Iron Ore: BHP's Decision Is Positive, But More Is Required

by: Price Point


After falling to a low of $46.70 a ton, iron ore prices recovered more than 20%.

BHP’s decision to take a slower path to expansion is positive for prices.

However more closures/suspensions are required for prices to stabilize.

Iron ore prices fell to a low of $46.70 a ton on April 2, but since then have recovered to $57 a ton on April 24. Both the hopes of stimulus spending in China and BHP Billiton's (NYSE:BHP) announcement to slow its expansion plans added to the recent rally. However, I do not believe a rally driven by sentiment will be sustainable as the fundamental reality of the iron ore market remains unchanged. Iron ore is still vastly oversupplied and the situation isn't expected to change much in the next few years either as more mines are commissioned.

Nonetheless, BHP's decision to slow its iron ore expansion capacity to 290 million tons per annum [mtpa] is the start of the kind of supply response needed from the big players to stabilize prices. However, the actions of one player alone will not be enough. All four big players, including BHP, Vale (NYSE:VALE), Rio Tinto (NYSE:RIO), and Fortescue Metals (OTCQX:FSUMF) will not only have to slow down their expansion plans but also cut output at least from their higher-cost mines. According to Michael Zhu, former global sales director at Vale, while most supplies from the largest producers are low-cost, about 10-20% of their output does have higher costs, and such output should be cut to stabilize prices.

BHP Takes A Slower Path To The 290mtpa Capacity

BHP, in a response to lower iron ore prices, announced its intent to put brakes to its expansion plans. The company said that its hopes to get to 290mtpa WA Fe run rate without doing its Inner Harbor debottlenecking project, ensuring a slower path to the 290mtpa capacity. According to Credit Suisse estimates (report published April 22, 2015); these actions will result in capex savings of ~$500 million reducing capex spend on the expansion from 225mtpa to 290mtpa from $30 per ton of annual output to $23 per ton.

The installed iron ore infrastructure continues to exceed the company's expectations. Earlier the company believed that it needed to spend more money on port infrastructure but now it thinks it can achieve the expansion target without spending more on port. But obviously it will take longer than before. Before this announcement, the company planned to reach the 290mtpa run rate in FY17. The recent announcement should delay the expansion by at least 2 years (CS estimates).

Perhaps the Market Got A Little Too Excited

While the news of BHP putting brakes on its expansion plans is indeed positive for the iron ore industry but the supply forecast for the major iron ore producers has only changed modestly. On the other hand, demand story remains weak. Both BHP and RIO have been operating at the assumption that China's steel production would continue to grow and would peak at around 1 billion ton towards the middle of next decade. While others, in particular the World Steel Association [WSA] thinks the peak might already be here and we are perhaps "at the beginning of a very long and flat peak." BHP's recent decision is an admission on part of the company that perhaps its earlier forecasts were too optimistic.

WSA expects Chinese steel demand to fall by 3.3% this year and a further 0.5% in 2016. The market is showing signs of maturity as China moves to slow economic growth. China's new leadership is trying to shift the country's growth model from its investment and credit-fueled addiction to a more sustainable footing. Xu Zhongbo, the chief executive of Beijing Metals Consulting, who expects Chinese steel production to decline by 5% per year over the next decade recently said, "Steel production in China will keep decreasing, now is just the start. The total demand in China will decrease because the economic structure has changed. The future economy is not so steel-intensive."

China the Biggest Worry

China is experiencing the lowest growth in years. In the first quarter of 2015, the economy grew by only 7.0% Y/Y, down from 7.4% a year before. Since the global financial crisis, the GDP deflator dropped to negative for the first time amid disinflation in consumer prices and deflation in producers' prices. Industrial production grew by only 5.6% Y/Y, versus Bloomberg consensus estimates of 7.0% growth. While infrastructure investment growth was improved by central government driven projects, it did not result in overall improvements in growth.

While these statistics are weak, the actual growth momentum is probably weaker, judging from expert commentary and the recent performance in industrial production. The slowdown of the industrial production growth is broad-based rather than driven by particular factors, depicting overall weakness in the economy.


Despite the recent rally in iron ore prices, the commodity's troubles are far from over. The world's four largest iron ore producers continue to boost low-cost output and add to the supply glut. On the other hand, steel production in China is expected to decrease. The net result is drop in overall iron ore demand. 2016 is likely to be even tougher year than 2015 as steel production in China continues to decline, Roy Hill mine comes to market, BHP adds 25Mtpa, and Rio Tinto continues its ramp up towards +350Mtpa output.

While BHP's decision to take a slower path to its expansion plans is positive, further, and preferably bigger, actions are required. The iron ore market needs further closures of sticky iron ore supply through 2017-18 as Brazilian supply tons continue to enter the market.

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