Shipping Costs And Iron Ore

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By Greg Peel

Australia's August trade balance data showed that while the running surplus was extended, it was due to a 5% drop in imports, and exports actually fell 2%. Within that export figure, coal exports rose 10% but iron ore exports fell 10%.

One must therefore assume, at least in August, that demand for Australian iron ore from China was less than was implied by the heady export numbers in July. This further implies that the next round of quarterly iron ore contract pricing will see lower price settlements, one assumes, which is consistent with most analyst forecasting. Falling steel prices provide a barometer.

But steel prices in the fourth quarter have improved on the third quarter, if for no other reason that Beijing has been recently taking an aggressive stance on heavy polluting industry and forcing the shut-down of those mills and smelters which fail to comply with strict new environmental measures. In the eight months to August, China accounted for around 60% of global steel production. Reduce supply and you must push up price.

At the same time, iron ore prices are cheaper than they were. In April, the price of high-grade ore delivered to Tianjin port was US$186.50/t but along came the European crisis and prices took a dive. By July they had recovered to US$144/t which is still “cheap” compared to April. So with steel prices rising, and supposedly cheap iron ore on offer, it doesn't take much to assume orders for ore shipments might pick up.

Bloomberg reports that the cost of hiring a “capesize” dry bulk ship – the largest on the oceans and as long as three football fields – has jumped 20% this week. That's the biggest three-day jump since August. Analysts like to look at the cost of shipping as a forward indicator of iron ore pricing.

It must be appreciated that there are only so many ships available at any one time, that they cost a ridiculous amount of money and time to build, and that ships need to be booked well ahead of time to ensure deliveries reach steel mills before stockpiles run out. The cost of hiring a ship is a moving feast – a spot market – and hence if demand is strong shipping prices will begin to rise ahead of iron ore prices.

That is why the Baltic Exchange Dry Index (the Baltic Exchange is actually in London) is closely watched as an indicator of commodity prices. Dry bulk carriers carry not just iron ore but coal, base metals, grains – anything “dry”. Note the index chart below:

It shows clearly that shipping costs rose in April before peaking in May and collapsing to June. It was around this time analysts were suggesting lower iron ore contract prices ahead but we can also see that “cheap” prices spurred on demand in July before topping out again, but as we enter October the index has taken another turn – consistent with the evidence of this week's 20% increase in capesize hire rates.

So what does all this tell us about iron ore prices?

Well firstly that although the Chinese will try and drive a hard bargain on contract pricing, they invariably shoot themselves in the foot by buying too much iron ore when prices are cheaper. It is also important to note that high-grade ore (such as Pilbara ore) is cheaper to produce steel from so it attracts the greatest demand. While some analysts have been building in consecutively lower iron ore prices in successive quarters into 2011, this may not yet prove the case.

Analysts are not necessarily very good at forecasting iron ore prices, which is understandable because China always manages to surprise. One assumes the next round of quarterly prices will be set at something lower than April, but as to what that price will be is not abundantly clear.

Then there's the small matter of the rocketing Australian dollar, which will impact on local earnings. As to whether the likes of BHP Billiton ((BHP)) and Rtio Tinto ((RIO)) end up with net earnings forecast increases or decreases for the fourth quarter is pretty much up in the air. Shipping prices may nevertheless be offering a hint.

We do know that the BHP-Rio production joint venture is off, but the market had begun to factor that in a while back. The big clue came when BHP bid for Potash Corp given the bid is worth around US$14bn and BHP would have had to pay a US$5bn “equalisation fee” to Rio to enter the JV. It was unlikely, analysts assumed, that BHP would stump for both.

Clearly concern from regulators and steel makers regarding the pricing power of a combined entity rendered the JV ambitious, although in theory the two companies were always going to market their ore separately. There is not necessarily any reason to assume the collapse of the JV proposal would lead to lower iron ore contract price settlements.

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