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Back on September 19, BHP Billiton's (NYSE:BHP) Alberto Calderon stated:

No repeat of iron ore scarcity pricing

What did he mean? What's this "scarcity pricing" and why is it important?

Scarcity pricing

Everyone knows how pricing results from the struggle between supply and demand. However, at the edges of this struggle, weird things happen. Such is the case when demand so overpowers supply that one can talk about "scarcity." That is, there's not enough supply to satisfy all the demand.

That was what happened with iron ore in the last decade. China's growth and demand for steel, and hence iron ore, was so strong that its demand for a while grew faster than the entire world could supply it.

Usually pricing in a market will tend towards the marginal production cost of the least efficient producer that's still needed to supply all the market. In the case of scarcity pricing, however, what happens is that the last bit of supply takes a wild increase in price for a small increase in supplied volume. You're really scrapping the bottom of the barrel. The little inefficient producers which can only bring a little product to the table at high cost (Fortescue's estimate of the 2010 iron cost production curve, reproduced below, shows how this works with the hockey stick appearance of the cost curve).

(click to enlarge)

Worse still, if even bringing the little inefficient producers is not enough to satisfy all demand, then you get higher and higher prices until demand is rationed by buyers quitting from participating in the market.

During the last decade, due to China's exploding demand, both such events were true (small, inefficient producers setting the price and price rationing of demand).

Consequences of scarcity pricing

As we saw, in an environment subjected to scarcity pricing, a small difference in demand can lead to huge jumps in price (because only small, inefficient producers are servicing that last bit of demand, or because price needs to go up until buyers quit). Now, the problem here is that this works both ways. A small drop in demand or a small increase in supply, under these conditions, can have a large impact.

Additionally, under these conditions every large, low-cost supplier, such as BHP Billiton, Rio Tinto (NYSE:RIO), VALE (NYSE:VALE) or Fortescue, is seeing large margins. And obviously, these producers are investing in further production capacity. So the small increase in supply is certain to come.

Add to that China's slowdown, namely in basic materials due to its residential boom stagnating, and you got a situation where increased supply meets stagnated demand under conditions of scarcity pricing. So the scarcity pricing goes away.

Example from another industry

There was another industry, just like iron ore, which was subjected to scarcity pricing during the last decade. It, too, got faced with demand which couldn't be satisfied promptly, because of the long lead times prevailing in that industry. That was dry bulk freight. Ships took time to build, even if there was no particular barrier to build them. Much like iron ore bodies are known and can be mined, only it takes a lot of time and investment to mine them.

This is what happened to dry bulk prices (source: InvestmentTools.com):

(click to enlarge)

However, as new ships hit the market left and right, the scarcity pricing ended. And with it, the consequences for stocks which participated in the illusion that such pricing was forever were brutal. Dryships (NASDAQ:DRYS) was the poster child of that particular illusion, and this is how it traded:

(click to enlarge)

Iron ore, long term

So what does scarcity pricing going away, as per BHP, mean? It can mean a return of the iron ore pricing towards prices that prevailed before scarcity pricing set in.

And at what prices did iron ore trade before the boom (source: IndexMundi.com)?

(click to enlarge)

As we can see, iron ore prices which prevailed during the last decade, under scarcity pricing, were quite a bit different from those that preceded them. Obviously in the meantime there was also a measure of inflation and demand is not going away, but still this illustrates the problem clearly.

Now, I don't expect that pricing to come back. But still, the prices from the recent past, prices between $100/ton and $200/ton for 62% Fe, those prices will probably be history over the long term - those were scarcity prices. And scarcity is mostly over as we speak.

Conclusion

It's likely that, as BHP says, scarcity pricing in iron ore is about to be done for good. This will mean stable prices well below those the market has grown accustomed to in the last 8 years or so. My own opinion is that short term prices will tend to stabilize below $100 per ton, and longer term (2014 onwards), prices will stabilize below $75-$80 per ton.

A measure of this is already in the prices the producer equities trade at, but some companies such as Fortescue or Cliffs Natural Resources (NYSE:CLF) might run into trouble under this scenario, due to high debt (Fortescue) or higher costs (Cliffs Natural Resources). BHP should handle this change gracefully due to its higher diversification and awareness.

Source: BHP Billiton: Scarcity Pricing And What It Means