Iron Ore: Key Themes To Consider
Summary
- Iron ore has been one of the better-performing commodities in 2020, supported by demand from Chinese steel mills and supply-side disruptions in Brazil.
- Australian miners have benefitted significantly but Australian-Chinese relations are dicey and this could alter supply-side issues going forward.
- Chinese demand for iron ore may slow over the next couple of months due to the onset of the summer season but could return post-August.
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This extraordinary metal, the soul of every manufacture, and the mainspring perhaps of civilized society. Of iron. - Samuel Smiles
2020 will mean different things to different people, but I think we can all acknowledge the one common theme we've all been afflicted with this year has been uncertainty. Whilst this theme of uncertainty will likely continue for the foreseeable future, ironically, one thing I'm almost certain of is that I won't be getting any Christmas cards from Papa Powell and the League of Extraordinary Bankers. If you've been keeping abreast of my views across the internet and other media platforms, you'll know I've been quite critical of the actions of central bank policy in socializing losses and using bountiful stimulus to abet sub-substandard businesses. Admittedly, the US Fed isn't alone in churning out this largesse, with key central banks, the world over resorting to similar measures. I've postulated before on what all this could mean for the world going forward, and one argument I've repeatedly brought up is the reflation angle.
Supply chain bottlenecks continue to linger, and I think one area where you could see all this excess monetary stimulus being diverted to is the industrial commodity space. Within the broad industrial commodity space, I've got an eye on iron ore - a commodity that has proved to be somewhat resilient in 2020 and one that has seen a spike this month (up c.26% from April lows), mainly on account of supply-side issues. I will now provide some context on what's happening in the iron ore space and some of the key developments that investors need to look out for, which could likely impact iron ore and iron ore-related investment assets.
Things to watch out for
Chinese industrial data, export demand, and any infrastructure stimulus
First things first, China continues to remain the preeminent guzzler of global iron ore, and any change in circumstances for the industrial sector in this country - tiny or large - tends to have a monumental impact on the dynamics in iron ore. Last year, the country accounted for almost c.70% of total global iron ore imports with the next prominent country - Japan - accounting for just a little over one-tenth of the Chinese aggregate figure.
Source: World's Top Exports
Initially, when the pandemic struck, support for iron ore prices was boosted by containment measures in China, which limited transportation of domestic iron ore, driving both domestic and seaborne prices higher. Another contributing factor for iron ore demand was the shortage of recycled steel on account of complications in the scrap-metal industry. Then, while the rest of the world was being mired with the disease, China began opening up to cater to domestic requirements with demand from steel mills gaining pace. The pace of recovery continued over the next few months, and according to the World Steel Association, by the end of April, all major steel-consuming sectors were back to near full productivity. This is evidenced by the Chinese steel production which bounced back to levels greater than the pre-COVID-19 range in April (up 7% m-o-m).
Source: Trading Economics
More recently in the month of May, China's steel sector PMI increased by five points from April to hit 50.9. The sub-indices of both steel production and demand were up while employment was stable. The sub-index for new domestic orders rose by 13 points to 52.9. The Chinese central bank halving reserve requirement ratio for banks was another supportive factor. Chinese May imports of iron ore hit 96.8 million in May, up from 86.4 million in April. The ongoing demand from steel mills was further exacerbated as overseas exporters of iron ore were hampered by the pandemic and port maintenance. Worth noting that as of May 29th, iron ore inventories at China's ports dropped to its lowest level since Nov 2016 at 109.5 million tonnes (according to SteelHome).
Currently, the momentum in steel continues to stay elevated. You can gauge this from the 10-day average steel output for Chinese mills which has been inching upwards since April and is currently at a much higher level than that seen over the last few years.
CISA (China Iron and Steel Association) mills' 10-day average steel output mn t/d
Source: Argus Media
In addition to that, the steel stockpiles continue to be absorbed at a rapid pace. For the week ending May 15th, steel inventory in China had fallen by 34% to 17m tonnes.
CISA (China Iron and Steel Association) mills' steel inventory mn t
Source: Argus Media
Broadly, demand for iron ore from China is outpacing shipment arrivals and this is leading to a fast depletion of port inventories. As of now, it is believed that most of the iron ore and steel demand is coming from the domestic economy. Going forward, I would look out for export demand for steel which has not really gained steam. In the recently released steel PMI data, the export orders index was up at 31.9, slightly up from 27.8 but well below 40 for a third consecutive month. Export momentum becomes even more crucial as China will soon enter its off-season (the summer season) from late June to August where domestic construction activity slows down and demand for steel usually softens. In fact, if I look at last year's utilization data from Mysteel consultancy, I see that weekly utilization levels across Chinese steel mills fell to around 66.4% in July from 70% plus levels in the previous months. Investors can also keep an eye out for any potential infrastructure stimulus spending (this has been mooted by the press there) that would likely tilt the supply-demand scenario for iron ore even more favorably. If this were to come through, China could help offset any potential demand declines in 2020 for iron ore from the rest of the world.
