Iron Ore Prices And The RBA

By Jonathan Barratt

 

The iron ore price is currently trading sub US$90/t. It has fallen from March 12 highs of US144.66 and literally collapsed over the last month. Overall it has fallen in line with the lackluster global economy since reaching the record high of US187.18 traded in Mar 2011. It appears that the Australian authorities have just woken up as to the magnitude of the fall and are now questioning the extent the fall-out will impact on the local economy — even to the extent that the RBA has decided to put interest rate cuts back on the agenda. In this Bulletin Focus we look at the price fall for the commodity, and the downstream effects the collapse may have on the economy. A concern that has prompted the RBA's renewed dovish tone.

It goes to reason that as the global economy stalls the demand and price for primary inputs must also fall. We have argued in our Bulletins on numerous times that the prices paid for commodities must be justified by the demand. Prices cannot and should not be artificially kept high. Currently the only reason for some commodity prices remaining high is either a consequence of sector events or the possibility of more stimuli. The stimulus path has been well trodden with talk of stimulus continually being on the tip of most central bankers tongues but rarely these days is being delivered. Maybe ECB’s Draghi will put his money where his mouth is [he did last night, to some extent]. Needless to say that even in the absence of stimulus, prices paid for inputs such as oil, coal, copper and iron ore must also reflect the market demand for the commodity.  The current collapse in the iron ore price is of particular interest to us. Why? First of all it puts to rest any lingering hope that we can rely on the resources boom to carry us through these difficult economic times and secondly, it has prompted the RBA into some action. Our economy is as resilient as the country that can afford to buy our resources. In this case our economy is riding on the back of China. If her economy contracts then so will ours; if her economy has a hard landing so will ours.

So what has happened to China? China, along with the rest of the world, is finding it difficult to stimulate demand within her economy. Both the internal and external economies are suffering. As we are amidst the changing of the guard we feel that little will be done until the new power base has been firmly established. Also, we feel that this is one reason why the Central Government has made only token changes to monetary policy. The fact is that the GDP is contracting, and with the recent manufacturing PMI reiterating the story (coming in 49.2) it's no wonder that if China is having problems that we will inherit them. Remember a reading below the 50 intimates an economy contracting.  GDP growth under 7% we feel is an issue for the PBoC as it will not justify the years of leverage and investment that needs to be paid for. As such, the possibility for a harder landing has to be thought through. Although we feel that PBoC has the tools necessary to engineer the a soft landing we feel that they are holding out on the global call for governments to promote growth via fiscal or monetary needs.  We continue to hold that China will only act when she deems it necessary to do so and whilst we wait we need to prepare for the fall-out.

China is a country that like Australia has large deposits of minerals, however the problem is that for some reason it has missed out on quality and accessibility. When it comes to iron ore China is a high cost producer.  It costs Chinese miners about US90 to mine the ore, in Australia it costs about US40. The fall in the price of the commodity will harm their industry more that it will ours and this is one reason why we are getting closer to some form of action by the PBoC.  However, the underlying problem regardless of the price is that Chinese steel mills do not have the order flow whether internal or external and in an industry where the margins are so tight we suspect any hiccup in demand will have a rippling effect throughout the industry and the buck stops with the miners. The lack of demand for iron ore could do us more damage than first thought and this needs to be looked at. After all, why did the RBA decide to put interest rate cuts back on the agenda? Simply put, the mining boom has allowed our economy to stay afloat when other economies have sunk into recession. In fact for the last 21 years we have failed to register a recession. We have weathered the economic storm of the GFC riding high on the back of the demand from China for our resources. The price of the commodity has halved from its high, perhaps now is the time we should be knuckling down as the resilience of our economy to shocks is currently being tested?

Rio Tinto ((RIO)), BHP Billiton ((BHP)) and Fortescue Metals ((FMG)) have seen extraordinary profits over the last few years and as a result all had embarked on ambitious plans to provide more iron ore to China’s steel mills. Once the market has gone, so to must the expansion projects. As such we have over the last few months seen some dramatic changes in the attitudes of the miners. Projects have been put on hold, some cancelled and many workers have been laid off. It was often bandied around the market that if you need money, head off too the mines where you can easily get a six-figure salary. These days we feel are gone and we feel that profits will normalize and the industry will settle down. FMG's latest announcement concerning the expansion of Solomon and the lay-offs of 1000 employees provides testimony to the concerns that Twiggy [CEO Andrew Forrest] has over the state of demand from China, and as we look further into the what lies ahead we feel concerned that we are one economy that could have more to lose. After all we have the burden of new taxes and with demand waning, we expect the RBA will be justified in its action to lower rates and then lower rates more.