Any Bargains in Iron Ore?

Iron ore prices dropped 45% this year to reach five year lows. From a high of US$135 per tonne in January, the spot price is now sitting at $75.50.

Australia is a major producer of iron ore. In fact, three of the world’s four largest producers are Aussie companies trading on the ASX. Along with the iron ore price, their share prices have also taken a beating.

As a contrarian investor, you might be thinking you can pick up a bargain and wait for the recovery. The commodity’s 45% fall might have you doubting it can fall any further. But don’t be too certain that a recovery is in store.

This is far from the bottom. And it’s not just me saying so.

Prices have further to fall

ANZ have cut their iron ore price forecasts by 23% for 2015. While the bank doesn’t expect prices to drop below US$70 per tonne, it doubts there will ever be a recovery back above $100 per tonne. BHP Billiton also expressed doubt that iron ore will reach that level again.

Citi Group is even more bearish. They say prices could fall into the $50s. Citi expects an average iron ore price of US$60 by the third quarter next year, and says it could go even lower.

To offset the price falls, the Australian dollar would also have to fall rapidly. Despite the Aussie’s weakness this year, it’s failed to keep pace with iron ore’s drop.

It all comes down to supply and demand

Iron ore producers have ramped up their production this year just as Chinese demand began slowing.

China is the world’s largest buyer of iron ore, the raw material used to produce steel and build its mega-cities. It consumes around 60% of global supply, and its residential property market alone makes up 24% of the world’s steel consumption.

Yet, this year, for the first time since 2000, Chinese steel consumption fell. In recent years, steel demand was driven by infrastructure projects and the country’s booming property market. Steel demand will keep falling into next year following a crackdown on lending in China, and the Chinese government prioritising sustainable economic growth.

China’s economy grew at 7.3% in the past year, and is set to slow further. A growth rate of closer to 4% is in sight. This is well down from the 10% annual growth over the past 20 years. The country is not interested in returning economic growth to previous levels. Chinese leaders insist that the economy must adjust to a sustainable, domestic consumer led economy.

Encouraging more domestic consumption will shift away from reliance on excessive real estate speculation and massive infrastructure building and their huge debts.

Property lending in China has been tightened to reduce mortgage defaults. Chinese steel mills are also struggling to secure funding as borrowing rates rise. So there’s no reason to believe that these mills will want to restock iron ore reserves.

This reduced demand, along with excess supply, has led to a surplus of iron ore reserves in China.

Stockpiles at China’s major ports have jumped 30% this year to record high levels. To make up for the lower iron ore price, iron ore producers have bumped up production.

The global surplus is set to double by next year thanks to new production capacity in Australia and Brazil. Rio Tinto and BHP Billiton have already ramped up production and next year, the world’s largest iron ore producer, Brazil’s Vale, is set to do the same.

The market needs to absorb a surplus of about 110 million tonnes next year, almost double the 60 million tonnes in 2014. In fact, in the coming three years, the world’s top producers will bring nearly 400 million tonnes of new supply to the market.

It appears that record high profits in iron ore are over. Chinese iron ore demand growth is not great in the short term and uncertain, at best, further out.

This doesn’t bode well for iron ore producers

The world’s three largest producers — BHP Billiton, Rio Tinto, and Brazil’s Vale — control two thirds of the market.

Despite the difficult environment, these big, low cost producers have ramped up production as they strive to gain market share and keep average production costs down.

Rio Tinto and BHP Billiton look the most resilient as they break even at iron ore prices of US$42 and $51 per tonne. Brazil’s Vale breaks even at the higher price of $60 per tonne. While Australia’s third largest player, Fortescue Metals, breaks even at an iron ore price of $71 per tonne.

These break even prices are calculated after the ramp up in production. When production returns to appropriate levels, average iron ore prices of US$90–100 a tonne are believed to be sustainable in the long term.
They aim to drive higher cost competitors out of the market and position themselves for when iron ore prices rebound. However, that rebound may very well not come.

BHP and RIO share prices have held up relatively well, each down by less than 10% in the past year.

Fortescue Metals shareholders haven’t fared nearly as well. Since the start of the year, FMG has fallen slightly more than the iron ore price — down 49% to date.

After such a fall, you might be tempted to buy FMG. It is trading on a trailing P/E ratio of just 3.2 and a trailing fully franked dividend yield of 7%. And it’s most recent earnings results showed a 56% rise in net income thanks to higher production.

Don’t get too excited. Its higher income was thanks to it heavily ramping up production, which reduced short term operating costs.

FMG has a huge debt bill that it will struggle to repay if conditions don’t improve, let alone worsen. This could threaten its ability to pay dividends.

Remember, not long ago the worst case scenario was seen to be prices dropping to US$100 per tonne by the end of 2014. That’s come and gone. With supply flooding the market and reduced Chinese demand, there’s no prospect of a major reversal in iron ore prices.

This is not the time or place to make a punt on a beaten down sector. Without a catastrophic fall in the Australian dollar, or an unintended surge in Chinese economic growth, iron doesn’t present a lot of upside.


Meagan Evans
For Markets and Money

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Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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