Iron Ore’s Train Wreck
When Iron Ore was trading above $120 we challenged the iron ore industry’s view that the commodity price would remain supported. Indeed in this post back in 2012 we noted; “FMG’s Nev Power reckons while iron ore prices have slumped to $US104 a tonne in recent days, “as soon as restocking and production returns to normal we expect to see prices back in the $US120 to $US150 per tonne range”.
In this post while Fortescue’s Chief Nev Power said he was confident that the iron ore price would rebound to the US$120/tonne level following its recent weakness, we noted, “before 2002 the iron ore price averaged between US$15-$20/tonne.”
The widely observed slow down in China’s property and infrastructure sectors has meant that the 839 million tonnes of steel being produced in China annually is not being absorbed by the construction industry. In fact residential property construction (which demands the highest proportion of steel), commercial and industrial have all entered a period of steady declining demand. In fact total China steel consumption is forecast to fall from 756 million tonnes (mt) last year to 728mt this year. Subtracting 728mt from 839mt leaves 111mt of steel oversupply to be dumped on global markets each year.
The impact of this is already being felt by the world’s largest steel producers. For example in the latest quarter Arcelor Mittal reported revenue down 18 per cent and EBIT down 30 per cent Year on Year. In the company’s second quarter conference call (we track global company conference calls for our Montgomery Global and Montaka Global Fund investments) the company said: “I think we had expected…that Q2 would be the bottom for the market…I think now there’s a view that we can more or less write off the prospects for any improvement for the rest of this year.”
For Australia and it’s Iron Ore sector, the ramifications cannot be overstated. The two largest marginal producers are Fortescue Metals Group and Vale and both companies are highly leveraged and free cash flow (FCF) negative.
In Vale’s case, even though it is already highly indebted and FCF negative, it is only half way through its S11D expansion and has another $10billion to spend. In the last six months Vale has has seen sales down 17 per cent and cash flow from operations down 56 per cent.
High gearing perversely incentivises marginal iron ore producers to keep producing more of the commodity to amortise their very high fixed interest expense over a greater volume. In turn this is exacerbating the iron ore oversupply and driving its price lower.
To top it off, the race to reduce operating costs is also deflationary for the iron ore price.
With Australia unprepared for a recession, the continued pressure on the Aussie dollar, on the Australian federal budget and on the Terms of Trade (which of course receives all the press attention), may only be exceeded by pressure on individual mortgaged home owners if they lose their jobs.
When the Iron Ore price traded at $140 we suggested $40 was a possibility. Well, here we are, and we believe the price could still halve. So test any suggestion that now is the time to be buying iron ore producers.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Aaron Somner
:
Roger I would love to understand that comment that commodities do not move in unison. I have looked at commodity index charts all the way back to the war of 1812. The charts that are redily available on the internet show a group movement in unison. I think anyone old enough would remember the great commodity boom of the late 1970’s. A look at the great commodity boom of 1919 shows this group movement in unison and they all seemed to bottom in 1932 along with the stockmarket. Is there a commodity at the moment that is breaking out to new alltime highs? I have looked at the majority of prices on the commodity sector and I can find plenty at or close to alltime lows. Could you point out what you mean?
Roger Montgomery
:
Hi Aaron,
You have highlighted periods where they did move in unison, but you have concluded that they always do, and that they all do. You also suggest that if some commodities are registering lows, there must be others registering all time highs for low correlation to exist. That is plainly unnecessary. We don’t have the time to go through dozens of example for you, but by way of example, look at the prices of coffee over the last 12 months or cocoa and compare them to the price of sugar or oil. I see no ‘unison’ there. If you’d like to pay for one of my team’s time, we’d gladly find you hundreds of examples, going back as far or as recent as you would like. We will have to agree to disagree.
Aaron Somner
:
Can I just point out that iron ore is not trading in isolation. Iron ore just like gold, oil, nickel or any other commodity you can name are all trending down since 2011. Fundamentals do not explain this as all commodities have differing fundamentals. Why do all commodities move up and down in unison?
Roger Montgomery
:
Perhaps rarely, many of the commodities are being impact by the same fundamental influences. Go back before 2011 and you will see they don’t all move in unison.
Peter Todd
:
So how does this correlate with the “Green Shoots” article?
I know some experts are saying now is the time to get back into miners particularly BHP.
Roger Montgomery
:
Hi Peter, sometimes the observers are premature, but only time can tell.
Scott T
:
Great reminder of your thoughts from years ago. I remember when you were on Your Money Your Call one night, Iron Ore was $140 a tonne and you said it was headed to $40 a tonne, and another panelist laughed at you and said if anything is was going to $160 a tonne but maybe not until 2014/15. That panelist doesn’t appear on the show anymore.
As you have said “Better to be 6 months early than 6 minutes late.”
All the best
Scott T
Jackson Lee
:
G’day Scott – any chance you still have a link to the video so I can watch?
Cheers,
Jackson
Scott T
:
Sorry Jackson I don’t. I watch the show live on Foxtel, and don’t have any stored copies, and I don’t know if they keep a library online of old episodes.
All the best
Scott T
Jackson Lee
:
No worries, thanks mate :)