Iron Ore Prices Will Fall But How Far?

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

-Iron ore to hit a supply flood
-Prices will fall, but how far?
-Dependent on exit of Chinese supply
-Environment stable for big producers
 

By Eva Brocklehurst

Iron ore is one of the key export ingredients on which Australia's economy relies. Commonwealth Bank analysts have looked at the scenarios facing the market in the medium term. The worst case scenario is that expensive capacity remains in the market longer, necessitating a lower price for most of the rest of the decade. This is not the base case, the analysts hasten to add. They expect a steady retracement in prices towards long-run sustainable levels as the new, cheaper supply enters the seaborne market and displaces expensive capacity in a relatively orderly fashion.

Large increases in seaborne supply are expected over the rest of 2013 and into 2014. This will pressure the expensive Chinese capacity to exit the market. It's a question of how long this takes. Chinese iron ore is considered expensive because it is lower grade. China is expected to invest in cost-reducing technology but geology ultimately drives the high costs. With an average reserve grade of 33% iron, Chinese iron ore is some 20-30% below the grades of Australian and Brazilian ore. The analysts speculate on the extent to which China will tolerate loss-making iron ore mines. They believe the government is signalling an intention to promote self sustaining and competitive markets as the economy evolves, hence the belief that Chinese supply will gradually exit. As the Chinese financial markets become less government controlled, loss-making businesses are expected to close as banks allocate capital more efficiently. This should also prevent the opening up of  new iron ore mines.

So, Chinese supply should exit the market. If it does not do this, or is slow to exit, then this could result in substantially lower prices than the analysts foresee. Long term they are not changing price expectations. Medium term prices have been updated to reflect the impact of strong growth in cheap seaborne supply from Australia and Brazil and as almost all of China's expensive domestic supply exits by 2016-17. Of note, diminishing Chinese supply will not herald any shortage. Production ramp-up, brownfield expansion and a small number of new greenfield projects that make economic sense, are all sufficient to satisfy predicted demand to 2020.

The analysts note there are also projects for which returns fail the benchmark hurdles but for which capital has already been spent. The analysis assumes these projects will be completed and produce iron ore. Either way, there is the very real prospect of new supply that is not needed or fails to make attractive returns. There's no shortage in either view. One outlier is Indian production. Indian production is expected to rebound after mining bans affected output in 2012. Forecasting export supply is very uncertain, the analysts warn. Government export bans, corruption enquiries and environmental damage have made the export sector opaque. The chance of that country being a net importer is higher than many would have ascribed as recently as last year, in the analysts view.

Starting with the near term, strong steel output, driven by a seasonal recovery in construction, falling steel inventory and low iron ore stocks at ports and mills could drive a re-stocking of iron ore. Chinese domestic iron ore output should also accelerate seasonally as mines resume post-winter output. The spot price (62% iron, CFR China) is seen averaging US$135 per tonne for the June quarter. From there, the analysts are positive about medium-term global steel demand. There may not be the strongest growth in China but it will still grow. The analysts also envisage continued demand growth in a number of other developing economies and some developed economies, such as Japan. Nevertheless, the iron ore price is seen easing back to average around US$118/t in FY14.

The other factor is scrap. China's scrap market is expected, in some quarters, to grow to 200mtpa by 2020, from 100mtpa in 2012. The CBA analysts do not see it growing that much. Either way, it will result in a simple correlation to iron ore demand. More scrap growth, less iron ore demand. Ultimately, it will also be a matter of the relative price differential between scrap steel, new pig iron and steel, and relative energy costs. 

Despite this reasonably positive outlook, iron ore prices will continue to fall. The analysts have FY15 average forecasts at US$110/t, FY16 at US$102/t, and FY17 at US$100/t. Risks remain centred on China's domestic supply and the price outlook requires almost all of China's domestic iron ore capacity to ration out of the market from 2016-2017. Should this not happen and Chinese mines continue to produce while losing money, the market will be in even larger surplus and prices will need to be lowered further to send a stronger rationing signal to producers.

Iron ore demand is all about steel production and steel production is linked to GDP growth. The relatively strong correlation between growth in world GDP and steel production observed over the last decade is expected to stay intact, but the analysts do foresee a gradual weakening of the correlation. This would come as developing economies mature and the rate of growth in steel demand in these countries slows. China's steel intensity peaked in 2010-11, in the analysts' view, and should track steadily lower as a proportion of Chinese GDP through the rest of the decade. A lift in infrastructure construction is expected to be sustained over the rest of this year, based on the analysts' observation of the property market in a visit to China earlier this year. Subsequently, it has become clearer that the new government is not going to implement further stimulus, and in turn drive steel production rates, as long as the economy is on track to grow 7-8% this year.

Back to iron ore production and the outlook for the big players is considered solid. Brazil's Vale and Australia's Rio Tinto ((RIO)), BHP Billiton ((BHP)) and Fortescue Metals ((FMG)) are all expanding cheap seaborne capacity at the expense of high-cost marginal Chinese producers. In 2012 they accounted for 36% of global supply and this share is projected to rise to 44% by 2020. What about new iron ore deposits in Africa, as investment in projects is boosted by the high iron ore prices of the last five years? The analysts note Guinea, Liberia and Sierra Leone are likely to increase production but even by 2020 their share of global production will be relatively low.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms