The Beginning of the End for Iron Ore…

Is everyone starting to get it now?

In Tuesday’s Daily Reckoning, I quoted from an article written by Ross Garnaut. It suggested that Chinese steel production could decline by more than 25% over the next 15 years. The implications for Australia’s iron ore industry would be disastrous.

Now, more confirmation that Garnaut’s prediction isn’t all that crazy. From the Financial Review:

Li Xinchuang, President of the China Metallurgical Industry Planning Association, said he has just completed research on this very issue.

Li is forecasting Chinese steel consumption to fall by a little over 20 per cent to 560 million tonnes by 2030.

Add in a projected 50 million tonnes of exports, and you are very close to the 600 million tonnes Garnaut cited.

That is a truly horrendous figure for the iron ore industry and for Australia. Adding insult to a near fatal injury, the Chinese government just announced that it will subsidise its iron ore miners by giving them a tax break on production.

This just delays the supply response to falling prices. In the same way, the WA government’s decision to give royalty relief to junior miner BC Iron keeps it in production for longer than it should be.

The bigger issue here is how this will flow through to the broader economy. The iron ore boom drove a historic boom in Australia’s terms of trade, which is shorthand for saying it increased the purchasing power of our currency…which in turn helped to increase living standards.

Now the terms of trade are in free fall, and this fall will likely keep on going for years to come. That means our standard of living will fall as the value of our exports buy much less in terms of imports.

What can we do about it?

Well, successive governments have pretty much spent the windfall delivered by the terms of trade boom. That is, they have provided things like extensive superannuation concessions, middle class welfare and generous pension allowances to buy votes along the way.

Once benefits become entrenched, they are very difficult to take away. You’re seeing this now with debate about how to repair the budget deficit. No one wants to get off the gravy train.

Well, like it or not, the gravy train is slowing. It will take a while to become apparent to most but the good times are well and truly over. The question is how long this iron ore/terms of trade bust takes to flow through into the heart of the Aussie economy — and the religion of the Aussie population — property.

This is where the RBA comes into it. Their interest rates cuts have created a mini housing construction boom (and a massive house price boom in Sydney and Melbourne), which has had a flow on effect on consumption.

Consumption is actually pretty strong right now. It might not be showing up in the figures of traditional retailers like Myer [ASX:MYR], but the likes of Harvery Norman [ASX:HVN] and JB Hi Fi [ASX:JBH] are doing well out of this boom. After all, newly built houses and apartments need whitegoods and electronics.

Perhaps this is partly why the RBA held off cutting rates on Tuesday. They are clearly concerned about inciting more property speculation, but they also must realise that cutting rates isn’t going to increase the iron ore price or bring back falling capital expenditure.

That is, monetary policy only has so much of an effect on the economy. Consumption is healthy as is housing construction. But it just isn’t enough to offset the fall in mining investment, a trend that still has years to play out.

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Lowering interest rates to push the currency down is clearly one of the RBA’s aims. While a weaker currency does help exporters, let’s not forget years of a strong currency decimated the manufacturing sector in Australia and pushed most of it offshore.

So now, with the currency falling, it will push up the cost of the imported manufactured goods we used to produce ourselves.

What a mess we’ve gotten ourselves into.

As the saying goes, you reap what you sow…

It’s not all doom and gloom though. In slightly better news for Australia, oil company Royal Dutch Shell announced yesterday a takeover offer for BG Group, a British oil and gas company.

Shell offered a massive 50% premium to BG’s share price, indicating Shell believes the current oil price weakness will not persist. The market didn’t like the price Shell paid, and it’s share price fell about 8% yesterday. That’s standard though when the acquiring company offers such a large premium.

The acquisition gives Shell market leadership in liquefied natural gas, and it will become the owner of BG’s massive LNG project on Curtis Island in Queensland, which is why the deal is important for Australia.

Right now the economics of Australia’s large LNG projects are quite dubious. The multi-billion dollar investment decisions were all made years ago on the assumption that US$100-plus oil prices would be the norm.

Now, with prices 50% lower, the projected return on investment in some cases doesn’t even cover the cost of capital.

So it’s a bold move by Shell to pay a big premium to get these assets now while the oil price is so low. They will probably do it tough for a few years. But looked at from a 10 year plus time horizon, the deal is probably quite a shrewd one.

While it gives confidence that Australia hasn’t built a bunch of LNG white elephants, it really doesn’t make a huge amount of difference to the economy. In the next 12 months, the LNG construction phase will mostly be over, meaning a huge reduction in jobs as these projects transition to the production phase.

And with projects like BG/Shell’s Curtis Island being foreign owned, any profits will accrue to foreign shareholders. States will get production royalties, but apart from that, everything else leaves Australia.

As I said, you reap what you sow. When the nation collectively decides to own property at the expense of everything else, this is what happens. You sell off your productive assets to finance property speculation.

With the RBA lowering interest rates, state governments withholding land supply and a tax structure incentivising property speculation, building ‘wealth’ through property looks like a genius move for a lot longer than it really should.

But the madness will eventually end. Perhaps the realisation of what’s coming in the iron ore market is the beginning of the end for property.

Greg Canavan+,
for Markets and Money

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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