Following my iron ore tidal wave piece yesterday, I was prompted by several readers about why I’m bearish about the big miners. The Australian has story as well on the subject:
The iron ore story is now one of product displacement, as China will have to remove up to 100 million tonnes from its domestic market if the price continues to hover around $US90 a tonne.
While some of Australia’s junior iron ore miners and high-cost producers struggle with margins at $US90 a tonne, Australia’s big producers will be the winners.
The country’s main producers are expected to account for more than 60 per cent of the total tonnes imported into China by 2020, according to Wood Mackenzie’s key iron ore analyst.
…“It is a good news story for Australia, it will take a bigger share of that Chinese market,” Mr Gray said.
Yes, in the long term, the big miners, RIO and BHP, will be big structural winners in a consolidated iron ore market. But the cyclical outlook is terrible. To understand why consider the likely course of events from here.
The approaching iron ore surplus is vast. Prices will have to fall to below the cost of production for all of Australia’s emerging iron ore players to balance the market. The minnows, like AGO, aren’t deep-investment players. They mostly just scrape up red dirt where it’s most convenient and truck it out. By my calculations there is roughly 50 million tonnes of light-weight production that can disappear without fuss.
However, beyond that, we are into the much more serious business of rationalising huge infrastructure investments. In the case of FMG, the sunk costs and debt are huge. If forced to restructure it’s debt, it will dilute shareholders nastily but it will continue to pump out ore. If the price keeps falling, below its break even costs for an extended period, even if it is seized by creditors at some point, it will still keep pumping out ore. The price will have to virtually collapse before mines are actually closed. The same is the case for Vale and Ferrexpo.
As the case of coal shows, rationalising big investments isn’t a rational process. It’s a raging against the dying of the light. All producers and governments scratch, pinch, poke, punch and maul their costs to stay afloat. We have an example of just that today with FMG buying purpose-built ore bulkers. The fight for survival among ore producers will go on and on, including in China. One wonders why the process would be thought of in any other way.
That will not be good for big miners in the short to medium term. Their margins will be artificially squeezed by the cost-out shootout. Sentiment in the sector will be ground down to fines as prices march lower and lower and volumes can’t keep pace.
When I read the analysis of the brokers on this process they never factor in the final point. Discounted cash flow valuations, floods of free cash, price earnings and book valuations, none of these things matter if investors turn off the sector. And that is what is coming in my view. Even Wood Mackenzie sees five years of over-supply. Five years!
The big miners will play the long game. A few years of squashed margins is no big deal for management and they’ll happily quaff the champers as their competitors eat the dirt. And, at some point the truth will dawn on investors that the majors have restored pricing power, but the great risk is that it will first cause them pain.
