Australia’s miners and the iron wall of supply

Recent drops in iron-ore prices are overplayed, but the world’s mining companies are creating a potential glut in supply for the mineral in a few years’ time. This oversupply could well send the price of iron ore tumbling, reports Ben Power.

  • 02 Dec 2011
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A recent sharp slump in the price of iron ore has triggered a rash of fresh concerns in Australia that China’s boom is over. It has also led investors to question some unprecedented expansion plans by Australia’s major iron-ore producers.

Shares in commodities majors BHP Billiton, Rio Tinto and Fortescue Metals, sold off sharply in mid-October after spot ore prices fell 15% in just five weeks to around US$150 per tonne.

The sell-off came amid slowing Chinese growth, European debt woes and reports that Brazilian producer Vale was accepting 10% cuts in iron-ore prices.

Chinese steel mills – the world’s biggest buyers of iron ore – are already looking to exploit the lower prices and are attempting to renegotiate quarter prices in line with the weaker spot rate.

But despite all the concern, BHP Billiton, Rio Tinto and Fortescue Metals all reported recent strong iron production results in the September quarter and remain upbeat at the prospect of strong ongoing Chinese demand.

“There are a lot of conflicting signs in the market which are confusing to people that don’t follow it all the time,” says UBS resources analyst Tom Price. “People are saying ‘Oh my God, it’s the end of the world and the Chinese story is over’. But the reality is it’s a seasonal weakness. Prices have corrected from a very high level.”

Price says that iron-ore spot prices have been unusually high and unusually stable at around US$170 a tonne all year, and the recent weakness is typical of October when trade is low. He predicts that the price should stabilise and lift in November and December when Chinese mills start demanding more iron ore and as supply constraints – including a one-third cut in India’s export capacity due to export bans in Karnataka state – are felt.

“The Chinese are very excited now but they know they’re going to be screwed over in a couple of months,” says Price, adding that the export ban in Karnataka creates a supply shortage when Chinese steel mills really need iron ore. “It hands greater spot trading control over to Australians and Brazilians, who will exercise it.”

But while the recent falls in the price of iron ore may be temporary and seasonal there are still concerns about the outlook for the industry. Of particular worry to iron-ore producers is a looming ‘wall of supply’ set to hit the world around 2014 to 2015 once major iron-ore projects, particularly in Western Australia’s Pilbara region, come on stream.

The expected supply has led analysts to forecast a steep fall in the iron-ore price and in producer margins, particularly if Chinese growth and demand falters. Some question the strategy of Australia’s major producers to massively ramp up iron-ore production.

Hitting historical highs

Iron ore has been a boon for the global mining industry in recent years, with Australia’s largest players some of its biggest beneficiaries. Prices have surged to their highest levels in more than a century on the back of strong Chinese demand, creating margins of up to 70%.

In fact it has been so successful that iron ore is now the dominant profit driver of the mining industry. UBS expects that iron-ore sales will generate 62% of the earnings before interest and tax of the ‘Big Five’ mining companies’ (BHP, Rio, Vale, Anglo American and Xstrata) this year.

The huge demand, particularly from China, is reflected in recent production reports. BHP’s Western Australian iron-ore shipments rose 28% to a record annualised 173 mtpa (million tonnes per annum) in the September quarter.

In the same period Fortescue’s shipment of iron ore rose 21% to 12.4 million tonnes, keeping it on track to achieve a run rate of 55 mtpa. Meanwhile, Rio Tinto’s Pilbara production rose 5% to 60 million tonnes, a quarterly record.

All major players are moving to fully exploit demand and record prices and are undertaking substantial expansions of their operations in Western Australia’s Pilbara region.

Rio Tinto is increasing production by 7% per annum (330 mtpa), BHP by 10% a year (220 mtpa), and Fortescue by 18% a year (75 mtpa).

In March BHP announced approval of US$7.4 billion of capital spending to expand its Western Australian iron-ore operations, which will increase its capacity by 220 mtpa. The investment includes US$3.4 billion to develop its Jimblebar mine, with first production expected in early 2014.

Rio Tinto is investing US$15 billion over the next five years in expanding its iron-ore production in the Pilbara. Its production capacity will surge 50%. Production will expand to 225 million tonnes per annum in 2013 and increase to 333 mtpa by 2015.

