Iron Ore at US$40 — Why it Matters More than China’s Growth

Citigroup is predicting that iron ore prices could fall to US$40 a tonne by next year. This bleak forecast is said to hit that low point during the first quarter of 2016.

It’s a bearish outlook, but Citigroup’s viewpoint is by no means unique. Earlier this year Goldman forecast the exact same price floor for iron ore. But Citigroup’s timeframe brings the price decline forward.

Either way, there’s a pattern emerging. One that assumes iron ore prices are far from bottoming out just yet. This won’t come as a surprise to anyone following the industry’s prospects.

The iron ore market has a problem with oversupply, despite low prices. And it’s all down to the insatiable desire for market share. Larger, low-cost producers are betting this will end up driving out the competition.

But demand, or rather lack of it, remains the real barrier for the industry.

This morning China’s steel industry quashed suggestions that iron ore prices might rebound. Baosteel announced total steel production may fall by 20%. China’s industry lost $3.9 billion in the eight months to August. Which is troubling considering it reported a $3 billion surplus this time last year.

As you probably know, iron ore is a key component in steelmaking. That makes the well-being of China’s steel industry an important reference point for iron ore prices.

With steel making on the decline, it’s a real wakeup call for anyone believing China’s economy is on the up. We can stop pretending China’s 6.9% GDP figures in the year to September were ‘better than expected’. It may have boosted global confidence in China. But its benefits for Australia are less clear. Especially now that China’s steel industry is on the decline.

As long as Chinese iron ore demand declines, we’ll have to look elsewhere. Yet finding another buyer as reliable as China is not easy.

China is the largest steelmaker in the world. It accounts for half of all global output. And it’s by far the biggest buyer of seaborne iron ore. Aussie iron ore and coal shipments make up 65% of our export to China. You don’t replace that overnight. Outside India, there’s no market with China’s potential. And you can’t replicate the pace of China’s expansion either. Not to the degree where new cities arise from nothing in the space of a few years.

The iron ore rally peters out

A US$40 iron ore price is significantly low for the industry. It’s a stark contrast to days when it sold for US$160 a tonne. By next year, iron ore might sell for a quarter of what it did in 2013.

It puts the recent iron rally into perspective. Not only was it fleeting, but it raised unrealistic expectations.

For one, the rally relied on stable demand from Chinese steel mills. And it also depended on changes within China’s steel industry. Several high cost producers dropped out of the market, easing the pressure on the industry.

It was a short-lived coming together of favourable factors. But the rally didn’t last.

The price of iron ore slipped 0.3% overnight. It’s down US$0.14 to US$52.79 a tonne.

Any chance of prolonged price stability is done and dusted. Especially when the Chinese are in the middle of an economic transition.

The shift to a consumer driven economy is gathering pace. With it comes less need for rampant construction. That means housing construction, and large scale manufacturing, are both on the wane. Again, you only need look at falling steel production as evidence.

Consumerism is now less about rabid expansion. Which relegates steel, and iron ore, to a lower standing.

As this unfolds, we find ourselves with the worst variable of the supply and demand curve. Demand is heading south, even as supply picks up.

What’s more, oversupply will only worsen. As mentioned, Chinese steel making is declining. How bad it gets will depend on what Chinese producers do next.

The steel industry is pressured into doing things that don’t benefit it. Take production for instance.

Chinese producers must maintain high production rates for reasons that often have nothing to do with demand. They do this in order to keep credit lines open with banks. Why? Because lenders assess their ability to service debt through operating rates.

On top of which, market share matters. So much so that steel makers are hoping to outlast other producers by keeping supply high. All in the belief that someone will crack eventually.

When competitors engage in this type of behaviour, there’s usually only one outcome. The levee breaks and producers find themselves out of business. One way or another, balance sheets won’t survive negative profit margins forever. The industry will have to start pulling back on steel production. Even more so than it’s already doing.

That would be a positive development for iron ore prices. Right? Well, it would be anyway if steel makers alone could influence iron ore supply. But they can’t. So it won’t account for much in the end. Brazilian iron ore supply is heading up. And Aussie producers continue to maintain steady supply lines.

There’s no end in sight for the iron ore supply glut.

The positive outlook on iron ore

Not everyone however is bearish on iron ore prices. Financial consultancy Prestige Economics reckon China’s currency devaluation will benefit iron ore in the long run.

As the yuan loses value, it should lift steel exports. A weaker currency helps boost the attractiveness of Chinese exports. For this reason, Prestige believe iron ore will trend between US$58 and US$68 next year.

Meanwhile, HSBC sees a price band between US$50 and US$60 for iron in 2016.

Either scenario would be a positive development. It’s the best that the iron industry can hope for really.

Let China devalue its currency. Get around slowing domestic demand by shipping steel abroad. And hope that it lasts for a couple of years. Enough to restabilise the iron ore industry. It would however result in an industry shakeup. Which might suggest that more high-cost producers would head for the exit.

BHP [ASX:BHP] and Rio Tinto [ASX:RIO] would survive. As would Brazil’s Vale [NYSE:VALE]. As for the rest, there’s no point predicting their future. The likes of Fortescue [ASX:FMG] would probably need to sell assets to keep up. Otherwise it might find itself sidelined altogether.

Either way, the price of iron ore is a good prism to view China through. For Australia, China’s economic growth should be seen in the context of iron ore.

If consumerism sent China’s GDP to 7.2% next year, it’d boost global confidence, sure. But it wouldn’t make much difference to Australia. We’d still be looking at steep revenue shortfalls from weak iron ore prices.

Mat Spasic,
Contributor, Markets and Money

PS: Share prices across mining stocks are edging lower as a result of China’s slowdown. And they’ll play a big role in the future direction of the ASX.

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