The Outlook For Iron Ore

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By Greg Peel

It's been a good year for iron ore, thanks to China, and a good year for investing in iron ore producers. The were some hefty gains to be made.

Had you held BHP Billiton ((BHP)) shares for the year to date you'd be up 5.4%, but if you held the more volatile Rio Tinto ((RIO)) you'd be up 15.8%. While they are Australia's biggest iron ore producers (and part of the world's leading trio including Brazil's Vale), BHP and Rio are also heavily diversified into the likes of uranium, coal, and copper, and in Rio's case aluminium and in BHP's case oil and gas.

Moving away from the big diversifieds and into the pure iron ore space, we find leading pure-play Fortescue Metals ((FMG)) would have returned you 52%. There were also spoils to be had among the juniors, with Mt Gibson Iron ((MGX)) rising 26% and Atlas Iron ((AGO)) 55% to name but two.

Resource Capital Research notes that a basket of Australia's 58 listed junior iron ore pure-plays, which includes Fortescue, has gained 38% year to date compared to the flat result from the ASX 200. In the past three months alone, the basket has returned 25%.

The reason the last three months have been particularly spectacular is because by mid-2010 the market was assuming the extraordinary gains achieved in 2009 and into 2010, and the iron ore contract price increases behind those gains, were all over. Or at least, things would now pull back somewhat. China had entered 2009 with a sole determination to restart the global economy which it did by buying everything in sight, including record amounts of iron ore. By early 2010 however, Beijing was concerned the Chinese economy was overheating and thus began forcing a slowdown. There was a particular impact noted in steel production.

And of course there was Europe. With Europe being China's biggest customer for manufactured exports, it stood to reason that European austerity would translate into less Chinese demand for iron ore. China's domestic economy was (and still is) the big growth story, but Beijing was trying to slow that down, and in particular stymie the property bubble.

After years of trying, BHP scored a coup earlier in the year by finally steering the Chinese, and by default all the rest of Asia, into quarterly contract pricing rather than annual contract pricing. It is assumed this is a first step towards ultimate spot pricing. Initially this had analysts all excited, given their forecasts were for greater and greater demand. This would mean rather than being stuck with a price fixed early in the year, the producers could raise their prices each quarter.

But the system works both ways, of course. As soon as there was a fear iron ore demand would actually reduce in the latter half of 2010, expectations switched to being for price reductions in the latter quarters. So that's where we found ourselves mid-year and through to September – iron ore producer share prices pulled back as a result.

It wasn't to be. China continued to surprise with its largely relentless iron ore demand and the September price fix resulted in an increase rather than a decrease. But it's not all just about the demand side of the equation, as RCR notes.

The iron ore spot price has continued to rise recently. One influential factor underlying the rise, says RCR, is increasing US dollar operating costs for Australian and Brazilian producers. India, which is a major supplier into the spot market, has suffered from production disruptions. The market in general is now suffering from supply tightness, and this is likely to continue until mine capacity expansions have an impact after 2012. And there is also a small matter of Chinese steel restocking.

When Beijing began to rein in the Chinese economy, and Europe started to teeter, Chinese steel production dropped sharply. The knee-jerk conclusion was that the reduction was a direct result of economic forces translating into a collapse in steel demand. But analysts now realise that while there clearly was some reduction in demand, China had also entered a destocking phase after having produced so much steel as part of Beijing's late 2008 stimulus plan, all the way through 2009. China was still consuming plenty of steel in construction but it was drawing on inventories.

That destocking phase is now over and a restocking phase has begun. On that basis, analysts have returned to being bullish on the iron ore price.

RCR suggests the global iron ore market is now relatively stable after the volatile period from the GFC to the introduction of quarterly pricing. This implies we won't be seeing the same sort of spectacular price hikes we saw in 2009, but by the same token we won't be seeing any alarming price cuts either. The increase in spot prices in the third and fourth quarters of 2010 suggests price rises will be achieved at the first quarter 2011 contract settlement, RCR offers. Having seen a good hike in September, rises will be in the order of about 10%.

Weighing on future price hikes is China's determination to increase its own internal production rather than have to pay up for imports. China produces only low-grade iron ore, so high-grade material from Australia and Brazil will still be coveted. Yet those grades have been quietly slipping over the years as reserves of prized haematite ore decline. This has swung focus onto lower grade magnetite which is more abundant but more costly to refine.

Most of China's ore is magnetite, so the Chinese are very experienced in its refinement. It's of little surprise therefore that China has been making inroads into Australian magnetite with direct investments – another way to avoid paying too much for imports.

Yet on a longer term time frame it's still all about industrialisation and urbanisation in China, and in India, and elsewhere, which few disagree will go on for some time yet. Steel demand, and thus iron ore pricing, will be tied to this post-GFC trend for “the foreseeable future”, RCR suggests.

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