Rudi's View | Aug 02 2007
This story was first published two days ago in the form of an email sent to registered FNArena readers.
By Rudi Filapek-Vandyck, editor FNArena
Allow me to take you on a short trip through recent history. Until early this year most securities analysts at major equity brokerages seemed convinced that after price increases of 71.5%, 19% and 9.5% contract prices for iron ore had peaked and the only logical trend to follow would be a gradual decline in price over the following years. In January market consensus was that prices for iron ore would fall by around 10% in the following year.
By the end of the first quarter, however, a change in overall market sentiment became apparent with most experts starting to pencil in another potential price increase of 5-10% for the Japanese fiscal year that starts in April 2008.
By June these estimates had already changed into projected price increases of up to 20%. Analysts at Credit Suisse stated the next price increase might well be as high as 25%.
In the light of these developments it can hardly be a surprise that upcoming developers of iron ore projects in Australia such as Murchison (MMX) and Fortescue Metals (FMG) have been amongst the best performers on the local stock market since March.
However, the trend hasn’t stopped in July with analysts at Morgan Stanley factoring in a 30% price increase from April 2008 onwards, to be followed by a further 5% increase in 2009 before prices are expected to flatten out in 2010.
And this week the Metals and Mining research team at Merrill Lynch said contract prices for iron ore could potentially increase by 30-40% as the global market for iron ore is moving through its tightest era ever in modern history. Merrill Lynch believes that, unless something fundamentally changes to the supply dynamics, prices are unlikely to go down until at least 2011. (The Merrill Lynch team claims that industry sources believe the availability of iron ore is currently tighter than in JFY05 when the price settlement was for an increase of 71.5%).
Underneath this trend of upward price forecasts is a surprisingly strong global economy with economists similarly lifting their GDP growth forecasts to 4.5% (and higher) for both this year and next. As a direct result of this steel prices have remained at higher than previously anticipated price levels, and more and more capacity increases are taken into consideration.
Underpinning the strong demand outlook for iron ore is a Chinese economy whose growth continues to defy expectations. Chinese steel manufacturers are expected to increase their share of the global iron ore consumption to more than 45% this year and the figure is forecast to rise further in the years ahead. (China represented only 5% of world seaborne iron ore demand in 1990 and only 20% as early as 2001). Equally important is that demand appears to be strong across all corners of the globe and some experts even argue global demand is becoming less US dependent as well.
As iron ore is a key ingredient for producing steel (it is the raw material used to make pig iron, which is one of the main raw ingredients in the process), there seems little at the horizon that could spoil this party for major producers Companhia Vale do Rio Doce (CVRD), Rio Tinto (RIO) and BHP Billiton (BHP).
One obvious question that comes to mind is: can this story develop into something better still?
The answer is: yes, it can.
Securities analysts have started to zoom in on the price differential between iron ore shipments by CVRD from Brazil and those from Rio Tinto and BHP Billiton. The difference in price is predominantly a result of the fact that customers do pay for freight costs between Brazil and Asia but mostly not for shipments from Australia. Estimates are that iron ore from Australia is currently US$20-30 per tonne cheaper than shipments from Brazil or even compared to spot sales from India.
BHP tried to convince its customers three years ago to share some of the freight costs but the attempt failed and nearly backfired.
It is a public secret that fellow producer Rio Tinto thus far has abstained from dragging the issue into the annual contract negotiations. However, if the market is truly as tight as analysts believe it is, it would seem but logical for both Australian producers to take the matter back to the negotiation table.
The team at Merrill Lynch couldn’t agree more. The broker issued two reports on the matter in the past two weeks highlighting the illogic of the current situation which not only allows for Brazilian ore to be sold at a large premium (or Australian ore at a large discount) but even Indian ore, often of lower quality than Australian ore, to be sold at a higher price.
Merrill Lynch believes there is a viable case for all Australian producers, including upcoming producers such as Fortescue, to combine forces and make this a national issue. After all, the broker argues, “the concept of “landed cost” sales is not new, and is completely logical. Japan sells steel landed cost to its customers; China sells coal landed cost to the Japanese; China sells washing machines/air conditioners landed cost to foreign markets; the Indians sell iron ore landed cost to the Chinese. Why should Australian iron ore be priced differently?”
Assuming Rio Tinto CEO Tom Albanese decides to join forces with BHP on this matter this year, sharing costs for the freight of iron ore to Asian customers could -on the broker’s calculations- generate some $3bn in additional revenues for Rio Tinto and BHP Billiton combined.
Or to put it differently: achieving a US$10/t freight share from steel manufacturers in Asia would automatically imply an 18% price rise on the current FOB price that is being charged for at least half of all shipments from Australia (Free-On-Board, meaning the supplier pays for the transport to the end destination).
Another positive surprise could well come from the Middle East where steel production is on a steep rise. Thus far, however, the region receives hardly a mentioning in the iron ore market reports written in Australia.
A recent report by Citi acknowledged the Middle East, and Saudi Arabia in particular, seems poised to become “one of the most important areas for steel consumption in the next two years”. Under a positive scenario this could tighten the supply/demand dynamics for iron ore even more in the years ahead. Under a more negative scenario Middle East demand could potentially compensate for any loss of demand from the US.
Which leaves us with another question: what could potentially spoil this iron ore party?
The most logical danger seems to be a scenario whereby the current problems in the US housing sector, including sub-prime mortgages and collaterised debt obligations (CDOs), would turn into something really nasty leading to a recession in the world’s largest economy which would have an undeniable impact on the rest of the world.
So far, however, almost nobody is taking such a scenario into serious consideration.
