How To Interpret China's Decision To Support Its Iron Ore Industry

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Includes: BHP, FSUGY, HEVY, RIO, VALE
by: MarketGyrations

Summary

China has taken action to support its iron ore industry after prices continue to drop.

China's move means that it doesn't want to rely on foreign supplies even if they're cheaper.

Iron ore suppliers outside of the big four are now at even greater risk than before.

The decline in the price of iron ore has continued and broke below $50 at the start of the second quarter in 2015. This is understandably causing a lot of problems for suppliers of iron ore. Especially since the drop in prices for a ton of ore with 62 percent iron content comes after many years in which the market was booming.

Among those most affected are the domestic suppliers in China's iron ore industry. That's because current prices are below the cost of production for many of them. However, recent reports indicate that the Chinese government has decided to step in to make sure that domestic suppliers of iron ore can continue to operate and do business.

Why iron ore from China is more expensive than those from Brazil and Australia

Generally speaking, the iron ore in China tends to be relatively expensive; at least in comparison to the iron ore available to the largest miners of iron ore. They are Vale (NYSE:VALE), Rio Tinto (NYSE:RIO), BHP (NYSE:BHP) and Fortescue (OTCQX:FSUGY). The first is located in Brazil and the other three companies extract their iron ore in Australia.

The reason why iron ore mined in China tends to be pricey is that the amount of iron in the ore tends be relatively low, typically somewhere between 20 to 40 percent. In contrast, the amount of iron in the ore available to Vale can be as high as 67 percent. This means that iron ore companies in China need to extract a lot more ore to get the same amount of iron as their foreign competitors. This raises the price.

The pros and cons of supporting domestic suppliers of iron ore in China

In a perfect market low-cost suppliers would displace high-cost suppliers in the current environment where supply is outpacing demand. China would actually benefit in this scenario by paying less for the iron ore it needs for its steel industry, which is by far the largest in the world and accounts for roughly two thirds of the global trade in iron ore by sea.

On the other hand, the loss of domestic suppliers of iron ore would make China dependent on a small group of foreign suppliers. Furthermore, most of them are also concentrated in one country, namely Australia. Any supply disruption in that particular area could therefore have an outsized impact on the local steel industry. That's not good from a business standpoint.

China is willing to pay more in return for security

There are two options available to China. The first is to let local suppliers of iron ore go out of business due to low prices and replace them with the big iron ore mining companies that can supply cheaper iron ore. The other is to pay more for iron ore and prevent the possible formation of a monopoly or duopoly in the iron ore market that has the potential to set or control prices for iron ore.

China's decision to prop up its miners at the cost of paying more for iron ore implies that China thinks that the second viewpoint makes more sense. Price is not everything. Any manufacturer that relies on just one or two suppliers runs a much greater risk of experiencing interruptions to production due to supplier issues.

In a hypothetical scenario where one or two mining companies supply all the iron ore to China, they could in the future collude to artificially raise the price of iron ore in the absence of alternative suppliers to China. China could be forced to pay much higher prices than needed. To help mitigate this risk, supplier diversity is a must.

Implications for suppliers in the iron ore market

China's decision is support its miners is a signal that it's not comfortable with the idea of being overly reliant on outside suppliers. Assuming that China's steel production remains at the current level, the country's demand for iron ore in 2015 will amount to around 1200 million tons in total according to data from the China Iron and Steel Association.

If domestic suppliers are allowed to maintain their current share of around one fifth, imports will amount to four fifths or between 950 and 1000 million tons of iron ore. That's the most China seems to be comfortable with and can be expected to import from abroad. China's decision to protect its miners effectively reduces demand that external suppliers will have available to them.

If Rio, BHP, Vale and Fortescue stick to current production targets, the four will have about 1050 to 1100 million tons of iron ore that they need to sell in 2015. Once you account for demand in other markets besides China, there should be enough room in the market for the big four miners. Vale and Fortescue will feel more pain than Rio and BHP, but all should make it through.

However, the same can't be said of the second-tier suppliers. They are the biggest losers with China's latest move and are now caught between a rock and a hard place. Prior to China's move to prop up its miners, there was a clear pecking order based on how much it cost to mine for iron ore. The assumption was that domestic suppliers in China would be among the first to go due to their high cost of mining for iron ore.

Other external suppliers besides the big four tend to be cheaper than China's internal suppliers, but their costs are not as low as those of the big four. China's intervention in the iron ore market effectively shifts the pressure away from its own miners and unto the mid-tier suppliers of iron ore.

This brings forward their day of reckoning and these miners will probably be driven out at a faster pace than previously anticipated. Any hope by some investors that they could somehow survive has been vastly reduced now that China has made it clear that its local miners will not be facing the brunt of the impact in the collapse of iron ore prices.

Conclusion

The market for iron ore will not recover as long as the balance between supply and demand has not been restored. For that to happen demand must either increase or supply must be reduced. Since the former looks highly unlikely in the immediate future, the latter is what needs to happen.

Besides the elimination of smaller and costly suppliers of iron ore, the big miners should also reassess whether current expansion plans in the iron ore industry are really warranted. There should at the very least be some adjustments to production targets and expansion plans.

While Rio and BHP have the advantage over Vale and Fortescue due to their lower costs, the news from China is a hint that it doesn't want supplies to be monopolized by a few. It's wise for any business that the wishes of their most important customer be taken into account. In the meantime, it's best to stay away from iron ore companies until the market has sorted itself out. It's not worth the risk for most investors.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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