Iron Ore: Not What You Think

This story features FORTESCUE LIMITED, and other companies. For more info SHARE ANALYSIS: FMG

By Rudi Filapek-Vandyck, Editor FNArena

I'd like to, hereby, introduce you all to my personal approach to day-to-day happenings in global financial markets: the Incomplete Information Market Thesis. It doesn't make for a compelling acronym, such as BRICs or FOMO, but it does capture my personal analysis and observations about what goes on, and off, in financial markets daily.

The central premise behind my thesis is simple and straightforward: all market participants make decisions on what are, in various gradations, incomplete streams of data and information. Because we don't know what we don't know, while viewers, readers and newsletter subscribers require answers, we do a lot of "hineininterpretierung".

That's one of the more intriguing German expressions, untranslatable of course, and it means that we simply mould our explanations so that they fit with our previous view on the matter. Another translation could be: the making of a biased explanation. Or try this one: the formulation of an explanation for today's event so that it means what we want it to mean. There's generally a lot of hineininterpretierung going on. Take the stubbornly low unemployment rate as one example.

Anecdotal evidence suggests there have been a lot of jobs gone missing on Australia's Eastern seaboard in the past two years and the sectors that employ the most people -retail, construction, finance and manufacturers- have been doing it tough. One could say that while base materials have been enjoying an extended honeymoon, most other sectors in Australia have been forced to operate in recession-like circumstances. Yet the official unemployment rate doesn't seem to move too far away from the all-time low 4.9%.

How can we explain this? Well, if you're a glass half-full person, you simply see this as more evidence the Australian economy is strong and in much better health than Gerry Harvey and those other complainants want us all to believe. If, on the other hand, you're on the side of Gerry (and there's a lot of other data and anecdotal evidence to suggest Gerry's complaints have at least some merit) than you resort to the unofficial survey conducted by Roy Morgan which shows real unemployment in Australia might be up to twice the official data. Not that group one and the Australian government, plus about every economist in the country, necessarily care.

But what if there's more going on behind the data of Australia's active labour force? What if we are experiencing two major generational shifts that combined keep official unemployment lower than it otherwise would be?

In the US, where unemployment has remained stuck above 8% since 2009, and only fallen because of falling participation, a closer inspection of trends behind the labour market data teaches us that older people leave the market as their chances to find a job shrink considerably during tough times, while younger people opt for extra studies to increase their chances further down the track. Add a third phenomenon in that more people start their own business or turn to work as a contractor and one can see why the situation in the US is much more dire than the official unemployment rate suggests. Other data such as record numbers of families on food stamps confirm this.

This shows why the Federal Reserve does not feel comfortable with today's status quo in the US labour market, but it also points to one helluva task ahead to turn this situation around.

Turn to Australia, where the socio-economic situation is pretty much the opposite of what's going on in the US, but the same characteristics apply for the labour market here: older people participate less, while younger people opt for extra studies to become more attractive in a few years' time. As a result, the participation numbers in Australia have been in steadily decline since 2009. Amazing huh?

How about we simply accept that current dynamics in the Australian labour market mean the old data gathering is, for now at least, no longer generating a truly representative insight into what is really happening in the Australian market for labour? Just like the Chinese share market has long ago stopped leading the rest of the world in equities direction. Just like the Baltic Dry Index long ago stopped showing us what really goes on in global sea transport and trade.

All of the above is captured in the two charts below (thanks Macquarie Research). I have added our in-house view on Australia's commentariat in the third illustration – just for fun.

What has all of this to do with iron ore, I hear you ask? After all, the title above today's Weekly Insights comes with a direct reference to Australia's most important export product.

We have witnessed a lot of hineininterpretierung over the last few months. First we had hedge funds going short the likes of Fortescue ((FMG)) because demand for Chinese steel was weakening. But demand and the price for iron ore kept up because Chinese traders and producers simply stuck to their usual script in anticipation of stimulus from Beijing. Meanwhile, investors and analysts were confident the spot price would never, ever, fall much below US$120/t, or US$110/t at the lowest. That was until the spot price sank to US$86/t, of course. That's when the panic and the downgrades started kicking in.

At its peak, we saw Fortescue's CEO Neville Power stoically declare nothing would change at the world's number four producer, but within seven days EVERYTHING changed, including the delay of expansion plans, re-negotiations with lenders of the company's debt and a temporary halt in the share price. A more subtle change was that Fortescue management's confidence in August, as reflected in the "countdown to re-rating" moniker in investor presentations, has been quickly replaced with a more modest attitude. The new moniker is now a less aggressive "forging ahead".

