Why Iron Ore’s Price Rally is Over

The recent iron ore price rally looks to be over before it ever really got going.

Last week’s US$65.61 a tonne high appears to have been the ceiling for spot prices. Now, after four consecutive days of falling prices, the commodity is trading at US$61.51 a tonne.

Source: Financial Review

To be fair, that price is still well above April’s US$47 floor, when prices bottomed out. But it will still dampen any optimism over an extended rally. As it is, market realities are catching up with the commodity.

But we didn’t need a crystal ball to predict which way this would go. With the pace of construction cooling in China, it was always going to remain a temporary rebound. There was very little in the actual strength of steel fundamentals which suggested a prolonged rally. And this was supported by rebar (reinforcement steel) prices.

The value of Chinese rebar fell by almost 1% in the past week. That came on the back of data showing that daily steel production has declined by 2.2%.

Equally disappointing were rebar futures contracts, where October deliveries fell by 1.6%. That only points to demand for steel remaining very flat in China for the rest of the year. Yet, according to NAB senior economist Gerard Burg, it will be tough to predict what China does to address weaker steel demand.

China’s steel industry is both big and highly controlled. The industry employs a large number of people, and any prolonged decline in steel demand could prompt them to take action. In order to prevent the industry from shedding too many jobs, China may very well take measures to prevent demand (and prices) from falling too steeply.

That would of course come as a slight respite to iron ore producers. But it’s not likely to affect long term prices from weakening further.

Iron ore price outlook for 2015 and beyond
Macquarie Capital Securities survey for June’s steel sector highlighted that orders are declining. On top of that, profitability is stagnating too. That’s a clear sign that market sentiment will continue to drag on prices over the course of this year.

But the longer term outlook is even gloomier.

Investment bank Goldman Sachs have been the most vocal, and pessimistic, on long term prices. They predict that the a tonne of iron ore will settle at US$50 by 2016, sliding down to $40 a tonne by the end of the decade.

The likes of BHP Billiton [ASX:BHP] and Rio Tinto [ASX:RIO] would survive in such an environment. They’re market leaders as far as the cost of production is concerned. But it will squeeze profit margins significantly.

That’s why they’ll need to be a bit more sensible about their expansion plans. Their high production outputs won’t help prices maintain their optimal level amid falling market demand.

They could do a lot more to scale back their production plans. But with market share at the forefront of their strategy, that’s not likely to happen. Even with the delayed Port Hedland project, BHP is still on course to ship 270 million tonnes this year.

All of this ensures that their aggressive market share strategy will work in tandem with sluggish demand to bring prices down quickly over the next few years.

Will investors stand by BHP and Rio amid low prices?

Considering prices (and profits) are only set to drop much further, it bears asking what it will mean for investors.

In the last month BHP shares have declined by just over AU$2. In the same period, Rio stocks have dropped by almost AU$4. And that’s while iron ore prices were still above US$65 a tonne…

But both Rio and BHP still maintain progressive dividend strategies, with yields of 4.57% and 5.22% respectively. BHP alone paid out AU$8.2 billion in dividends last year. Profitability, even with squeezing margins, remains healthy. On top of that, recent buy-back scheme have lifted investor confidence in the companies.

So investors won’t be in a rush to dump holdings, as the big two producers still present good value for most portfolios. But it’s worth repeating nonetheless: iron ore prices, and producer profit margins, are likely to worsen still in the future.

Mat Spasic,
Contributor, Markets and Money

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Major iron ore stocks still present value for investment in the market. And they’re certainly not alone in struggling with fluctuating share prices. The economy’s struggles are beginning to catch up with the share market as a whole.

The ASX200 has shed $29 billion of its market cap since the start of the year. Experts see falling stock valuations as a sign that a much larger collapse is imminent.

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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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