Commodities | Mar 12 2014
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-Fear of steel mill bankruptcy
-Falling price a chance to buy
-Chinese fundamentals maintained
-Case for a bounce in Fortescue
By Eva Brocklehurst
An orderly de-stocking of iron ore in China has turned into a buyers' strike, according to Macquarie, setting the iron ore price on a sharp downward spiral. The spark came from news a steel mill in Shanxi entered bankruptcy proceedings and, in response, banks were believed to have restricted credit to some mills, raising fears of more bankruptcies. Macquarie's contacts in iron ore in China have indicated environmental restrictions in Hebei have forced some capacity off line but demand is also soft in some areas. Mills are not willing to hold as much inventory.
Macquarie's contacts believe this year may be a little different in that, even when purchasing activity returns to normal, an oversupply could still be evident. Prices are expected to become more positive in the second half. Macquarie suggests that if lower iron ore prices in coming months bring about supply cuts, and pressure on steel capacity means profitability can improve, then prices for iron ore could move back up.
UBS observes the iron ore price has fallen 20% since early December and with this fall comes the usual question of the price at which iron ore producers break even. The broker reminds investors that the publicised iron ore price is not what producers actually receive. When determining the realised price, adjustments must be made for freight, moisture, iron grade and impurity penalties.
Looking at iron ore producers in Australia, the broker estimates the 62% iron CFR break-even price ranges from US$42/dmt for Rio Tinto ((RIO)) up to US$91/dmt for Gindalbie Metals ((GBG)). Fortescue Metals ((FMG)) is at US$72/dmt. Falling iron ore prices provide an opportunity for investors to buy iron ore mining stocks, based on the broker's view that iron ore will average over US$110/dmt in 2014. Fortescue is the most leveraged large cap while Atlas Iron ((AGO)) offers small cap leverage. The broker accepts there may be further pressure on share prices until the iron ore price levels out.
Final demand should have the last word. That's JP Morgan's view. The broker sees no evidence of a more serious problem in the most commodity-sensitive parts of China's economy. The sell-off in the stocks is viewed as a buying opportunity. The broker thinks the steel industry's lack of profitability and readily available credit is magnified by financing. As prices drop, the collateral call induces forced selling but commodity-intensive investment is still holding up. Moreover, there's no sign of a problem in end demand so any impact is considered temporary. The broker assumes that the increase in iron ore supply this year will not shift the cost curve enough to put prices under continued pressure. Chinese currency appreciation in recent years and cost pressures on Chinese producers provides the confidence in this viewpoint. The broker expects iron ore stocks will trade a significant discount to valuation and should be bought very cheap and sold cheap.
Assertive investors should trade the dips and portfolio managers shouldn't panic. That's Morgans' advice. Physical market indicators have been seasonally weak and therefore short-term price volatility shouldn't come as surprise. This broker also doesn't think Chinese fundamentals have radically changed. Peak steel consumption occurs in the construction season during the northern summer. Morgans observes Chinese traders are particularly opportunistic around pricing. If high prices are crimping mill profitability into a de-stocking period then the traders, and even the mills, will often exit physical markets or even default on cargoes, preferring to draw down from high inventories. At lower price levels the bargain hunters re-emerge.
Simply put, the broker observes a dip to around US$110/t for iron ore, around the marginal cost level for Chinese supply, brings out the buyers of import cargoes Conversely, when prices approach US$140/t where the steel mills struggle to make profits, the traders exit. Morgans doesn't see the latest events as heralding anything much different.
PhillipCapital is not surprised. The broker considers Chinese GDP growth and forward indicators have been slowing for some time and iron ore stockpiles have grown because of wrongly-anticipated demand as well as the pollution issues shutting down some steel production. Financing deals in China have reported increased use of iron ore as security, the broker notes, and the recent high profile debt default could add pressure to unwind financing. For Fortescue, particularly, the broker thinks the case is mounting for a bounce, but market needs time to digest the latest news. The broker sees few catalysts coming from the company itself, in order to determine the way the stock will trade in coming weeks. The negative trends appear to be well discounted. The broker notes recent monetary data suggests a gradual leveling of China's recent growth deceleration. A fall in the renminbi also should boost Chinese export margins and competitiveness in the next quarter.
PhillipCapital thinks a tradeable rebound in Fortescue's price is becoming more possible, particularly if it can hold recent technical level pricing. A definitive upside break is likely to require more time and benign, or improving, Chinese economic statistics, or measures that entail reduced Chinese ore supply and a consequent rebound in iron ore prices.
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