I am not blaming or criticising anyone in this saga of sudden events that were supposed to never occur in this market, just adding up more evidence that we are all acting and responding on the basis of incomplete information and insights.

Once the unthinkable had happened, most market watchers and analysts pared back their price expectations. Many adopted the view that, given large inventories built-up among China's steel producers, it would take a while before spot iron ore would be back above US$100/t. Yet, within a matter of days the price in China surged back above US$100/t and it has remained there since. What to make of this?

Clearly, if you are a glass half-full expert, like the analysts at UBS, you simply issue a "told you so" response. You reiterate your view that the sudden fall below US$90/t had been nothing but a temporary aberration and you predict prices will be back at US$130/t in a few weeks' time. Many other analysts will probably have to use the "demand has returned sooner than anticipated" line, while awaiting further developments to find out whether price projections now have to readjust higher.

Clearly there's more going on in iron ore than the information we have at hand and it's not necessarily all related to the fact that China remains a largely opaque study object.

Imagine, for a second or two, things had unexpectedly worsened and Fortescue had to halt its operations indefinitely. Imagine how the sudden shock for founder "Twiggy" Forest and his shareholders would have been perceived as a free out of jail card for other producers including Rio Tinto ((RIO)), BHP Billiton ((BHP)), Atlas Iron ((AGO)) and Grange Resources ((GRR)).

Well, that's exactly what has happened to iron ore in the weeks past. Fortescue is still in business of course, and now without annoying debt covenants that make it vulnerable to sudden price weakness, but the equivalent of its total annual production in volumes has been taken off the market. Chances are these volumes won't be coming back anytime soon. Does anyone think this might explain the sudden and quick jump back in price?

On Friday, Analysts at Standard Chartered issued a report on iron ore and their conclusion is production troubles in India are far worse than anyone thought they are. The result is for an anticipated loss of 59m tonnes of ore this year compared with the country's production volumes in 2010 and next year, in 2013, total accumulated losses will rise to 78m tonnes on present calculations. Fortescue produced some 55m tonnes in FY12. Standard Chartered does not see a recovery in India's exports until at least 2015 and by then only from a largely decimated volume level.

Effectively, state the analysts, the loss of Indian production offsets nearly all expansions by the Top Five producers between 2010 and 2013. What's going on in India? It has emerged many mining operations were operating in breach of government rules, often in violation of environmental, wildlife and other laws, under a mutually beneficial "see no evil, hear no evil" policy from local governments and responsible authorities. Now the central government in Delhi has clamped down on the unwritten practices and blunt violations. Many mines had been operating under licenses that had expired up to twenty years ago but those licenses had simply been extended without further formalities.

As a result of the government's actions, many mines had to cease operations and Standard Chartered predicts it will be a long, hard slog for many to get back up and running. India is known for its red tape under the best of circumstances. Now imagine an irate and angry government in action. This sizable loss of supply, predict the analysts, will become a major factor when the Chinese restocking cycle starts. Free translation: the bias has again turned to the upside for prices of iron ore and their producers. Since 10th September, all mining operations in Goa have ceased operating, impacting on the region's coal and iron ore production volumes, in particular iron ore.

For more information: search for "Shah Commission recommendation" and "Goa mining ban", plus look at the details of the two tables below (thanks to Standard Chartered).

Analysts and investors in Australia have yet to catch up on the Indian losses. I have yet to spot the first research update on the sector that actually mentions "India" or "Goa". This just goes to show, even with more analysts concentrating on bulk commodities this year, in Australia they've still been blindsided by the seemingly all-important role that plays China, while potentially the most important development for years to come has now occurred in left-field India.

(This story was originally written on Monday, 24 September 2012. It was published in the form of an email to paying subscribers on that day).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)

P.S. Last week's Weekly Insights triggered questions about how the Australian share market has performed over the past ten years. Below is an updated price chart. It is easy to see how the pattern below fits in nicely with the chart I used last week and which showed US equities' price action from 1965 till 1981.

P.S. II – The sudden change in market dynamics for iron ore might provide investors with a valuable lesson in the commodities space for the years ahead in that more markets will be impacted by losses in production. It's not only onwards and upwards from here on. Not for prices, but certainly not in term of supply and additional supply

P.S. III – In line with my Incomplete Information Market Thesis, everything that's been said and predicted must be seen as "valid" only within the framework that all information available is incomplete by default and we will only know what we don't know today when someone does the extra research or the news announces itself from tomorrow onwards.

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