The Unsustainable Past And Unattractive Future For Iron Ore Producers

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Includes: BHP, CLF, RIO, VALE
by: Jesse Moore

Summary

Cratering investment in Chinese infrastructure will structurally decrease demand for the next decade.

Sticky supply due to the cost of mine shutdowns will ensure the market remains oversupplied for several more years.

The prisoner's dilemma for iron ore companies will maintain a long-term price war that will endanger every producer's balance sheet and destroy shareholder returns.

Introduction

The iron ore price has plummeted recently and made many headlines. In this article, I will attempt to explain the decline with simple quantitative examples, and provide an overview of the future for the commodity. I'll examine:

  1. Demand, with a focus on Chinese steel and infrastructure
  2. Stickiness of supply and the reasons for it
  3. Why breakeven costs are misleading when considering mine shut downs
  4. Prisoner's dilemma and why iron ore will continue to be a victim of self interest
  5. Wrap-up

I will focus on what I consider to be a few of the important data points in each section.

Source : indexmundi.com

Crashing Demand

We all know that demand for iron ore is weakening, but how bad is the situation? Zhu Jimin, the deputy head of the China Iron Ore Association, has stated that demand is crashing and that "Although China has cut interest rates many times recently, steel mills said their funding costs have gone up." (Bloomberg). The second statement is more worrisome than the first. China produces over half the world's steel and consumes over half the world's iron ore. Rising funding costs for Chinese steel mills mean that the Chinese banks have lost confidence in the industry. In many places, Chinese steel mills are a center of local politics, and while the Chinese steel mills may remain difficult to shut down, they will eventually begin running underwater. Closing steel mills collapse the price of seaborne iron ore even further as a larger percentage of Chinese iron ore demand can be met locally, cratering the price of seaborne iron ore.

Data Source : (WorldSteel)

Forbes recently posted a stunning visual of the growth in Chinese consumption of concrete over the past three years, with China consuming more concrete in these last three years than the USA did in the entire 20th century.

Source : (Forbes)

That is a monumental amount of concrete. And where does the concrete get consumed? In the same places steel does. About 50% of both materials share uses - highways, bridges, residential construction, commercial construction, etc. In fact, you will hardly ever find concrete without steel bound amongst it. China tops the world with over 50% of the world's cement production.

If we think about this on the larger scale, this has some serious implications for the demand for these commodities. China has been in a period of accelerated catch up for the last two decades. This catch-up period is seen in infrastructure. Hence, the boom in commodities as one of the world's largest populations industrializes.

Source (Hofstra)

It is simply not possible for China to continue building infrastructure at the same frenetic pace that it has in the past. We will see a slowing of the pace of construction, followed by a bending of the curve similar to that of the USA. As China's infrastructure ascent was much faster than the USA, the bending of the curve will occur over a much shorter time frame. There are only so many cities to connect. Declining construction will lead to a long-term contraction of steel demand that will be felt for a long time as the boom phase ends. Steel will have slower descent than something so tied to infrastructure as concrete. However, other industries will not be able to make up for the decline in steel consumed by infrastructure in China. It is unsustainable for 20% of the world population to use 50% of the world's steel for more than a few decades.

Source : (WorldSteel)

Sticky Supply

Supply is incredibly sticky in iron ore for a few reasons. The scale of most mines is quite large, as the only way to make money is to produce high volumes, resulting in substantial costs in putting a mine into care and maintenance (the same thing for restarting a mine). Large swathes of the operating costs of mines are linked to long-term contracts subject to penalty rates, or a lump sum payment. If the miner owns its equipment, then it can sell this at auction or the salvage yard after a large write down to the balance sheet. Write-downs will have implications for the high debt that most iron ore companies carry as debt covenants start to bite.

A recent example was headlined by miningweekly.com here, covering a Cliffs Natural Resources mine (NYSE:CLF). The closure of this iron ore mine, estimated at CAD$650-$700 million, resulted in the sale of the mine to Champion for CAD$10.5 million and the assumption of roughly CAD$42.8 million. That is a massive cost to bear for shutting down a mine and selling it for next to nothing. These decisions will be put off as long as possible, specifically outside of North America, where activist investors are less present to 're-align' management's priorities with shareholders.

After all that, one needs to consider the position of the management running the company. In the case of a junior company, does a CEO deserve a multi-million-dollar salary for running a company that has no operations? The answer to that is likely no. A management team in a small company will, therefore, delay the decision of going into care and maintenance as long as possible. The more likely scenario is that many small companies will high-grade mines and ramp up production to pay the bills. This is specifically prevalent in smaller companies that do not have other operations to tide them over. In many companies, this results in continued commodity price pressure. Even BHP (NYSE:BHP) and Rio (NYSE:RIO) have all but decided to push production even further.

Breakeven Costs for Miners

There are constant discussions regarding breakeven costs. While these are informative, I believe them to be misleading. The Sydney Morning Herald provided the following Citi chart showing breakeven costs for various miners back in April.

