Is It Time To Short Iron Ore?

 |  Includes: BHP, FSUMF, RIO, VALE
by: Price Point

As the Chinese steel industry moved to rebuild inventories, iron ore prices in August rose to their highest level in five months. The steel making raw material's prices have rallied from a low of $110 per ton (CFR China) in late May to over $140 more recently.

Iron ore is important to the global economy as the metal used in making steel, which is used in industries like construction, transport, machinery, home appliances and electrical equipment. So basically iron prices ultimately feed through the prices of everyday goods.

The wave of buying by Chinese steelmakers and traders and lower supplies from two main iron ore producers, Australia and Brazil, drove prices higher. However, as Chinese growth slows down and producers from Vale (NYSE:VALE) to Rio Tinto (NYSE:RIO) increase supply, the iron ore market is set to transit from the current state of high prices and the seaborne balance state of low prices and excess supply.

The Asian giant consumes about 60% of the global seaborne market, making it the biggest consumer of the commodity. China's construction boom triggered record prices for the steel raw-material, which rose to its peak of close to $200 a ton. But as the second biggest economy in the world slows down and supply growth overtakes demand, prices are expected to fall significantly.

"China is slowing down and steel production is going to be at a lower rate than what we've been used to," said Christian Lelong, an analyst at Goldman Sachs in Sydney. "It's a long-term trend that's starting next year. On the demand side, it's hard to see a return to the strong rates in the past."

An acceleration in iron ore supply growth combined with steady but waning growth in demand are both pointing toward a bearing outlook for iron ore prices. Although prices might maintain relatively buoyant levels for a little while longer, but once supply growth overshadows demand growth, the decline in prices could once again surprise the market as is usually the case.

Rio Tinto, the world's second biggest iron ore producer, is boasting record iron ore production. The company has been pumping cash into its Australian Pilbara operations, which will lift annual operating capacity to 290 million tons by the end of September. Sam Walsh, CEO of Rio Tinto, said that the company would decide this year on how to expand its Pilbara operations in Australia to lift further its output capacity from 290 million tons this year to 360 million tons.

BHP Billiton's (NYSE:BHP) Jimblebar expansion project is also on track to be completed in early 2014 and will add 35 million tons to annual capacity. Fortescue Metals Group (OTCQX:FSUMF) will also increase its annual production to 155 million tons by end of 2013. Vale's Additional 40 project also started up in August and is now at the ramp-up phase. The project will permit a 35% expansion in output at Vale's Carajás Mine and is expected to be working at full capacity in the first half of 2014. By the end of 2013 the plant will be processing 4.9 million tons of iron ore per month, implying an annual rate of ~60 million ton.

Goldman Sachs predicts iron ore surplus of 82 million tons in 2014, the highest since 2008, and the investment firm predicts the surplus to grow till 2017 at least. UBS surplus projections (150.7 million ton) are almost double of that of GS. Tom Price, UBS commodities analyst, predicts iron ore prices to fall as low as $70 a ton between August and October. According to UBS, Chinese steel makers will soon start curtailing production, leading to a decline in iron ore demand. Analysts surveyed by Bloomberg predict iron ore to average $115 ton in 2014, almost 20% less than the current prices and the least since 2009.

Chinese steelmaker Ansteel also recently warned that iron ore prices could fall as China's steel makers are unable to break even. Zhang Xiaogang, Chairman of the Chinese steel making giant, expects iron ore prices to average between $110 to 120$ per on in 2013.

Blackrock, the world's largest money manager, sold a huge share of its iron ore shares last week. The world's biggest mining investor sold down about $60 million worth of iron ore stocks particularly from Fortescue Metals and Atlas Iron. The company also sold smaller stakes worth millions of dollars in both Vale and Rio Tinto.

BLK's decision to sell a huge chunk of its iron ore investment also sends a clear message where the investment firm thinks iron ore prices are headed. Iron ore prices fell to $86 per ton in last September, and BLK's huge sell-down is supporting the views of those analysts and miners who are predicting a similar spring slump this year as well.

Other than supply and demand, destocking and restocking of inventory has also been a major driver of iron ore prices in recent months. Significant destocking occurred between July 2012 and April 2013. Port stocks, which had reached all-time highs of 100 million ton in mid 2012, declined by 25% to 75 million ton over a 9 month period. This destocking period also coincided with a significant price correction in the third quarter of 2012.

Current port stocks in China (72 million tons) remain well below their average stock level of 2012 (94 million ton). The inventory position across the steel value chain indicates that stock levels are at the lower end of the range and it is unlikely that a destocking event similar to 2012 will occur at current levels of inventory. However the upside from restocking is also unlikely to occur as the steel industry is more comfortable with the relatively low inventory position due the expectations of a price decline in an oversupplied industry.

Seasonal factors also play a role in iron ore market e.g. Chinese production contracts during the severe winter season. Similarly Australian production is disrupted during the Australian cyclone season (Q1). Weather also plays a role in steel consumption as construction activity accelerates during spring and summer and slows down during autumn and winter. Over the last three years prices have strengthen during the supply disruptions (Q1) and peak demand (Q2) periods, before softening in Q3 and rallying once again in late Q4.

Bottom Line

The recent upturn in iron ore prices would not be long-lived. The factors that dramatically tightened the iron ore market are now behind us, actual demand and actual supply should show more distinctive signs of moving along different growth paths. The iron ore market is set to transit from its current state of high prices and seaborne balance to its future state of low prices and excess supply. Prices may maintain relatively buoyant levels for a little while longer than fundamentals would suggest, but as supply growth overtakes demand, the decline in prices would be inevitable.

Now is the time to establish short positions in iron ore.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.