined). The following graph gives another clue to Vale’s offer to reduce:

    To my mind, far to early to call. September was a near record month for iron ore imports (only surpassed by Jan 11)
    Stock fell recently (imports from Oz increased but Brazil declined…)
    Steel production fell but still impressive volumes

    For those that are really interested there are a range of dedicated iron ore and steel production sites, generally requiring membership.

    If China were to combat decline in manufactures (if indeed that were to continue) with another boost to fixed asset investment should suffice to support the market.

    • You’re on the money imo. RIO and Vale seem to prefer forwards, wheras FMG and BHP take spot.

      The price is more likely to stabilise in the 120-140 range rather than crash imo. Chines imports for IO > in September than in August, and their economy isn’t slowing that much (we hope)

      FMG is ofcourse being punished disproportionally to price declines because it is a higher cost producer and is laden (or will be) with debt. At $100 and above it is still a company that will generate alot of free cash flow. Couple that with reducing costs (lower strip ratios etc) it’s not as bad as it seems…..unless ofcourse the price does crash, then it will be back at $1.50-2.50 in no time.

    • Slide 30 of the BHP presentation asserts a production strip ratio of 2:1 for > than 30 years. If that’s achievable/true they will have no problem making money on LT prices of far less than what it is now.

      For comparative purposes FMG has a current strip ratio of > than 5:1, though this is reducing.

    • China is trying to deflate its fixed-asset bubble without busting it.
      The only boost they can seek is in infrastructure, which could certainly be big, there’s no end to a bridege to nowhere, but by definition not as big as the 2008 if it’s to offset declining real estate construction.

      • Oops – I did mean to say infrastructure. I’m not sure real estate construction has declined significantly thus far…but may in the future.

    • If declines continued it would be of greater concern to marginal producers.

      Given that we’re talking 100-120 range there wouldn’t be any producers in Australia with these sort of cash costs would there? i.e. marginal producers that take a hit would be located elsewhere??

      On an a partially related matter: Rising iron ore prices hit marginal steel mills and in some respects it would be good for the long term rationalization of China’s steel production to have higher prices for a sufficient period to accomplish the sort of rationalization that dictatorial fiat seems unable to achieve.

      • I wasn’t specifying a range rather the comparative impact, but fortunately you are right. Estimated marginal cost of production for Chinese iron ore at around US$150 for 62% Fe equivalent.

      • MontagueCapulet

        From memory even the smaller producers like Atlas can make decent money when iron ore is at A$80 per tonne. So if prices fell to US$60 and the Aussie dollar fell back to 75 cents on the “end of the mining boom”, this would give you an A$80 price for iron ore and the miners would still be profitable.
        However the AMOUNT of profit is another matter entirely. When costs are fixed every drop dollar lost to lower prices comes straight off the bottom line.
        If iron prices drop to around US$100 per tonne over the next 3-4 years, we’ll ship just as much iron ore to China, but we’ll make a lot less money doing it. So potentially there is a significant hit to Australia’s export income, and flow on affects to the share price of BHP, a lower Aussie dollar, a hit to the Australian market psychology as people feel poorer, etc.
        The perceived end of the mining boom will impact our national confidence.