Iron Ore, The 'Magnetic Metal'

Includes: BHP, RIO, VALE
by: Vandana Bharti

Ire ore had an amazing rally of 1770% in 11 years. It is one metal that more or less ignores all concerns of a so-called economic recession haunting the entire world. The spellbound rally in the prices is narrating the same story. We have seen an uninterrupted rally in iron ore, with prices trading just above the level of $10 in 2000, that has fascinated the entire world. It touched a high of $187 in 2011.

Iron ore is believed to have been extracted through the process of smelting as early as 1800 to 1200 B.C., and most likely began in India. It is used primarily in structural engineering applications, for maritime purposes, in automobiles, and for general industrial applications (machinery). Such a wide array of uses helps it to be in evergreen demand and makes it recession-proof to some extent. However, it is not immune to economic growth.

Iron Ore Consumption

World consumption of iron ore grows at 10% per annum on average, with the main consumers being China, Japan, Korea, the U.S., and the European Union. Sales of iron ore and pellets will likely grow 4.3% in 2012. However, recently we have seen some decline in consumption. Ever-increasing demand, however, from Asian economies is ultimately giving an upper hand to demand. In the meantime, we have seen the supply-side squeezes. World production averages 2.5 billion metric tons of raw ore annually. Major iron ore mining companies continue to reinvest profits in mine development, but increases in production capacity may outstrip expected consumption within the next few years.

China's Role

Like with other metals and commodities, China also takes center stage with regard to iron ore. As the biggest iron ore importer in the world, China accounts for about 60% of global trade in it. China's steel sector imported a record 686 million tonnes of iron ore last year, up 11% from 2010, and at prices that, on average, were up more than 14% from the previous year. Despite some slowdowns in the housing sector, demand increased and the trend is likely to be continued in future, keeping pace with the ongoing infrastructure development.

However, the country has weak influence over pricing, which creates problems for domestic steel mills and iron ore traders. To become a price setter instead of a price taker, China has launched iron ore contract in future exchange.

Africa, Future Home for Iron Ore

Africa is home to huge iron ore reserves, matching those of Australia in terms of quality. Currently, about 200 iron ore projects are estimated to be in contemplation across the continent. Nevertheless, Africa does not have a sufficient port and rail infrastructure to ensure massive quantities of iron ore supplies. Unless it improves its infrastructure, the world will not be able to take the advantage of this huge reserve.

Pricing Methodology

In the last 40 years iron ore prices have been decided in closed-door negotiations between the small handful of miners and steelmakers. The deal made by these two groups became a benchmark to be followed by the rest of the industry. Gradually, participants shifted to short-term pricing. This move follows a switch to index-based quarterly pricing by the world's three largest iron ore miners -- Vale (NYSE:VALE), Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP) -- in early 2010.

To offer transparent pricing, a number of financial exchanges and/or clearing houses around the world have offered iron ore swaps clearing. The CME group, SGX, London Clearing House, NOS Group and ICEX all offer cleared swaps based on the steel index's (TSI) iron ore transaction data.

At present, trading in the spot market for seaborne cargos is done directly between buyers and sellers. People widely use Platts iron ore index for price reference, with some skepticism as to its transparency and fairness by steel companies and iron ore traders from China, Japan, and South Korea.

Industry-wise, there are three major giants -- Vale, BHP Billiton and Rio Tinto -- dominating the world iron ore industry. Their trading activities have a strong influence on prices.

Price Outlook

Prices are expected to be in upside territory on concerns that supplies from Brazil, the world's second-biggest exporter, will be lower than expected due to "substantial delays" to new projects and expansions. The export market is likely to remain in a deficit in 2012 and 2013.

Though prices moved down in 2011, it should be considered as a healthy correction after a multiyear rally. Demand is still strong from Asia, particularly China, amid tight supply. Industry experts expect supply constraints for iron ore to continue for at least three to four more years. India, the world's third-largest iron ore producer, has banned iron ore exports due to illegal mining activities, which will further squeeze the supply. The crisis in U.S. and Europe is a challenge, but at the same time there is strong demand from China, Japan, South Korea and India. Furthermore, difficulties in bringing new iron ore production capacity onstream are also supporting higher prices. If new supply comes from Africa, that may cap the upside. Additionally, China's economy is facing risks of weakening exports resulting from the European debt crisis, as well as internal uncertainty about a deceleration in housing investment; that is also a concern for the market.

Prices should remain on the higher side for three to four years. It should trade in a range of $120-$225 in the future. $160 should be the average price for 2012. GDP numbers will set up the pulse of price movements of this core commodity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.