Iron Ore: The Price of Red Dirt…

An Australian icon is under the pump: ‘red dirt’, aka iron ore. The price continues to fall…yesterday the spot price fell to US$87/t. The 2012 low around US$86 is a matter of days away.

The very weak bounce from June should be a big concern for the iron ore bulls. At the time, China announced a range of mini stimulus programs, and the consensus opinion was that iron ore was going back to $100/t or more.

Instead, the bounce lasted a few weeks…then it resumed its slide.

The chart below shows Australia’s three iron ore majors, Fortescue (FMG), Rio and BHP. FMG is the most sensitive to the iron ore price, and as you can see, its shares bottomed along with iron ore in mid-June.

It then rallied nearly 20%, but has since turned back down. But it’s still higher than it was in June, even though the iron ore price is lower. Given my bearish views on iron ore, FMG still has a long way to fall.

As for BHP and RIO, well, they’ve defied the recent price falls because they are ramping up production. But just because you’re increasing production doesn’t mean profit will increase, especially if the price is falling at a faster rate.

And don’t forget, lower prices hits total production, not just the increased amount, so overall profitability of the operations will decline. That’s not a grave threat to these two companies; they will continue to make decent money from iron ore. Just not as much as the market currently thinks!

FMG on the other hand will really struggle in a sub-US$90/t price environment. It has an inferior quality product, which it sells at a discount to the iron ore price. If the recent price action persists, FMG won’t earn anywhere near as much as what the market currently expects. The result: more share price falls.

All this prompted me the write the following to Sound Money. Sound Investment. subscribers a few weeks ago:

…keep this China ‘rebound’ in perspective. History says a crisis lies ahead. At the very least, China will experience a number of years of much lower than expected growth. If it keeps going at the present rate of 7.5% for too much longer…it will eventually blow up. So hope for lower growth…it’s the best outcome for China, and Australia.

By the way, keep in mind that this ‘rebound’ has generated a lacklustre response in the iron ore price. Spot prices bounced from around US$90/tonne to US$97. But they’re weakening again. With more and more supply on its way, and the prospect of weaker demand, I continue to see iron ore prices heading towards US$80/tonne by late in the year/early 2015.

So stay short FMG, and take profits on BHP and Rio if you’ve enjoyed the recent run up in prices…there’s more bad news for iron ore on the way.’

The bad news doesn’t just extend to the headline price. The strength of the Aussie dollar makes things that much worse. A falling US dollar commodity price usually corresponds with a weakening Aussie dollar, which mitigates some of the pain. But total manipulation of the price of everything by central bankers means the Aussie dollar remains strong…purely because our central bank hasn’t completely lost it.

Better than expected capital expenditure data gave the Aussie a boost yesterday too. It increased 1.1% for the June quarter, but was still down 4% year-on-year.

Based on capital expenditure expectations for this financial year, investment will decline a rather hefty 10.2% in 2014/15 as big mining projects (like LNG) finish up.

Will the Aussie continue to defy gravity? Maybe in the short term as FX traders continue to ignore fundamentals and focus blindly on yield…hang on…that’s been going on everywhere. Everything’s defying gravity!

Ahhh yes. Everyone loves the effortless nature of floating about in a bubble of bliss and ignorance.

But isn’t the higher rate of interest here in Australia a positive fundamental and reason for foreigners to buy our currency?

Well, yes, but only to a degree. Interest rates supposedly represent risk. Relatively high rates reflect relatively high risk. No one sees much risk in Australia right now, but that will change in the future.

As China continues to slow (and possibly slow sharply), the iron ore price and broader terms of trade will continue to decline. That means lower national income, which translates into lower wages and profits across the economy as a whole.

If that happens, there will be less inclination to leverage up and punt on property. Lower debt growth and a lower terms of trade will make it harder for Australia to pay its bills. There will be less surplus cash left over as economic growth slows. When this realisation hits, gravity will once again exert its force on the Aussie dollar. It’s just a matter of time.

Regards,

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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