Iron Ore Crash Worsens

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 |  Includes: BHP, CLF, FSUMF, RIO, VALE
by: Paulo Santos

The intention of this article is just to update on what's happening in the iron ore market in China. Basically things are getting worse fast. When I last wrote on iron ore, spot prices were still hovering at $110 per ton, and futures were around $99 per ton.

Today, these have fallen to around $90 spot, $86 futures (and these aren't updated for August 29 yet!). It should be kept in mind that my last update was just last week. So spot prices fell 18% and futures fell 13% in a single week.

Where it goes from here, short term

One important thing to understand is that there are still few signs of steel production slowing down meaningfully in China. Clearly the market is oversupplied, but very few mills are throwing in the towel just yet. This means that the iron ore panic still has to contend with a significant, if temporary, reduction in demand.

On the other hand, the first frail signs of reduced Chinese iron ore supply are already appearing, as the very highest cost suppliers fall off the map rather quickly. These haven't been enough to stop the price drops, though.

What's more likely to happen given these conditions, is for the panic to continue and reach for lower prices, which will eventually choke off not only internal supply, but even some importers.

Where it goes from here, medium to long term

One of the things which impresses the most while going through the major producers' earnings reports, is how every single one of them is expanding production and has plans to expand production in the near and long term. Be it Rio Tinto (NYSE:RIO), Vale S.A. (NYSE:VALE), BHP Billiton (NYSE:BHP), Cliffs Natural Resources (NYSE:CLF) or Fortescue (OTCQX:FSUMF), every producer has either brownfield developments, greenfield developments, debottleneckings, etc that enable them to both show increased production now, and expect increased production in the near and medium term future. Sometimes, the expected increased production is massive when compared to the entire market, for instance Fortescue expects to triple production into mid-2013, bringing in an additional 100 million tons of iron ore. To have a feeling for how much this is, BHP's production in the latest fiscal year was 179 million tons, so Fortescue is gunning to bring in an additional 55% of the entire BHP production within the next year. The market, as it is today, doesn't seem able to handle this.

Not only is every large producer increasing production and planning on increasing near term, medium term and long term production significantly, but every small producer one finds is also doing the same. There are countless news of 2-3-5-6-10 million ton projected increases in production from small players. There are also entire new mines about to enter production, such as the 27.6 million ton Sino project which has seen countless delays and is now expected to come online during November 2012.

What does all of this mean? It probably means something BHP has already expressed in presentations - that the worldwide iron ore demand is about to be met by increased capacity coming from low-cost sources. Such has the potential to transform iron ore pricing.

Iron ore pricing

As in most markets, iron ore pricing tended to be established by the highest marginal cost producers needed to meet demand. As new low-cost supply comes online, the highest cost margin producers will have a lower and lower cost, and equilibrium prices needed to supply the market will be lower and lower.

We know that the largest producers have costs below $50 per ton and will in all likelihood continue to be profitable. However, as prices are set lower and lower, they'll be less profitable. At this point, given all the new production capacity that's expected to come online, together with the likelihood of stagnated demand in China for some time, it would seem likely that iron ore will first find an equilibrium price below $100 per ton, and will then converge to a pricing regime that's similar to what existed before this decade's China boom. That would mean $75 per ton and below.

Conclusion

The iron ore crash I have been predicting has already happened. This last week saw an intensification of the crash. Right now the focus turns into trying to understand the implications for the medium to long term.

The first signs indicate that it's likely iron ore will revert to pricing that will be consistently below $100 per ton, with below $75 per ton being possible over the longer term as more low-cost projects come online.

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.