Although this is not the consensus view, the best days for the iron ore industry, globally, are perhaps over, at least in the decade ahead. Global iron ore prices have fallen sharply from the height they reached in the middle of 2008 and despite their strong recovery in 2009 are still lying well below their peaks.
While short term fluctuations in the market will be driven by the dynamics of the market on a day to day basis and more particularly by the changes in inventories, the longer term trend will be shaped by the developments in the supply side of the market rather than by what is likely to happen to the industry consuming iron ore, that is iron and steel.
In simple words, what is going to happen in the iron and steel industry, have been reasonably well predicted so far by most analysts and one cannot expect to get surprises here. But, how the steel industry worldwide and more particularly in China will react to the emerging conditions, especially in terms of their inventory management, sourcing decisions, ocean freight changes are some of the matters where speculative forces will rule. All such speculations will provide for a strong ground for volatility but at the same time a direction too for the iron ore market in the medium term.
Both the Chinese steel industry and the iron ore majors have taken strategic positions in the battle for prices. Although with the Chinese resorting increasingly to the spot market and the iron ore behemoths also adopting such an approach for their immediate convenience in addition to using the time to consolidate their strength and reposition themselves in the global iron ore market, the importance of annual contracts has started wearing out. There will be routine talks this year too. The Japanese, the European and the Korean mills, say, will value such deals. They would look for stability and a safety net in these times of uncertainty and volatility. The strategy the Chinese mills will adopt is difficult to predict. The point of concern is that, today, this is the most critical element in the dynamics of the iron ore prices worldwide.
Today, there are not many who will believe that steel production in China is going to fall in the coming year. They have the capacity and intent to maintain their production levels for home consumption in the first place and then for the world. Whereas one can reasonably predict what is going to happen in the world of steel outside of China, the same is not true when it comes to this country itself. If China has stood out against the impact of the massive global economic meltdown with a phenomenally successful stimulus package, how far will they remain on this track to continuously taste success is difficult to say.
In other words, demand growth for steel in China will slow down in 2010, yet, their absolute volumes will be larger. In the worst case scenario, if steel production remains stagnant in China, the global iron ore industry will come under an oversupply stress.
The supply side of the iron ore market looks to be shaping up well and is in order. A lot of new iron ore mining capacities have been operationalize and infrastructure development whatever has taken place in various iron ore producing regions around the world brought down costs of delivery of iron ore. The new infrastructure has also helped increase supplies to the market as critical bottlenecks have been removed.
The Chinese steel makers have been able to strike critical deals with Australian iron ore companies where they have held some significant stakes. In the days ahead, more of such deals are likely to be put in place. The Chinese steel and mining companies have invested heavily in iron ore mining projects wherever there was an opportunity for them to do so.
The Chinese iron ore industry cannot be written off. The industry will come up strongly if the iron ore spot prices are set at levels above USD 80 per tonne on fob basis. At least another 20 million tonnes to 25 million tonnes of high cost iron ore concentrate capacity will be pushed to operation.
The other important factor in iron ore business is the ocean freight. The excess capacity in the industry kept the freight rate low much to the benefit of the buyers. With low freight differential, the iron ore buyers had the option to secure iron ore from anywhere. This could work to erode the pricing power of the iron ore miners. The shipping industry continues to be in trouble although is much better placed today. The ensuing competition triggered by excess capacity in shipping will mean the ocean freight rates will remain more or less at levels to cover marginal costs in average expectations.
Unfortunately for the iron ore miners, given the level of competition in the iron ore market, the benefits arising out of lower freight will be largely going to the steel industry if contract prices are maintained on fob basis. It is also to be noted that the freight rate is not autonomously determined. The volume in seaborne iron ore trading business makes a big impact on the freight rate. Therefore, if low freight rates encourage long distance haulage, the advantage will be there for the mining or the steel industry only up to a point.
These are the key elements to trigger a negative speculative drive in the first place to cause a fall in iron ore prices later in 2010.
With Australia emerging as a major source of iron ore for the Chinese steel makers, the price reference for spot transactions has changed. For example, in the past, an Indian iron ore miner would look at the cost of iron ore sourced from Brazil landing at a Chinese port to have the reference for the fob price it would seek to take for exports. The Chinese industry also used to take this reference to guide transactions in regards to Indian iron ore. In effect, when scarcity ruled, the highest alternative cost to import by China was the point of reference for Indians or even for Australian iron ore miners.
Will the lowest cost be the reference in the days ahead if scarcity falls?
Most of the factors outlined above have short to medium term implications. But, the ultimate direction of iron ore price in the longer run will also be driven by the continuous rise in demand for iron ore from the growing steel industry worldwide. On the demand side, pricing conditions will also be governed by how much of steel production rise is accounted for by the countries dependent on global sourcing of iron ore. It will also be influenced by the fact whether iron ore demand is rising faster for fines, lumps or pellets. Any structural change in the composition of iron ore demand will trigger corresponding changes in the pricing dynamics.
Whatever is the medium and the longer term outlook for the iron ore prices, which may not be looking miserable at this point, in the immediate, the pricing scenario looks significantly vulnerable, and to put it more positively, it is not as optimistic as most of the major research organizations have advocated recently.
In the recent days China accumulated significant stock of iron ore. While many would like to pass this off as bad planning on the part of the Chinese steel makers or the traders collectively speaking, we also see a design in the same. It looks the Chinese are trying to lower the average cost of iron ore they buy by timing their purchases in such a way that they are in a position to take advantage of lower prices whenever their requirement increases.
Irrespective of whatever has been observed till date, the mid term iron ore export prices from India are expected to drop to the range of USD 85 to USD 90 FOB, Indian ports, depending on the grade, by the turn of 2010. This also depends on the nature and strength of the collective resistance the Indian iron ore miners can put up.