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Iron ore miners’ war of attrition

The following article is a good simple explanation of the dynamics at play in the Iron Ore market. As part of Intralinks quality screening, we have removed all miners from our preferred investments other than low cost BHP and RIO.

This is because they are low cost producers and this provides them with a very important protection that high cost producers do not have. As they increase production (which they have in a big way) this will increase supply. An increase in supply will reduce price. As a result the supply from the high cost producers eventually declines or disappears altogether as they cannot produce at a profit. In a price boom these high cost producers can see profits soar, but when the party is over they are often worthless, unable to produce anything at a profit. We only invest in companies with strong positions in their industry and where we are comfortable with the industry outlook.

Since the start of December 2013 a high cost producer like Atlas Iron has seen its share price fall by over 50%, but RIO who can continue increasing output well below the current iron ore price (cost is about $40 per tonne) at high profit margins has not seen a decline in it’s share price.

The article is Alan Kohler’s Business Spectator released on the 25th August 2014.

Iron ore miners’ war of attrition

BHP Billiton and Rio Tinto are in a fight to the death with Chinese iron ore producers, the latest manifestation of which is BHP chief executive Andrew Mackenzie’s weekend declaration that he will dramatically expand Pilbara production.

As reported by The Australian this morning, Mackenzie has told the market not to expect prices to go back above $US100 a tonne, and at the same time has revealed a plan to increase production to 290 million tonnes per year, at a cost of about $US3.5 billion.

Mackenzie knows the price won’t go back above $US100 because he is largely responsible for it being $US92. Global overcapacity of steel is estimated to be 334 million tonnes, according to Morgan Stanley, and it is increasingly likely that steel output and iron ore demand will fall. Yet BHP is increasing production. Why? To drive the price down and send Chinese producers to the wall.

The iron ore spot price has fallen 35 per cent this year not because of a collapse in Chinese demand, but because of increased output by the big three — BHP, Rio and Vale.

Growth in Chinese demand for iron ore is slowing — from 9 per cent last year to 5 per cent this year — and the profitability of China’s steel mills has collapsed. China’s iron ore miners are also underwater. Research house GaveKal Dragonomics estimates the average cost of production of the Chinese miners at $US125 per tonne. The spot import price is currently at $US91.90.

In the past when the import price fell below the cost of production, Chinese miners — supplying about a third of China’s iron ore market — temporarily shut down production to allow the price to rise again. But not this time: the Chinese miners and the big three western producers are responding to the price decline and falling demand growth by ramping up production, not cutting back. They are in a war of attrition.

Says Michael Komesaroff of GaveKal: “The basic reason seems to be that this time, Chinese mine-owners know that if they shut down, it will not be just for a few months but forever. With their backs to the wall, Chinese miners are looking for any way possible to keep operating for just a while longer.”

They are pleading for support from local governments, and getting it, as a regional employment policy. But with many local governments as broke as the miners, that can’t go on forever. And most of the mines are privately owned, very expensive underground operations and they don’t have the access to capital needed to modernise their operations, turn them into open cuts or to last long operating at a loss.

BHP, Rio and Vale are in a very strong position, and they know it. They are all very efficient low-cost iron ore miners and, unlike the Chinese, they are making money at current prices.

Now Andrew Mackenzie is turning the screws with a big increase in production. Along with Sam Walsh at Rio and Murilo Ferreira at Vale, he believes that by flooding the market with iron ore, they can drive the Chinese producers out of business, along with a range of nuisance producers in Australia and elsewhere.

But with government support, the Chinese miners could keep going for a few years yet, which is why Andrew Mackenzie is counselling the market not to expect a rapid recovery in the iron ore price.

But if, or perhaps when, they eventually close, the price will go well above $US100 a tonne and stay there.

Disclaimer

The information contained herein is of a general nature and does not take into account the reader’s particular needs, circumstances, financial circumstances or preferences. It is a guide only and based on current legislation. We believe the information contained in this update has been obtained from reliable sources but we cannot be responsible for any errors, omission or inaccuracies. You should seek professional advice before acting on the information in this update.

Please contact your Intralink Wealth Management adviser, on (03) 9629 1100, if you require any clarification or further information regarding this update.

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