The iron ore dominoes

By David Llewellyn-Smith

First up, yesterday’s iron ore price moves, which are not pretty:

So, a new low for spot, 12 month swaps rolling over and Chinese steel prices still weakening.

Complimenting the price action, the international interest in iron ore ramped up again last night with more bearish analyses.  The first story of interest is from FT Alphaville which references research from Nomura drawing on the steel PMI (provided exclusively here a few days ago):

The survey suggests steel has plunged in the past few months:

China PMI steel total August 2012 Nomura

The sub-sub-components that measure production and new orders for the steel sector show a similar path.

However component for steel inventories looks quite different:

China PMI steel inventories August 2012 Nomura

What does this mean? The consensus opinion, argue Cross and Lee, is still holding to the story of the $120/tonne ‘floor’ in iron ore prices, and explaining away the recent fall to about $90 asreflecting ‘destocking’. (We think the consensus might be getting a little sceptical about that $120 floor of late, but carry on.)

The reason Cross and Lee think it will get uglier for China’s steel production is that their preferred leading indicator — mapping inventories against new orders — is showing this:

China PMI steel leading indicator Nomura

The analysts on why they think there could be more to come:

We’ve breached the US$120/t ‘floor price’ for iron ore and reached below US$90/t before any major steel or domestic iron ore production cutbacks have begun; and

Steel mills are destocking from loss-making or breakeven positions, having never really recovered profitability wise from the October 2011 de-stock

As they write, this destock may be different: the marginal Chinese steel mill may not be able to afford the marginal Chinese iron ore producer’s break-even price.

That is, to clear the market, the iron ore price will need to fall further to knock out seaborne sources. Something we are already seeing in Fortescue but not enough of yet. Which brings us to the second piece from Macquarie Bank via Zero Hedge and Alphaville. What happens to the economy in that event?

Sharp falls in commodity prices undermine mining company cash flow, which could prompt firms to divest assets and cut capex budgets. With mining investment the mainstay of Australian growth in recent years, were mining investment to fall in 2013, the economy could shrink. This possibility would trigger further aggressive monetary policy easing from the Reserve Bank of Australia (RBA), while the combination of lower commodity prices, and a narrowing interest rate differential would remove support from the A$.

Furthermore, the combination of reduced mining company profits and weaker economic growth would place severe strains on government revenue and lead to a large budget deficit. That may also undermine foreign investor appetite for Australian government bonds which has also supported the A$.

…This note has presented a scenario taking as our starting point the potential impact on mining investment that would occur as mining companies cut spending in response to reduced cash flows.

In our view, three points quickly emerge.

First, that the impact of a rapid decline in mining investment would be severe on the economy.

Second, that one should not take too much consolation from the fact that there are still many investment plans on the books: if cash flows evaporate, investment will be cut back.

Third, that the current level of iron ore prices is not consistent with the current level of the A$. In the past we have argued that the A$ is not solely driven by commodity prices, but that interest-rate differentials and Australia’s AAA credit rating have become increasingly important factors. But as we have argued in this note, if iron ore prices were to remain at current levels, that would have a material impact on those other factors that are currently supporting the A$.

In our view, the relative resilience of the A$ suggests that most investors believe that iron ore prices will recover over the next few months. But if they don’t then this could be the “Wile E. Coyote moment” for the A$. What we are referring to here is the well-known cartoon character who, when he’s chasing the Road Runner, frequently runs off the edge of a cliff. But, initially at least, he doesn’t fall. His legs are still running as if he is on land and he remains suspended in mid air. But then he looks down, and realises that there is nothing supporting him, and it is only then that he succumbs to the forces of gravity and plunges towards the valley floor.

And the charts:

Of course, it’s the second round effects of this that are the biggest problem. As the media makes clear this morning, interest rates would fall – perhaps beginning in October – but if these levels of unemployment were to eventuate, what happens to house prices? A recent chart from Morgan Stanley may offer a clue:

This is all getting very bearish and my base case (which is feeling a bit shaky)  is still that we’ll see a bounce in iron ore before too long. Apparently Marius Kloppers agrees:

Mr Kloppers, speaking to analysts in Sydney, said iron ore prices should improve, but added that the rapid decline in commodity prices in general meant he would shut or sell any money-losing operations.

He said Chinese spending on fixed assets is expected to improve, which would prompt the country’s steel mills to bolster inventory and support iron ore prices.

The chief executive predicted the metal would not stay within the current $US80 a tonne range over the next six months.

That would slow the dominoes down. But if you feel in need of reassurance, it’s at times like these that I turn to Dr Andrew Wilson:

David Llewellyn-Smith
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Comments

  1. I reckon the future of China is bright in the long term, that its best days are ahead of it. That does not mean its future is bright in the short term, just like the US of A in 1929.

  2. The point is that Chinese steel mills may not have enough demand to sustain prices even in the absence of Chinese iron ore production. So even if Chinese mines close, there will need to be cuts to supply elsewhere for the price to stabilize.

