When I was writing at Business Spectator I spent a lot of time bewailing the incredible lack of iron ore expertise in Australian media and policy circles. I used to argue that given its importance to the nation, its every move should be front page news every day.
Be careful what you wish for. Now it is front page news every day but the outcome is less than useful to investors. From Gotti today:
This year China plans to phase about 28 million tonnes of polluting steel capacity and there is a lot more to come, including the closure of blast furnaces. On the other hand, China is looking to use more higher-quality ore and coal, which will help to its control pollution.
That means China will cut back its internal iron ore and coal production, and those cutbacks will be accelerated by the fact that Chinese ore is high-cost. This is good long-term news for BHP and Rio Tinto — and Australia — and underlines the longer-term outlook once the current glut is absorbed, including the extra 200m to 250m tonnes of iron ore production capacity coming on stream in 2015 or 2016. Meanwhile, Chinese banks have become more careful in issuing letters of credit to steelmakers for iron ore purchases.
And so we have a squeeze on buyers of steel and the makers of steel, which translates to tougher times for iron ore and coal producers. But there is light at the end of the tunnel, albeit that the tunnel is long.
This is the copy book explanation of a rational process of market rebalancing. It is fiction.
Chinese iron ore production is not slowing yet and I suspect it will be more sticky than most analysts think and much more so than Gotti declares. A strong domestic source of iron ore is a strategic imperative for China.
The light at the end of the tunnel is the oncoming freight train carrying an enormous iron ore glut – 150 million tonnes in 2015 or 12% of the seaborne market, 250 million tonnes in 2016 or 21% of the market. These levels of over supply are far too large to be “absorbed”. For comparison, the coking coal price has fallen 70% on an oversupply of about 7% of capacity. A similar fall in iron ore would be $55 though it has some offset in its greater ownership concentration.
The iron ore glut is going to rationalise through mine closures. Big ones. But that will take time. The lesson of coal is that sunk costs keep firms pumping well below break even for years. Unless burdened by leverage, mines can labour on below a recovery cost that includes the initial capital outlay but making a margin on current opex. That destroys returns on equity of course and eventually businesses fail but not before the price has fallen much further than anyone expected.
Commodity shakeouts are anything but rational. Keep your powder dry.
