The iron ore spot price has collapsed from $135 per ton to $111 per ton in just two weeks thanks to steel de-stocking, despite a broad-based commodities rally that began in July. Unlike copper (JJC), iron ore can't be stored and in an overcapacity situation, producers have to sell distressed stock.
While $120 per ton is the marginal cost of iron ore in China (which should provide a theoretical price floor), Citibank analyst Scarlett Chen argues that iron ore could go as low as $90 per ton, driven by steel de-stocking. Scarlett believes the excess capacity situation is out of control and that steel companies are set to see losses for every single quarter of 2012 - the first time in history.
China has been running steel production at a very high level -- 720 to 750 million tons -- partly to do with over-exuberant expectations of a big stimulus, and partly because smaller steel mills further up the cost curve start producing every time price ticks up marginally, with no real rationality behind it.
But current demand just isn't there to justify this production, and Chinese authorities have expressly stated that any new round of stimulus will be much smaller than the ¥4 trillion stimulus of 2008, and focused on domestic consumption, not infrastructure.
Citigroup Global Equities Team Vice President Anita Tanna argues that the actual level of steel production over the longer-term will be closer to 350-400 million tons as the Chinese economy adjusts away from an investment-led model to a more consumption-led model.
Miners are taking the hit
Mining equity earnings have been downgraded by 18% in the last five weeks alone. Normally when commodity prices weaken, so does the Australian dollar. But the Aussie remains strong, and combined with high oil prices, strong foreign exchange pressure and weak commodity prices, the cost base for mining companies is up 15% over the last month says Tanna -- not pretty.
The earnings downgrades are already taking their toll on cashflows. Rio Tinto (RIO) funds its capital expenditures and dividends out of operating cash-flow, which is now just $3.2 billion -- less than in the 2008-09 crisis -- meaning it may not be able to cover capex and dividends.
Wait - mining equities have rallied 10% in the last two months; what's going on?
European miners have rallied 10%, so are we missing something here? Yep. Mining equities were down almost 40% in the last 12-18 months before the July rally, so they are vulnerable to squeezes / dead cat bounces on pure China policy easing hopium. But the trend lines are in a downward direction and recent excitement about policy easing is overdone.
British miner Anglo American (AAUKY.PK) recently delivered its worst return on equity since the Great Depression. The only company to have shown real signs of reevaluating its capex spend thus far is BHP Biliton (BHP), which remains Citigroup's preferred name versus the rest of the sector.
Again, it's very concerning that despite the rally in many commodities, core "building blocks" like iron ore and coal can't get going. This truly tells you if the global economy is at work. Iron ore is a leading steel indicator, and it is plunging, not stabilizing like steel prices should suggest.