Source (smh.com.au)

The reason I believe breakeven costs to be misleading in shutting down a mine is that a lot of costs exists in shutting down a mine, and another large cost exists in restarting production. As discussed above, a mine can easily cost nearly a billion dollars to shut down. This mine produced around 7 million metric tonnes/year, meaning large mines could easily top that figure. All these costs need to be weighed, along with the management imperative mentioned above and taking into account supply and demand data in order come up with the best economic scenario.

In the management's realm, it is easy to paint a rosier picture for producing when you add up all these costs of a shutdown (whether temporary or permanent). This is one of the reasons that the value of bonds in iron ore miners is dropping fast. If the infrastructure boom in China is truly over, it is difficult to imagine any of the small miners paying off their debt in the future. The majors will survive, however, in a state of a decrepit balance sheet. It will take years for supply and demand to move into sync again, if not a decade. Rapid and widespread shutdowns would need to occur, and many companies will need to shut down to meet the pace of slowing Chinese demand. I am of the firm belief that many management teams will hold on as long as possible before throwing in the towel. At the end of the day, there is not much value to these small companies that can not pay off their debt as the majors wait to buy their assets after bankruptcy.

Prisoner's Dilemma

Game theory lends us an example why iron ore producers will:

  1. Continue to produce and oversupply the market
  2. Small producers will high grade mines to pay bills

For anyone unaware of the prisoner's dilemma, it is a simple economic game whereby two completely rational people will not necessarily cooperate. In a simple two company form for iron ore, the example has the following payoff matrix.

Company B Increases Output

Company B Decreases Output

Company A Increases Output

- Iron ore price collapses

- Both companies increase output

- Both companies see a decrease in sale price

- Both companies suffer

- Iron ore price falls slightly.

- Company B suffers a decline in price and output, collapsing their earnings

- Company A increases output, more than offsetting a loss of pricing resulting in an increase in earnings

Company A Decreases Output

- Iron ore price falls slightly.

- Company A suffers a decline in price and output, collapsing their earnings

- Company B increases output, more than offsetting a loss of pricing resulting in an increase in earnings

- Both companies cut back on operating costs due to decreased throughput

- Iron ore price climbs

- Both companies increase earnings

With the understanding that I have far oversimplified the situation (I prefer simple answers to complex problems), the answer looks easy, right? Both companies should cut output. The reason this doesn't happen is how easy it is for a company to 'cheat' on the other. If one of the companies cuts production, they bear the chance that they will just create a windfall for the other company at the pain of themselves.

From the stance of one company, let's examine company A, assuming they can only decide to increase or decrease output. Without knowing what the other company will do, my scenario of best return is to increase output regardless of what the other company does. I avoid the catastrophic scenario of cutting output while others increase, and have the possibility of increasing while others decrease production. The other company will have the same argument. Therefore, we again arrive at both companies increasing production. This dilemma occurs in a loop as companies continually attempt to balance budgets in the face of declining prices.

Imagine this multiplied by many more companies, with many more decision points along the way. It starts to get very complex to work through a mathematical example; however, the prerogative remains the same - increase production. The cost of mine shutdowns and the management's incentive to continue to produce further exacerbate the situation. Furthermore, it would be illegal in most countries to work together to try and fix a price and cut production. Even in the oil industry where OPEC "works together" to "maintain a price floor", they currently have found themselves in the same situation.

Prisoner's Dilemma on Cash Flow

With this same dilemma in mind, there is a multitude of other ways that a company can act for their intended self-interest. We can visually see the manifesting of companies paying for shipping costs, etc., when we look at realized prices. Here is the average realized prices vs. actual average commodity prices for BHP for the last few years as companies compete for market share in a market where there is no differentiation except for costs. My article on BHP discusses its current situation in detail (albeit a bit late to the party as some commenters would have it).

Sources: BHP's Annual Report 2015 and BHP's Annual Report 2014

Wrap-Up

As China's infrastructure boom inevitably continues to slow down over the next decade, supply will continue to exceed demand. The pace of mine shutdowns will start slow and accelerate over time as it becomes clear that no more funding via capital raising or debt issuance is available to them. Iron ore could take more than five years, and as long as a decade, to recover with no one left to pick up the baton from China's rapid catch-up growth years. As miners cling to hope with forecasts of a bounce in the iron ore price, deferring the costs of shutting down their mines, and their jobs, the price will continue to languish. RIO and Vale (NYSE:VALE) have all increased their debt loads over the past 5-10 years which will harden the fall as prices continue to drop. Many small companies will suffer a far worse fate. The prisoner's dilemma has resulted in the worst case scenario for iron ore suppliers. And, as the bosses of the majors continue their price war, shareholder returns will remain depressed for a long time coming.

Disclosure: I am/we are short BHP.

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.

Additional disclosure: I have tried to ensure that all data and analysis is as accurate and up-to-date as possible. Many of the assumptions are opinion based or inferred based on available information. This article should not be considered financial advice or an accurate picture for investment purposes