20 May 2014
“It’s tough making forecasts, especially about the future.”
That sage advice from New York baseball legend and famed tautologist Yogi Berra captures the mood on global capital markets as an army of analysts agonise about the repercussions of the overnight slip in the iron ore price below $US100 a tonne.
Is this a short-term aberration or the start of a long-term decline in the price of Australia’s major export?
While furious debate rages between and within the world’s leading investment banks and resource houses, the fundamentals suggest prices – at least over the medium term – are headed lower as the days of record $US190 a tonne fade from view.
That spells pain for Australia’s miners, particularly those with higher production costs or large debts.
It also does not augur well for a government facing a difficult budgetary environment as mining tax revenues look set to decline, although last week’s federal budget carried a bearish outlook for iron ore of $US80 a tonne.
The past two years have seen a massive lift in the global supply of iron ore, particularly from Australia. Alone, that would be enough to exert downward pressure on prices.
Combine that with a wobbly Chinese economy where a housing price bubble has begun to rapidly deflate causing a sharp drop in construction activity and there is a classic formula for serious price declines.
Within that general framework, however, are a range of complicating factors that could make prices swing either way in the short term.
A potential strike at Port Hedland – the main export facility for BHP and Fortescue’s ore – and uncertainty over Indian production and exports have thrown wildcards into the mix that make crystal ball gazing a dangerous game.
At the demand end, however, China’s economy is in a state of transformation – shifting away from reliance on investment and infrastructure and towards a more consumer focus – which ultimately will result in much slower growth in steel consumption.
Despite all the talk of rationalisation and pain within China’s steel sector, output has been increasing, leading many analysts to conclude that everything is hunky dory as far as demand goes for Australian ore.
But an ever larger proportion of that finished steel is being exported rather than being used domestically, which ultimately will cause a drop in global steel prices, putting further pressure on the market for raw materials.
Vast mountains of Australian dirt from the Pilbara have been piling up on the docks at Tianjin to the south-east of Beijing which for months have worried analysts and miners.
If, as expected, prices remain below $US100 a tonne over the medium term and possibly even sink as low as $US80, the global iron ore industry will be forced into a major readjustment – with business failures and mine closures.
Sustained falls in prices should force higher-cost producers out of the game. That’s the theory. But it is entirely possible high-cost Chinese producers will be protected by from official intervention which would only exacerbate the price falls.
Economics textbooks will tell you that businesses operate rationally, that output will always fall into equilibrium with demand at the point where marginal cost equals revenue. It is a great theory.
Fortescue most vulnerable to iron ore price slump
But it is not easy or cheap to shut down or restart a mine. Having sunk billions of dollars into new expansions, producers are likely to try to ride out a crisis to see who will fall first.
Rio Tinto, as the lowest-cost producer at just above $US40 a tonne, will continue to churn out as much as it feasibly can. Given almost 93 per cent of its revenue is now derived from iron ore, its share price could be expected to come under pressure as the iron ore price drops.
BHP’s cost profile is marginally above Rio. But it has the advantage of a far more diversified resources portfolio – half its earnings come from iron ore – that will help insulate its earnings from any price slump.
Fortescue Minerals suffered a near death experience when iron ore prices slumped to $US80 a tonne two years ago. Since then, however, it has more almost trebled production and used the proceeds of its revenue boost to pay down a substantial portion of its debt.
But it still is carrying $7.1 billion in net debt and at current prices is unlikely to be able to maintain its accelerated debt reduction program, making it the most vulnerable of the major producers.
Gina Rinehart’s Roy Hill Mine is now under construction, which will add further supply to an already oversupplied market, with higher grade ore than Fortescue which is likely to have a detrimental effect on Fortescue. Roy Hill’s projected costs are estimated at well below $US60 a tonne with Fortescue at above $US70.
According to investment bank UBS, Gindalbie Iron, Grange Resources and Atlas Iron all have production costs above $US80 a tonne, which would place them under enormous financial strain in the event of a long term slump in prices.
Mount Gibson is slightly below the $US80 production cost marker.
While a lower Australian dollar could help ease the pain, global interest rates at close to zero continue to push capital our way, elevating the domestic currency to levels far beyond its natural level.
If the currency does not give, the earnings from our major miners certainly will.
Courtesy of ABC News
20 May 2014