- Iron ore as a commodity faces long term oversupply.
- The shift to a service oriented economy lowers Chinese steel demand growth.
- Short term euphoria makes iron ore and related assets great for trading.
Iron ore is the world’s most mined and commonly used metal as 98% of it is used to make steel. As steel is mostly used for infrastructure and building it is not surprising that China is the world’s biggest consumer of iron. China produces 50% of the world’s steel output and 47% of the world’s iron ore.
Therefore, China is the main factor for iron ore pricing. As Chinese demand for steel grew so did the price of iron ore. Increased iron ore prices brought increased investments in mining, and currently supply is higher than demand. In such a situation, a decline in prices is unavoidable and the decline in iron ore prices has been unstoppable for the last 5 years. From $180 per ton in 2011, the price of iron ore has eroded to the current price of around $60, but also reached prices below $40 in December 2015.
Unfortunately for iron ore miners, the outlook is not bright. The World Steel Association (WSA) is forecasting a decrease in steel demand in 2016 of 0.8% and just a slight increase of 0.4% in 2017. Also, unlike other commodities like copper, the world’s iron ore reserves seem enough for many more years of increased consumption. Estimated global reserves are 170 billion tons while current global consumption is 3.2 billion tons per year.
With low prices, high iron ore availability and lower demand for steel, logic would have miners lowering output in order to realign supply with demand to increase iron ore prices. But the world’s biggest miners have chosen a different way, one that has also strongly influenced the above price decline.
The Iron Ore Increased Supply Strategy
The strategy in the iron ore mining sector is one of increased supply in order to force high-cost supply to exit the market. The goal of such a strategy is to increase market share and reach higher profits with lower margins on bigger volumes. The world’s largest miners—Rio Tinto (NYSE: RIO), BHP Billiton (NYSE: BHP), Fortescue and Vale (NYSE: VALE)—are all increasing production. RIO and BHP require iron ore prices at around $25 to break even while Fortescue and VALE require prices to be around $40. 25% of global iron ore production has costs above the current spot price and most of the high cost producers are in China. Therefore, the big global miners hope to reach maximum profits by increasing production and completely conquering global markets.
The strategy is not yet showing positive signs as all the above mentioned miners have reported losses (RIO and VALE) or minimal profits (BHP and Fortescue) in the last 4 quarters. In order to see if the strategy is going to pay off in the long term, it is necessary to look at the forecasts for iron ore.
In the short term iron ore prices have quickly recovered from this winter’s lows and are currently boosted by increased building expectations in China. But, Goldman Sachs is describing this increase in prices as temporary because there was no shift in raw-material fundamentals and expects iron ore prices to return to $35 per ton soon. Also, RIO and BHP have warned that prices will come down again.
A mid-term outlook shows that iron ore is bound to stay at low levels as the trade balance outlook remains highly positive through 2020.
The World Bank estimates that iron ore prices will be around $50 per ton for the next five years as the increase in low cost supply is much larger than the closures of high cost mines.
In the long term, iron ore prices are completely dependent on steel demand and steel demand is not expected to grow at the same rates it used to grow in the last 15 years.
As a country becomes more developed the infrastructure and building necessities become more service oriented and therefore demand for steel diminishes. A case for steel would logically be India as the successor of China in growth and infrastructure building, but it is forecasted that India will mostly be self-sufficient in its steel production.
As low commodity prices limit new investments and commodities are cyclical, somewhere down the line another surge in iron ore prices can be expected. But, according to Wood Mackenzie such a situation should only emerge after 2025 or even later, as current capacity is enough to cover demand and increased production will probably lead to a long term oversupply.
Considering everything above, iron ore seems a tricky asset. High availability excludes a copper scenario where it is known that mine grades are bound to be lower in the future. Long term oversupply and a shift in the Chinese economy from a manufacturing and heavy infrastructure investing one to a more service oriented one does not make a strong case for iron. But, iron ore prices have fallen more than 75% from their 2011 peak so there should be opportunities to make profits. Perhaps iron ore should be left to traders that have the stomach to weather huge swings and the knowledge to seize the volatility as the price is influenced by oversupply in the long term but also by short term euphoria like the in the last two months based on increased lending and hopes of a return to previous levels in Chinese infrastructure growth.