Fortescue is also making huge bets. It is spending US$8 billion expanding its production to 155mpta, including the construction of its new Solomon mine, also in the Pilbara, a second ore-processing facility at Christmas Creek, and duplication of part of its existing rail line.

Foreign players are also acting. Brazil’s Vale plans to increase production by 6% a year to 2015 (470 mtpa).

An iron wall

The undeniable result of all this production expansion is a ‘wall of supply’ in the medium term that could push down iron-ore prices and production margins, and undermine these huge investments.

“If BHP, Vale and Rio do everything planned the world will be swimming in iron ore by 2014/15,” says UBS’s Price. “There will be a huge surplus.”

Citi analyst Johann Pretorius expects total seaborne supply to increase around 73% to 1.57 billion tonnes per annum by 2015. He said given current project timelines and targets, 2014 is likely to be a “watershed moment” for the industry, with major projects such as Fortescue’s Solomon coming on line.

UBS’s Price anticipates global iron-ore supply to rise from 1.82 billion tonnes in 2011 to 2.2 billion in 2014, and 2.34 billion in 2015. Given that global iron-ore demand in 2014 and 2015 is predicted to be just 2.051 billion tonnes and 2.1 billion tonnes respectively, this will put the global balance of iron-ore production into surplus.

It’s a similar story when it comes to seaborne demand for iron ore. UBS expects there to be 1.09 billion tonnes of demand this year versus supply of one billion. But by 2015 supply of 1.45 billion tonnes will exceed seaborne demand of 1.4 billion tonnes.

Relying on China

Underpinning the miners’ expansion plans is an assumption that Chinese steel mills will be there to buy the additional supply.

According to UBS, China’s iron-ore import requirements will grow from 684 million tonnes in 2011 to 942 million tonnes in 2015, and its percentage of seaborne trade will rise from 63% to 67%.

But the market has recently been concerned about slowing Chinese growth, after it reported lower-than-expected third-quarter GDP growth of 9.1%. Justin Smirk, senior economist at Westpac, says his bank expects to see a modest slowing of China’s GDP growth over the next 12 months due to a period of overbuilding. But that period will be followed by a re-acceleration.

Smirk says any short-term slowdown needs to be seen in the context of China’s larger growth super-cycle. Compared to previous industrial cycles, including the US in the 19th and early 20th centuries, China is “still at a very early stage”, Smirk believes.

“There’s a long way to go in terms of growth,” he adds, noting that the urbanisation, industrialisation and consumerisation of China is nowhere near complete.

Smirk anticipates strong demand for iron ore from China by the time the ‘wall of supply’ kicks in around 2013-2014.

UBS’s Price doesn’t see any evidence of China faltering either. He notes that trade and production data are “surprisingly strong given [that] markets have [had] a lack of credit to work with all this year” and year-on-year growth rates are still extraordinarily large. “I can’t see that stopping now or any time soon.”

Miners are also confident that China’s growth story is sustainable. “We see short-term volatility currently in Chinese iron-ore demand but we believe the fundamental demand is very strong,” says a Fortescue Metals spokesperson. “Restrictions on monetary supply put in place by the Chinese government in an effort to control inflation have impacted on Chinese steel mills; however, Chinese steel consumption is forecast to increase by 7.5% this year so we see long-term strength in demand.”

But even if Chinese growth doesn’t falter the massive expansion of supply set to hit the market in just over two years will still weigh on iron-ore prices.

UBS expects prices for iron to slump to US$125.6 per tonne in 2014 and US$93.6 per tonne in 2015.

Citi’s Pretorius adds that the result of such an increase in capacity, “were it all to come online”, would soften iron-ore prices and cause margin pressure.

Deliberate delays

But the extreme scenario of the anticipated ‘wall of supply’ is not a forgone conclusion. Smirk notes that many projects are likely to be delayed.

UBS’s Price believes the major players will also act to prevent severe price drops.

“Given Rio, BHP and Vale overwhelmingly dominate the supply side of seaborne trade – 60% to 65% – they’re not going to let that happen,” he said. “Why would you kill the price signal of your own market?”

