Is It Time To Be Bullish On Iron Ore?

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-Buoyant prices not linked to demand
-China's steel metrics confusing
-Prices could still move down again

By Eva Brocklehurst

Iron ore is at an interesting point in its cycle. Why have prices been so resilient in the face of ongoing displacement of production and demand in a downtrend? Is the recent rally in the iron ore price a temporary respite?

Responding to client questions and assessing feedback, Morgan Stanley concludes that the stability of the seaborne price is underpinned by other factors such as the futures market, inventories and trade flows. China's domestic ore production is giving way increasingly to expanding imports. At the other end of the process, China's steel making industry is now loss making and unable to expand exports, with anti-dumping pressure growing, and local steel-intensive projects are facing queries over their likely returns. Morgan Stanley suspects that any slowdown in steel demand growth would likely prompt cost cutting and reduced purchases of raw materials.

There are some bullish signals such as China's port inventories being at the lowest level since 2013, despite a 20% increase in monthly average import flows, and official data suggests raw ore production is down 13% year on year. Moreover, the major miners – Rio Tinto ((RIO)), Vale and BHP Billiton ((BHP)) all believe demand is solid. Morgan Stanley suspects this optimism is centred on the stability of the ore price, rather than the actual price level.

The broker warns clients that this is the time of year when the steel mills pull back and there is usually a correction. Still, the degree to which the seasonal shifts affect prices depends on a number of factors such as credit conditions, inventories and demand. Morgan Stanley also warns about becoming too comfortable with US$60/t iron ore prices, comparing this to a fashion trend – its appeal may wear thin and you may regret it. Of note, while prices appear buoyant and the bulls are becoming twitchy, some Hong Kong traders have suggested recent transactions were index-linked and there is no change in actual physical demand.

Macquarie also observes iron ore has defied expectations of further downside, acknowledging the features of the current market do not stack up. Steel mill holdings appear relatively low and trader-held inventories have been falling. There is a general view that the major producers control the market and, in times of weak conditions, supply discipline has helped at the margin, Macquarie notes. Hence, the 55mtpa Roy Hill project, which is about to start pumping iron ore into the market in decent volumes in 2016, will be an interesting development to watch.

Another observation the broker makes is that the displacement of tonnage from the smaller producers has been remarkably efficient. Countries such as Swaziland, Honduras, Mexico, Malaysia and Sierra Leone, all which became consistent suppliers of iron ore to China, have had their volumes priced out and quickly idled operations.

Confusion stems from China's domestic production. Macquarie suspects there has been a substantial slump in output, by at least 100mtpa from the 2014 peak. Still, there remains some missing factors. While it is possible an inventory build up has occurred of which the market is unaware, this would be contrary to both sentiment and credit conditions. Maybe there is some under-reporting of pig iron production.

In the end, Macquarie would not be surprised to witness cuts to steel demand in October and, in tandem, the mills taking less iron ore onto their books. Pricing could move back towards, or even below, US$50/t CFR China. Through to 2017 the broker expects a cap at around $US$60/t and a floor of US$40/t. Macquarie has reduced long-run iron ore price forecasts to US$65/t CFR China from US$80/t previously.

Weak fundamentals suggest to ANZ Bank's analysts that the rally in the price is overdone. Strong supply growth has re-emerged from Brazil, while the upcoming holidays in China will negatively affect steel production and iron ore demand. Any upside in prices is likely to be limited and the analysts take a short position, with a view prices will test US$50/t.

So, how do Australia's mid-cap producers fare in this scenario? Macquarie has made material reductions to iron ore price forecasts, cutting them by 3% for FY16 and 10% for FY17. When factoring in a lower Australian dollar, the impact is far less severe. Indeed, on this basis iron ore forecasts for FY16 are upgraded by 4% and FY17 reductions are lowered to 3%. Australia's major producers will continue to generate strong returns.

Among the mid caps BC Iron ((BCI)) remains the brokers preferred stock, with an Outperform rating. After factoring in Iron Valley earnings, Macquarie estimates the company is cash-flow positive at spot prices. Grange Resources ((GRR)) benefits from a pellet premium which has been relatively firm and the company is also fully cash-backed, although lacking the potential of BC Iron. Hence, a Neutral rating. Mt Gibson Iron ((MGX)) also attracts a Neutral rating. Its future remains uncertain because Extension Hill is the primary source of earnings and output at Koolan Island is winding down. An acquisition could provide some clarity on the outlook, Macquarie contends.
 

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