Much has been made recently of a bear case for iron ore prices, with economist Andy Xie warning of $50 a ton iron ore by 2013, and the resident iron ore bear at Seeking Alpha surmising that ore prices, which were around $90/ton about a month ago, will stabilize below $100 in the near term and below $75 later on. I think that the bears have this one totally wrong, and continue to believe that spot prices will be somewhere within my target range of $120 to $150 by the end of 2012, that I forecast when ore was still sub $90/ton. Since then, iron ore has passed $115 a ton and retraced a bit to around $105. I anticipate it will come back up in the coming week and continue to rise to meet my target price range by year's end. This article will serve as a platform for presenting the case to justify this opinion.
1) Iron ore prices are determined in the spot market by supply and demand, and contract prices are determined by the spot market.
2) Demand is often described in terms of a cost curve of the marginal costs of production and shipping required to supply it. A recent estimate of the iron ore cost curve is below, courtesy of JP Morgan. The spot price may fluctuate in the short term above and below the cost curve, but it will fluctuate *around* the marginal supply cost of the highest point on the curve, relative to demand. Thus, we can see from the curve that a drop to $75 a ton iron ore would require seaborne iron ore demand to be reduced by 40%, and $50 a ton iron ore would require more like an 80% reduction in world demand. These are disaster pricing scenarios which would require a significant catastrophe to unfold, not a normal course of action in the business cycle.
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2a) In the short term, demand may spike or contract. A demand contraction will cause the steel mills and iron ore traders to stop buying iron ore where possible. They will sell it with the plan of being able to acquire more cheaper at the bottom. This is what we saw recently. A demand spike is another possibility, and I believe we are about to see one of these soon.
3)The long term supply of seaborne iron ore is largely controlled by the "Big Three" in iron mining - BHP Billiton (BHP), Rio Tinto (RIO), and Vale (VALE). Together, these three companies control about 70% of the iron ore supply. It is an enormous and growing world market of over 1 billion tons a year, the majority of which is consumed by the People's Republic of China. With this level of control, we should assume that the big iron ore miners will be able to set prices for their ore, within reason, according to how much they ship to their consumers.
3a) It is impossible for iron ore prices to go back to the prices of yesteryear without significant and unlooked for changes occurring. The miners' costs have been driven up in just about every country in the world by opportunistic governments levying additional taxes and royalties on mineral production, negotiations with labor unions and higher and higher salaries being paid to mine workers (even truck drivers at the mines in Australia earn hundreds of thousands of dollars a year), and inflation. This will inspire the miners to be careful to produce and ship an amount of ore that lends itself to maximum profitability over the operating year. The temporary plunge of ore prices we saw recently was a perfect excuse for mining companies to ax thousands of their overpaid workers, and they did so with aplomb. This wasn't just a cost cutting measure, it was a production cutting measure, too.
4) We can therefore see from the iron ore cost curve that the average spot price we should expect to see for sustainable supply of the market is around $120 or $130, assuming that neither demand nor supply grow. It is reasonable to expect that demand growth may be slow for a year or two due to the economic slowdown in China, but it is also reasonable to assume that the Big 3 iron miners will be able to adjust their supply response as needed very easily. It's as simple as not putting it on the boats to Qingdao Port. It is not appropriate to think of this point as an absolute price floor, as many have said. When mills keep stocks of 30 days worth of production on hand, as they did before the recent plunge, they can afford to stop buying iron ore for 2 weeks entirely, or buy it at half the pace for 1 month. This sort of behavior, which the Chinese steel mills engage in when end user demand for steel becomes weak, is unsustainable. In fact, as soon as they reach the end of their rope and need more ore to keep their mills running, the resultant buying spate sends the price roaring back up. Ultimately, this kind of short term behavior may cause brief fluctuations in the price, but as long as yearly demand remains unchanged, the average spot price point will hold.
5) Finally, we have plenty of near term catalysts going to push us right back up to this spot pricing equilibrium point. They are
A) Chinese steel mills are currently down to about 2 weeks of iron ore on hand at the mills. This is considered their bare minimum, as ore deliveries take this long. Letting ore levels get too low would expose them to real panic buying and tremendous prices in the future, as well as possible production interruptions, which are not good for the mills. Maintaining normal ore buying rates will allow the price to drift back up to the equilibrium point defined by the cost curve.
