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:

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:

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:

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: