By Thomas Streater
The blue skies of Beijing that greeted world leaders gathered
for APEC are no more. By the time the dignitaries had jetted into
Brisbane for the Group of 20 Summit, China's capital had once again
been enveloped by choking smog as the cogs of Chinese industry were
shifted out of neutral and back into high gear.
The return of the smog was meant to herald better news for the
global iron ore industry. The hope was that as China revved up
manufacturing activity, especially at steel mills, it would lead to
a rebound in the price of the steel making ingredient. Wrong.
Instead, iron ore prices have plumbed a fresh five-year low around
$70 a tonne and ratcheted up the miners' pain. UBS warned earlier
this week that it was now or never for China's steel mills to
restock iron ore. After the latest round of bloodletting, it may
seem to be more 'never' than 'now'.
It's been a bloodbath for iron ore stocks. Australia's Fortescue
Metals Group (FMG.AU), controlled by billionaire Andrew Forrest,
was smashed nearly 8% lower on Wednesday as analysts zeroed in on
the heavy debt load shouldered by the world's fourth largest iron
ore producer. BHP Billiton (BHP.AU) and Rio Tinto (RIO.AU), which
together with FMG dominate production from the Pilbara region of
Western Australia, were also sold down.
The cause of the iron ore miner's discomfort is a problem the
industry should be well accustomed to - supply and demand. In this
case, the big licks of shareholders cash invested in massively
expanding iron ore production have come back to haunt the industry.
A massive wave of supply has swamped the market at a time when
China's demand for iron ore has waned. The latest data on Chinese
property prices, which showed prices fell in 69 out of 70 cities in
October, was another reminder that the halcyon days of $180 a tonne
seen in 2011 are long gone as China shifts its economic model away
from a reliance on resource intensive fixed asset investment.
The industry is also having its logic for running their mines at
full bore tested by socialism with Chinese characteristics. The
theory was that by running their low cost mines at a maximum
capacity and pressuring prices lower that would force high cost
producers in China out of the market. Wrong again. With an eye on
employment and social stability, China's high cost mines continue
to feed ore to steel mills and high cost tonnes have not exited the
market as quickly as expected. Citi notes that about 70% of China's
iron ore production is controlled by subsidiaries of steel mills.
The Australian miners, plus Brazil's Vale, have also felt the cool
chill of Beijing's credit tightening. Stricter credit standards
have stymied the ability of smaller mills to finance imports of
iron ore.
Despite the gloom, there is the possibility that iron ore miners
may find some relief. The last two months of the year have
traditionally been a strong period for the commodity. The onset of
winter crimps production in China, while the cyclone season that
accompanies summer in the Pilbara weighs on production from the
trio of Australian miners. That would be a relief for FMG, with
Credit Suisse estimating that every $4 a tonne increase in the iron
ore price could add AUD1 to the company's valuation.
The miners have also embarked on a self-help program. Cost
cutting is the name of the game as the heavyweights of the industry
seek to push their costs as low as possible. BHP Billiton and Rio
Tinto are looking to sweat their 'tier one' assets, which have long
lives and low costs, even harder.
Rio Tinto's operations are exemplary in terms of costs, with
iron ore pulled out of the ground at a cash cost of around $20 a
tonne in the first half of the financial year. The company's "Mine
of the Future" program is driving down costs of production through
the use of autonomous, or unmanned, trucks and trains. BHP Billiton
has plans to drive down costs at its Western Australia iron ore
business by 25% to less than $20 a tonne over the medium term. But
the chasing of lower costs may just incentivize more
production.
But longer-term plans to add yet more tonnes to the market have
drawn widespread criticism. A vocal critic has been Ivan
Glasenberg, the billionaire chief executive of commodities producer
and trader Glencore (GLEN.LN). He has accused BHP Billiton and Rio
Tinto of "killing the super-cycle" by adding to the iron ore glut.
That said, having acknowledged an interest in acquiring Rio Tinto,
it plays into Glencore's hands to talk down the iron ore price -
and Rio Tinto's share price.
However, Glasenberg is not a voice to be ignored when it comes
to dealing with supply gluts. Glencore last week unveiled plans to
suspend production at its Australian coal operations for three
weeks. At $60 a tonne, thermal coal is fetching half what it did
three years ago. Glencore's action will remove five million tonnes
of output. What makes the move surprising is Glencore claims all
the mines it is temporarily closing are profitable. Glasenberg has
decided to show leadership by taking tonnes out of the market to
support prices, rather than continuing to run his operations at
full speed, add more supply to an oversupplied market, and hurt
coal prices, and his bottom line, further.
It's a lesson in resource economics that BHP Billiton and Rio
Tinto may want to take on board. With earnings under pressure,
there is no doubt shareholders may start asking why more tonnes are
being mined and shipped. It's then a question of who may blink
first in cutting supply.
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Email: thomas.streater@barrons.com
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