With some again calling for the
re-introduction of a mining tax, does this signal the top of the iron ore price
cycle? Three of the largest 20 companies on the ASX are iron ore miners, so
Australian investors need to be across the iron ore price.
For most of its traded life, iron ore was
sold on a contracted basis and sales were direct between two parties. This was
a stable period for prices where they averaged $US20 to $US30 a tonne until a
spot market with daily pricing was introduced in the early 2000s.
Producers in the Pilbara are trucking
iron ore hundreds of kilometres to port at a cost of $US100 a tonne and still
making a very high margin. Getty
Since then, the spot price has probably
averaged $US50 to $70 a tonne, according to Gaurav Sodhi, deputy head of
research at InvestSmart. Today it trades at more than $US200 a tonne, which Sodhi
says has never happened before.
The high price, says Atlas Funds
Management’s Hugh Dive, is a result of rising iron ore demand from China,
Australian miners operating at capacity, and supply constraints from Brazil,
the second-largest iron ore producer. Dam collapses in 2019 and COVID-19 in
2020 removed about 85 million metric tonnes (MT) from Brazil’s annual
production to about 300MT. For perspective, China imports about 1 billion MT a
year.
The similarities to 2011, the last time
the iron ore price was very high, are that demand is being driven by a $US506
billion stimulus plan announced by the Chinese government in May 2020. This is
slightly smaller than the $US586 billion package announced during the global
financial crisis, which saw the building of steel-intensive bridges, rail lines
and airports. The difference to 2011 so far is that the supply response this
time is slower.
During a boom, though, it is usually
difficult to forecast what will bring it to an end. Sodhi says producers in the
Pilbara are trucking iron ore hundreds of kilometres to port at a cost of
$US100 a tonne and still making a very high margin.
Dive believes there are five events that
could lead to lower iron ore prices. He says the period between 2012 and 2016
provides a good road map as to how the “air” could get taken out of the iron
ore price, though the situation is likely to unravel faster this time.
·
Brazil
moves back to full production of about 380MT a year with goals to increase to
400MT. Current annual production is forecast to be about 335MT this year, and
appears to be rising.
·
Chinese
consumption of iron ore slows as the impact of stimulus measures fade.
·
High
prices incentivise production. Mt Gibson Iron recently opened up mines that had
been closed after flooding.
·
New
entrants into the market such as Mineral Resources expand
from contract mining and mining services to producing their own iron ore.
·
In the
medium term, China naturally shifts to using electric arc furnaces (EAF). EAF
uses scrap steel and electricity rather than iron ore and coking coal to
produce steel. As an economy matures, it starts to generate scrap steel from
buildings that are torn down and cars that are recycled. In the US, 70 per cent
of steel is produced by EAF; in China, it is only 15 per cent.
Should the iron ore price fall, all iron ore miners’
profits would be affected. But the most exposed, says Sodhi, are high-cost
producers that have entered the market to exploit current conditions. Small
producers such as Fenix would not be able to sustain operations in a “normal”
environment.
Dive highlights that iron ore accounts for 100 per
cent of earnings for Fortescue and only 79 per cent for Rio and 69 per cent for
BHP. Mt Gibson Iron generates all of its earnings from iron ore.
Low-cost producers such as BHP are likely to be less
affected as they can still make healthy margins even when iron ore is $US50 to
$US70 a tonne. Even so, it’s worth looking at BHP’s share price chart during
the 2012-2016 iron ore collapse.
Iron ore investors who are enjoying high share prices
and dividends should ask themselves whether prices will hold forever and
whether “it’s different this time”.
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