“They just have a strong incentive to observe what their competitors are doing in the market,” he said. “If they don’t they could destroy the value of their own trades.”

Price said the major players will manage the supply situation by delaying long-dated projects and rebalancing the market.

“Either you believe they will deliver into the market and get really bearish, or you take a step back and look at the objective of the players in the market and come up with something a bit more realistic. We have chosen ‘b’, not ‘a’.”

Australia’s Big Three iron-ore producers are certainly talking up their prospects over the coming few years, anticipated oversupply or not.

Asiamoney sent a series of questions to the big miners on the outlook for iron ore as well as the strength of the Chinese economy. BHP and Rio refused to answer specific questions related to their outlook for iron-ore prices, Chinese steel demand, and how they would respond to a surplus of iron-ore production and lower prices.

In a statement to Asiamoney, Rio Tinto chief executive Tom Albanese says: “We have set new quarterly records for iron-ore sales and hard coking coal production as our operations recovered from the severe weather experienced earlier in the year.”

He adds: “Whilst we are mindful of current market volatility, the fundamentals are holding up well, particularly for bulk-traded commodities. We are operating at full capacity, selling all we produce and our growth programme is on track, supported by the strength of our balance sheet.”

At BHP’s recent annual general meeting, chief executive Marius Kloppers had similarly bullish views, noting that his company’s order book remained full. He added that softening prices were caused by global uncertainty, and said that customers were looking “closely at their inventory levels as they operate their businesses, cognisant of the potential need to tailor their plans if the global economic uncertainty continues.”

But he remained optimistic about the future. “The base case global economic outlook, however, remains one where growth is only modestly below potential, supported by ongoing growth in emerging economies such as China and India,” he said. “Provided that there are no large external shocks, and policymakers continue to manage inflationary pressures in these developing countries effectively, we expect these economies that drive demand for our products to grow solidly and sustainably into the future.”

Fortescue has a similarly sunny outlook, largely based on continued strength of demand from China.

“We are confident of sustained demand from China,” says a spokesman for the company. “The cautious environment we’re experiencing currently is due to concerns about the eurozone and efforts by the Chinese government to control inflation through monetary restrictions. We anticipate price softness to continue only in the short term with a return to stronger demand in the medium term.”

Well-placed position

Such optimism might smack of over-confidence, even hubris. But analysts agree that Australia’s major iron-ore producers are well-placed to cope in a lower-priced and lower-margin environment.

Both Rio and BHP are all ‘first quartile’ producers. Price notes that it costs them around US$25 to US$30 a tonne to get iron ore on a ship, with Fortescue production costs slightly higher.

“They have nothing to worry about; they have enormous capacity to cut costs as well,” Price said. “The spot price could go all the way down to the [2008-2009] global financial crisis low of US$62 and all of those majors would be okay.”

There is also an assumption that the smaller Australian players, such as Atlas Iron, will struggle if iron-ore prices drop by much. But that is not necessarily accurate, largely because of the preference of the world’s largest iron-ore consumer: China.

“A lot of people have written off the small guys in a bear scenario,” Price said. “But China will be very determined not to become beholden to BHP, Rio and Vale like they were five years ago.”

He predicts that a couple of smaller players will stay in the marketplace as China prefers to buy their ore in order to keep the supply side as diversified as possible.

Any fall in iron prices would also knock out high-cost production in China.

The spokesperson for Fortescue Metals says: “While it’s true that new sources of supply from Australia and international markets will come online in the medium term, it is also important to remember that some sources of iron ore, particularly those high-cost ventures in mainland China, will increasingly fall out of the market as market conditions become more competitive.”

Ultimately the ability of Australia’s iron-ore producers to continue to thrive lies largely in their own hands. Price believes that those concerned about the impact of a glut underestimate the ability of these companies to manipulate the market to deliver strong returns over long periods.

He said oversupply would be a problem “if BHP and Rio don’t do anything and don’t take strategic positions in the market; but that’s not what they do. They’re very active in repositioning themselves into different commodities, consolidating assets, and selling stuff off that doesn’t work”.

The world might be facing an iron wall of supply, but the leading producers of iron ore look well-placed to handle its impact.

  • 02 Dec 2011

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