B) The time before the coming Chinese winter season is traditionally a time to stock up on iron ore, as it is more difficult to transport through snow and ice than in more moderate weather conditions. Keeping steel inventory on hand at 2 weeks worth doesn't seem like a workable option throughout this time. Winter restocking, and the attendant push up in spot prices that will follow it, seems necessary.
C) The Communist Party of China will convene November 8th to choose the new government. Further infrastructure stimulus measures are rumored, and I do not believe any time will be wasted in announcing or implementing them. The steel industry is and has for many years been important for providing lots of jobs and social stability in China. I see these continued stimulus measures as aimed as stabilizing the end user demand of the steel market, rather than increasing it a great deal. It will then be allowed to grow organically, receiving support as needed from the Chinese government, which is backed by trillions of dollars in foreign currency reserves and all the authority that a command system famous for using a stern hand when it feels the need could want. I believe this will cause the end user demand in steel to be entirely worked out in Q4 2012 or Q1 2013, and I think that the Chinese steel mills will try to get in before then and buy while iron ore prices are still relatively low, so the iron ore market should recover before the steel market.
6) Finally, I will address the points of the bear case that I have seen.
i) Bear point: Chinese steel has massive overcapacity and there are a hundred million tons of iron ore laying around in warehouses, and steel piled high.
Counterpoint: because China is a planned economy, the steel overcapacity is as much of a fiction as the U.S. debt, given the Federal Reserve's demonstrated willingness to print money. Furthermore, the amount of iron ore and steel onhand is only about two months worth of use, and is constantly being cycled through. One might even imagine that having a national steel stockpile is part of the Chinese national defense plan, as it is pretty hard to fight a long war without stockpiles or adequate fast production capability of this and other industrial metals on hand. Given that they have difficulty producing enough ore for themselves and rely on imports, it seems reasonable that they would keep some on hand to be able to properly ramp up for a war... as a precautionary measure if nothing else. War is a tail risk event that a shrewd nation with a centrally planned economy undoubtedly is likely to prepare for.
ii) Bear point: iron ore producers like BHP Billiton are saying scarcity pricing won't last. Doesn't this mean that iron ore is going down, down, down?
Counterpoint: as I noted in the first comment to the recent SA article promoting this idea, BHP has plenty of strong material incentives to be less than lucid with its forecasting language. In addition to this, the end of scarcity pricing means that the ore price will not outrun the cost curve to nearly $200 a ton (and certainly if it does, not for long) like it did in the recent past, not that it will sink far far below the equilibrium point of the cost curve.
iii) Bear point: China is in for a hard landing. China has an investment bubble.
Counterpoint: The Chinese hard landing has been defined as less than 7% official GDP growth rate in a year. I have no real opinion on this macro issue, except to say that the lower GDP starts to plunge, the more strongly the CPC will engage in infrastructure stimulus backed by their massive cash reserves and ability to order the Chinese people to do what they want them to. On the investment bubble, I would liken what China does with fixed asset investment as being a stimulus measure analogous to what the United States does with buying mortgage backed securities via the Federal Reserve. The difference is that the United States is attempting to support and raise the price of houses to make people see them as desirable investments and also stimulate the housing market with ultra low rates to prompt buying interest, while China is just building a ton of housing stock and not letting its people in unless they work their butts off (producing more goods and services in the process) to get ahold of the money to buy in. Since the Chinese government owns ALL the land in China, they can decide how hard to make everyone work to get ahold of a place to live and keep it. It is a pretty powerful stick, and you need only to look at China's rise to see that it works. History will tell which method of stimulus works better in the end - but at least at the end of China's stimulus there are more goods in the country for the people of the country to use, all monetary fictions and play aside.
And finally ... some beautiful incipient head and shoulders bottom chart action for those who put much stock in these things. Prettiest on Cliff's Natural Resources (CLF), in my opinion. These chart patterns, assuming they develop, are just starting their final leg up. If they break resistance at the neckline, that could be taken as a technical buy signal. With CLF at a P/E of 3.8 and VALE at 5.8, the argument can definitely be made that there are some severely undervalued players in this space.
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DISCLAIMER: This article is for informational purposes only, and you should do your own due diligence before purchasing any security or other financial instrument.
Disclosure: I am long CLF.
