Iron Ore Outlook

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– There seems almost universal agreement current iron ore prices aren't sustainable
– Q1 expected to generate relatively high prices
– Analysts have started to incorporate higher price estimates for this year and next
– JP Morgan argues the outlook is all about supply

By Andrew Nelson

From the last few months of 2012 through the first few weeks of 2013, the prospects for iron ore have been looking increasingly good. But as we know; all good things must come to an end. This being the case, one of the main questions in the minds of both Australian investors and economists alike is: what about the iron ore price for the rest of 2013 and beyond?

The run in prices over the past five months has been nothing short of staggering. Back at the beginning of September alarm bells were ringing, iron ore prices were at US$86.90/t and about the only thing anyone could talk about is when the likes of BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Fortescue ((FMG)) would start shutting down operations and would solid companies like BC Iron ((BCI)) and Atlas Iron ((AGO)) even survive?

The answers ended up being they won’t and yes, they will. And that leaves us at the doorstep of the New Year feeling pretty good about iron ore. That’s really important, as it can’t be understated how important this commodity is for Australia.

Economists from National Australia Bank ((NAB)) point out that were the current price of around US$155/t to prevail for the remainder of 2013, the entire nation’s terms of trade would end up around 8% higher, national export income would lift by around $24 billion in 2013 alone and last year’s trade deficit would be erased. Not to mention that a surplus budget would look a lot more realistic.

And we haven’t even mentioned the dramatically positive impact that would be seen on the bottom line of producers, which would be huge. All things being equal, that is.

However, the research team from NAB joins the ranks of analysts at stockbrokerages and investment banks in believing that prices really can’t remain at current levels for that much longer. This takes us to another economics team, this time from Commonwealth Bank ((CBA)), who suspect the recent firmness in prices will take a breather in the coming weeks.  One of the main reasons cited by CBA is that current prices would drive a 7.6% increase in iron ore supply in 2013, while only 5% iron ore supply growth will be needed in 2013.

Sticking with its 5% number, NAB estimates an average price of US$112-122/t for the year ahead. Supporting this view is a tidbit from CBA, who notes futures markets have been moving backwards quickly and have shifted lower over the past week. As such, 12 month prices have fallen back below the oft cited US$120/t level.

In the meantime, analysts at JP Morgan have turned more positive on the demand side of the iron ore pricing picture. The broker cites improved data coming out of China, although it does see declining prices into the second half of the year, once inevitable supply additions start to put downward pressure on iron ore prices. Ironically, much of the new supply will be coming from… you guessed it, Australia.

The good news from China is that economic data have been improving, especially in key indicators. Also positive, is that imports of iron ore from China were up 8.5% in 2012, with a continuing trend highly supportive of seaborne iron ore trade. This, plus general improvement in the US and signs of hope in Europe have the broker feeling completely relaxed about the demand side picture. This leads JP Morgan to believe that the supply side is likely to be the main driver of iron ore prices over the year ahead.

And right now, supply side numbers aren’t looking that bad, says the broker, who expects approximately 75Mtons to be added to Australian production in 2013, which should balance out given lower expected exports out of India. But with domestic production inarguably ramping up, JP Morgan does see a weaker second half of the year in terms of iron ore pricing.  The broker is now forecasting an increased US$130/t for 2013, up from US$110/t previously. 2014 is at US$115/t, up from US$105/t previously, but lower than the prior year given the increasing levels of output.

The only major concern noted by JP Morgan is for the mid-cap players, the broker instead preferring stocks in the sector with strong balance sheets, positive cash flow and low development risk. Atlas Iron is the broker’s top pick, given the majority of its upside comes from assets already in production, while the company otherwise enjoys strong production, a solid balance sheet, good long term development options, decent port allocations and plenty of M&A attraction.

BA-Merrill Lynch has likewise recently lifted its 2013 average iron ore price by 9% to US$120/t and sees a chance of US$140s for the rest of the quarter.

The broker’s top picks in the sector are Fortescue, Atlas Iron, BC Iron, Rio Tinto, with BA-ML citing decent funding, high operating leverage to the iron ore price, a solid operating track record and lower cost, higher margin growth profiles.

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