Many Are Bearish On Iron Ore

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Summary

A great comeback in iron ore.

The death of iron ore and steel is greatly exaggerated.

Infrastructure in the U.S. could support steel.

Iron ore remains cheap.

The BDI and iron ore reflect on the state of China.

Iron ore is the primary ingredient in steel. In 2013 the price of the commodity was trading north $160 per ton. The secular bear market in raw material prices took many raw material prices to multiyear lows in late 2015 and early 2016 as the dollar climbed from under 80 on the dollar index to the 100 level.

The inverse relationship between the U.S. currency and raw material prices stems from the fact that the greenback is the reserve currency of the world. Compared to almost all other foreign exchange instruments the dollar is stable and with the end of quantitative easing in the U.S. and the first interest rate hike in nine years in December 2015, the ascent of the dollar weighed heavily on many commodity prices and iron ore was no exception.

Iron ore fell to lows of under $40 per ton in late 2015 and early 2016 but when the dollar stabilized because the Federal Reserve left interest rates unchanged throughout much of 2016; it staged a price recovery along with many other raw materials.

A great comeback in iron ore

Iron ore hit its nadir when the November futures contract traded at $31.88 per ton on January 12, 2016. Click to enlargeSource: Bar Charts

As the daily chart highlights, iron ore climbed to highs of $57.49 on August 23 and was trading at $54.80 on Thursday, October 13. The increase of over 80% from lows to highs has made the commodity one of the best performing raw materials of 2016. Iron ore made a great comeback, but many analysts continue to flash warning signs and are looking for the price to slip down below the $50 per ton level in the months ahead.

The death of iron ore and steel is greatly exaggerated

One of the issues facing iron ore these days is a resurgence in the strength of the U.S. dollar. Click to enlargeSource: CQG

As the weekly chart of the U.S. dollar index indicates, the greenback broke to the upside this week as the index rose above the 97.71 resistance to the 98 level before pulling back on some dovish Fed minutes released on Wednesday. The stronger dollar is not good news for iron ore and other commodities, given the historical inverse relationship between the currency and asset sector.

Meanwhile, some forecasts for future price path of iron ore are currently very bearish. Australia is a major supplier of the commodity to the world's number one consumer, China that requires imports to build infrastructure. In a recent report from the Australian Department of Industry, Innovation, and Science the government agency wrote, "The uptick in China's construction activity is unlikely to persist, and the use of commodities in the sector is forecast to decline." The Australian forecast projects that the price of iron ore will drop to $44.80 per ton in 2017.

While many miners believe that the $50 per ton level will hold, Goldman Sachs has warned about "growing vulnerabilities" in the Chinese housing and construction industry.

The specifications for the iron ore futures contract are for 62% contained metal delivered to the Chinese port of Qingdao. The commodity has averaged around $54 per ton in 2016, but many analysts are projecting price declines next year. Iron ore has moved higher in 2016 after three straight years of declines as the Chinese government introduced stimulative measures to deal with declining growth. A one trillion yuan infrastructure package helped to spur demand for steel in the Asian nation. As a result, Australian iron ore exports will increase to 877 million tons in 2017 from 813 million this year and Brazilian exports will rise to 411 million from 389 but as exports increase so will production. The increases in output are coming from low-cost producers in Australia and Brazil.

Another country that needs infrastructure updates could add to demand in the coming years and this would provide support for the price. Dire projections of a return to lower prices could be excessive worries because of the spike down earlier this year.

Infrastructure in the U.S. could support steel

Both of the candidates running for the Presidency of the United States have expressed the desire and intention to upgrade and rebuild infrastructure in the U.S. in the years ahead. It has been decades since the government has addressed decaying conditions of the roads, bridges, airports, and many other aspects of infrastructure. The Federal Reserve has been after the government to augment monetary policy with fiscal initiatives to support the economic recovery in the U.S. and a federal building and improvement project would create jobs and increase economic growth. America's capital stock is aging and in a recent article on Bloomberg, the author states that the average age of all fixed assets was at 22.8 years, the oldest in records dating back to 1925 according to the U.S. Bureau of Economic Analysis.

Any infrastructure projects in the U.S. will increase the nation's demand for steel and that is likely to support iron ore demand and the price of the commodity. At this point, iron ore at below $60 per ton is not exactly expensive.

Iron ore remains cheap

Iron ore is currently trading at a price that is much cheaper than just a few short years ago. Click to enlargeSource: Bar Charts

As the monthly chart shows, although the price had appreciated by almost 80% this year when it was at the highs, in February 2013 iron ore was at $157.30 per ton, and at $56 the price is over 64% lower than those 2013 highs.

The potential for an increase in steel demand in the United States could be good news for U.S. Steel Corp. in 2017. Click to enlarge Source: Bar Charts

As the monthly chart of U.S. Steel (NYSE:X) shows, the stock has been decimated since the 2008 financial crisis as it fell from almost $200 per share to the $16.54 level. U.S. steel has a 52-week range of $6.15 to $27.64 and in the middle of the trading range could offer some value as we head into next year. X pays a dividend of 1.14%. Additionally, some of the protectionist rhetoric during the Presidential campaign could lead to gains for U.S. Steel as candidates have addressed and made representations about Chinese dumping of steel on the U.S. market.

Both U.S. Steel and iron ore could offer good value at current prices if global economic conditions continue to improve and there are three signs that this may be happening.

The BDI and iron ore reflect on the state of China

The Baltic Dry Index (BDI) has had quite a ride in 2016. On February 11, the index that measures dry bulk shipping rates around the world fell to an all-time low when it traded 290. Click to enlargeSource: Bloomberg

As the chart of the BDI highlights, the index was trading at 906 on October 12. The increase of around 212% in just eight months is a sign that demand for dry bulk commodities has grown dramatically over the course of 2016. Iron ore is one of those dry bulk commodities and the prospects for increasing exports has bolstered demand for shipping of the raw material from production to consumption locales. China continues to be the world's largest consumer of iron ore, and most commodities for that matter and the increase in the BDI is a sign that the Asian nation is buying despite slower economic growth. The trade numbers out of China on Wednesday were weak but the move in the BDI is a sign that dry bulk commodities continue to flow towards the Asian nation.

This week, China devalued their currency the yuan for six straight sessions which could increase the attractiveness of the country's exports, spur economic growth, and increase demand commodities like iron ore in the months ahead. The ascent of the dollar has been a blessing for China as a weaker yuan provides economic stimulus for the Chinese economy.

Many analysts continue to project lower prices for iron ore as 2016 comes to an end and we head into 2017. However, the primary ingredient in steel is still cheap compared to prices just a few years ago in 2013. The lower yuan may stem or slow the rate of economic slowdown in China and any major infrastructure project in the United States could cause demand for iron ore to increase causing prices to remain stable or even add to gains since February. When it comes to both iron ore and U.S. Steel Corporation today's prices could look like bargains in 2017. In spite of bearish sentiment, appreciably lower prices may not be in the cards for iron ore and the lows earlier in the year could have been a spike lower and important bottom for the commodities that are requirements for infrastructure building.

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