  3. I am finding it harder and harder to ignore the idea that Australia
    s medium-term future is stagflationary – ie. high UE and relatively high (cost of living) inflation (not CPI, as this would likely be off-set by deflation in assets).

    ie. declining prospects for Aus, coupled with the resultant dropping AUD is not good for us.

    …and, yes, I know people say that a lower AUD isgood for exports, therefore it is good – and I largely agree – but that does assume that sluggish global activitywill still want the relatively expensive Aussie goods, compared to other Asian and African supplies that have started up since.

    My 2c

  4. “As they write, this destock may be different: the marginal Chinese steel mill may not be able to afford the marginal Chinese iron ore producer’s break-even price.”

    Does this mean that Chinese iron ore miners will be the first to shut down. Sounds like they should in theory, but whether that’s what happens is anyone’s guess. Market forces don’t necessarily operate in strategic Chinese industries.

    The next important question for Australia, if you believe in the idea that volumes will offset price declines, is what are the relative costs of our miners versus other non-Chinese miners?

    Could Australia be one of the last dominos? We know that established mines of the big boys have costs in the $30-40/tonne range.

    Are the recent expansions viable at an $80 price?

    • Cameron, are you able to show anything that clears that up definitavely?

      It sounds right to me but I keep hearing arguments from some in the industry that their costs are below $10/tonne.

      • The were back in the early noughties when iron ore was selling for $12-13 a tonne. No doubt it is still true for some mines.

      • I can’t recall whether that figure was one bandied about for costs of recent expansions, of for some miners in particular.

        My point is that we are probably still a low cost producer in global terms – particularly if you are right that costs are <$10/tonne. Australia should be one of the last dominos to fall in that case. But even so, it there are many other low cost producers, then the 'price floor' could be pretty low indeed.

  5. It’s entertaining to watch certain vested interests walk the double-think tight rope between economy is going gang-busters(buy houses now)and interest rates are going lower in response to worsening economic outlook(buy houses now).

  6. Has anyone done histoical studies like this that set out just how much of Australia’a GDP is atrributable to mining?

    For much of the 20th century, Texas’ economic performance was driven largely by changes in oil prices….

    To be sure, there have been ups and downs; but in general, data compiled by the Federal Reserve Bank of Dallas shows that the oil and gas industry has been a major driver of growth. In the 1970s and 1980s, when oil prices were rising rapidly, Texas’ economy boomed. In 1981, oil and gas production represented almost 20 percent of Texas’s total economic output. The oil price collapse of 1986 resulted in a statewide recession and significant job losses. Other sectors of the Texas economy took advantage of the oil bust and the economy diversified; by the late 1990s, oil and gas extraction was just 4 percent of economic output in Texas. The following decade brought higher oil prices and a resurgence of the industry. By 2008 oil and gas production had rebounded and oil and gas extraction alone accounted for 11 percent of Texas’ economy. [15]
    http://www.cbpp.org/cms/index.cfm?fa=view&id=3739

    I was living in Texas in 1986, and I can assure you that with the bust in oil prices, combined with the S&L crisis, it was like someone dropped an a-bomb on the place.

    Also, according to a recent CNN story, six of the world’s most expensive energy projects are located in Australia:

    http://money.cnn.com/gallery/news/economy/2012/08/27/expensive-energy-projects/index.html

    How much of Australia’s overall economy does natural gas represent? LNG prices are booming:

    http://www.ft.com/intl/cms/s/0/22943afa-a022-11e1-90f3-00144feabdc0.html#axzz25Vi9oBpV

    Is there any chance that, if other commodity prices crater, natural gas will pull Austalia’s arse out of the ringer?

    • In time gas will backstop us, yes. And the construction phase will certainly help. But the big pick up in exports is five years away and in the gap, if other mining investment falls heavily, there’ll be a big growth hole.

      • Hi H&H,

        Has anyone done a good piece on how gas will backstop us? I’ve only come across iron ore and coal commentary.

        I’ve noticed that you have mentioned gas a couple of times.

        -0

      • I have my doubts. But maybe that’s just wishful thinking – I’ve had a gutfull of the wrecking of my home town due to the construction of just one LNG plant, with rental and house prices that require a six-figure salary to service, upward pressure on living costs in general, hordes of drunks from out of town making the place less family-friendly etc.

        If it lasts as long as the projections, there’ll just be an empty shell of a town left by the end.

  7. The Macquaire report is an interesting read. It’s a shame that they have ignored the elephant in the room (I’m referring to that old English metaphorical idiom for an obvious truth that is either being ignored or going unaddressed. It is based on the idea that an elephant in a room would be impossible to overlook; thus, people in the room who pretend the elephant is not there have chosen to avoid dealing with the looming big issue). The elephant in this case being the weakness of our banks to overseas funding (40%) and our internationally expensive house prices. If they were to consider this I’m sure their numbers would look very different.

    Having said all of that I agree that a recovery in iron ore will eventuate. It will be interesting to see who blinks first though, BHP, Billion and Vale or the buyers who are currently on strike.

    -0

  8. H&H you guys do such a good job with these iron ore updates….my fav read every morning.

    Thanks and much appreciated.