Looks Like Iron Ore Is Back In Business

by: Seth Walters

It is no surprise to anyone following the iron ore industry that the price of this sturdy rock has suffered severe declines lately, falling from about $135 a ton in June to well below $90 now, with articles starting to crop up with analysts suggesting 2013 prices of $75 and even $50. I think this is far too bearish and I am anticipating a return to a spot pricing regime of between $120 and $150 by the end of the year.

With iron ore stocks such as Cliffs Natural Resouces (NYSE:CLF) in freefall, the price of iron ore so low, and analysts everywhere downgrading and urging people to sell these stocks, you might question why I am so very bullish on the commodity. The reason is simple - I believe that demand is returning to appropriate levels to sustain likely levels of supply at such a price. You may recall or have read that it was a 4 trillion yuan (about $600 billion) Chinese stimulus package geared towards infrastructure investment that prompted the spot price of iron ore to rally from around $60 a ton in 2009 to highs well over $150 a ton in 2010 and 2011.

China loves investing in infrastructure. The Chinese government is not about to stop investing in infrastructure. Infrastructure investments increase the productivity of their people, which has a compounding return. More productivity now means more economic product which can be invested to drive ever increasing productivity in the future.

It sometimes makes my jaw drop open when I see people writing about China overinvesting in infrastructure. In my humble opinion, it is a lot smarter to take capital and build a rail line that will ease traffic congestion, save on energy wasting, and give every person more time to pursue economic and other activities... than, say, to pump capital into unregulated financial institutions to create credit bubbles that allow people to live beyond their means and spend their money on baubles that don't provide for a long term future.

Guess which one of these approaches to economic development the Chinese government is getting behind? Maybe there is something to be said for prudent investment above wanton mass consumerism as a strong foundation for continued economic growth. Just maybe.

It seems that I just might share this view with with the Chinese government, as China just dropped another trillion yuan into infrastructure invesments within the last two days. This includes 25 urban rail projects, 13 highway construction projects, and 10 municipal service projects. And for the first time in a while, the Chinese stock exchanges are jumping up considerably on the belief that there is more to come.

Between the Chinese stimulus measures and recent ECB bond purchase promises, international stocks that are exposed to iron ore are already jumping. Fortescue Metals Group, a highly leveraged essentially pure play Australian iron ore producer, was up +11.45% in trading earlier today after a recent vicious plunge in the stock price and the departures of multiple senior executives. Less leveraged and lower cost producers have risen as well, if a bit less.

China has over $3 trillion in foreign currency reserves. This is a country that develops large segments of its economy in Five Year Plans. Would they have nearly a billion tons of annual steel making capacity now, and yet still be approving new steel production projects, if they didn't plan to make good use of that capacity? What producer would buy a capital good he had no intention of using to the fullest?

The bear case here involves some combination of the following: that China won't keep buying iron ore at levels to sustain seaborne prices at $120+ a ton, that China will subsidize the high cost (~$120 a ton cash cost) marginal Chinese iron ore producers, or that the iron ore majors Vale (NYSE:VALE), BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO), (and perhaps FMG) will attempt to ramp up production too much after the recent bloody nose they have all taken.

The increasing stimulus makes me believe the first point to be not true, which makes the second point superfluous... and after the events of recent months I would certainly expect some caution on the part of the iron ore majors, who control over 2/3 of the seaborne iron ore supply between them. If China fails to push through adequate stimulus for some reason, or otherwise fails to increase aggregate steelmaking demand relative to iron ore supply levels adequate to support the price levels seen in H1 of this year, then the bull case fails, and the (relatively) best iron ore plays are the low cost majors, who will help the iron ore price find a new sustainable equilibrium that maximizes their profit in the context of the new, lower, demand (which will put the squeeze on the higher cost producers). Even if I am being a little too optimistic about the size of my projected increase in the iron ore spot price, the very recently announced, very large Chinese infrastructure stimulus makes me confident in the medium term future direction of that price.

I also expect this new Chinese infrastructure stimulus to be bullish for met coal producers such as Peabody Energy (BTU) and Walter Energy (NYSE:WLT).

Disclosure: I am long CLF, BTU. 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.

Disclaimer: This article does not constitute a recommendation on my part to sell or purchase any security. Please do your own due diligence before making an investment decision.