Brazil's handling of coronavirus
Last week, we saw iron ore prices spike above the $100 mark and it has since stayed there. The trigger point for this surge was supply disruptions from the second-largest iron ore exporter in the world (accounting for c.23% of iron ore supplies in the seaborne market) - Brazil. To be more specific, a Brazilian labor court had ordered iron ore giant - Vale S.A. (VALE) - to stall mining at its Itabira complex on account of a spike in coronavirus cases (unconfirmed reports suggest close to 200 people have been afflicted) at their mill. VALE had already previously guided to a trimming of their production outlook from 340-355 mt to 310-335 mt on account of coronavirus disruptions. But on account of this latest development (Vale estimates a disruption of 2.7 million tonnes per month), we could now likely see 10% of Vale's iron ore output or 2% of the total global seaborne output come to a standstill, compounding the issue in what is already a rather tight market. Iron ore shipments from Brazil in May-2020 have already fallen by over 25% yoy.
Source: CEIC
Coronavirus cases in Brazil have not shown any inclination of slowing down, and while the growth rates in developed nations such as the US and UK have slowed down to 2%, in Brazil, it continues to grow at around 4%.
Investors can continue to monitor the pace of growth of infections in Brazil as mitigation measures here will weigh heavily on iron ore production and shipment. More emphasis can be given to the state of Para as this is primarily where most iron ore mining units are located (Para accounts for about 1/3rd of the country's total exports). At the moment, it does not look as though the Brazilian government has got a grip on things, but any signs of a flattening of the curve may temper iron ore prices.
Australian export data and Aussie-China foreign policy relations
The country that has most benefitted from the supply-side disruptions in Brazil and the demand-side push from China has been Australia, which is also the world's largest exporter of iron ore. China imports c.60-70% of its total iron ore imports from Australia alone. Last year, China imported around $61bn of iron ore from Australia, and this year, the Aussie government thinks they could see a further $81.5bn worth of iron ore exports to China, a potential YoY growth of 33%. There are obvious logistical benefits to this relationship as it only takes about 12 sailing days from Australia as opposed to around 45 days from Brazil. As per the latest iron ore export figures from the Pilbara Ports Authority, shipments towards China in May rose by around 4% YoY and 5% MoM to hit 47.8 million tonnes. Momentum seems to have carried on towards the first week of June with iron ore exports to China from the four largest Aussie producers reaching record highs of 32% above the usual average.
Australia's weekly iron ore shipments to 4 June
Source: Crestone Wealth
Iron ore shipments from Australia's 4 largest iron ore producers
Source: Argus Media
So far, Aussie miners have been making hay while the sun shines, but I would urge investors to keep an eye on Chinese-Australian foreign policy relations which have somewhat soured recently, ever since Australia called for an international investigation into the origins of the coronavirus from Wuhan. There have been some suggestions from Beijing that they could retaliate through import tariffs on key Aussie exports (do note that tariffs have already been levied on Aussie beef and barley). Given that about 60-70% of Chinese iron ore imports come from Australia, it won't be easy to break off, but if push comes to shove you never know and this could have large-scale supply ramifications jacking up the price even further.
Indian iron ore exports
India could prove to be a dark horse in the supply dynamics of iron ore if Australian-Chinese relations were to deteriorate. Worth noting that India has been stealthily leveraging its presence in iron ore exports, and according to data from 'World's Top Exports', since 2015, iron ore supplies to China have grown the most, up a whopping 2070%, the most by any country in the world. In 2019 alone, iron ore exports to China doubled to 15.75 MT. Fitch believes that over the next few years, India will likely emerge as a key iron ore producer, rivaling Australia, and Brazil. In addition to the logistical benefits, the other supporting factor for India's iron ore exports is that it is currently trading at a c.20% discount to international iron ore prices which makes it a little more competitive. Keep an eye out for Indian exports and India-Chinese relations (which admittedly are also on a sticky) as this could impact the supply situation as well.
How to play iron ore
As mentioned at the beginning of the article, iron ore has been one of the better-performing commodities this year and is up c.26% from April lows. Getting in it at this stage may not be ideal, more so if the Brazilian coronavirus situation normalizes. You must also consider that we are close to the Chinese summer season which is likely to see an easing of demand till August. Yet, still, I do think as global export momentum picks up, especially in some of the developed nations, we may continue to see some demand-side headwinds support prices for iron ore and I am broadly positive on industrial commodities. Currently, there are no core iron ore ETFs to exploit the opportunity in iron ore but other options could be one of the large global miners - Rio Tinto (RIO), BHP Group (BHP), Fortescue Metals (OTCQX:FSUMF) or Vale S.A.. It is estimated that every $10 per tonne increase in iron ore prices usually generates an additional c.$2bn of free cash flow for the miners. I would be hesitant to pursue VALE, as in addition to the current supply disruptions (it costs them about $50m per month), the next quarter will also be likely challenging on account of increased cash costs which are already quite elevated vs. peers. The Aussie miners are better placed, as last year, they all undertook significant debottlenecking initiatives at their plants which enable them to be flexible and help maintain the right balance in the market.
Within the Aussie miners, you may consider FSUMF. It is the only pure-play iron ore miner, its cash costs of $12.5 per ton are the lowest in the industry (Rio Tinto -$14-15 per ton and BHP-$13 per ton) and EBITDA margins have been strong across all cycles. New management (since 2018) has done a great job and this has been reflected in the share price which is at all-time highs. Given the overbought nature of the share, it would be preferable to wait for some correction in the share price. Alternatively, you may also consider BHP, whose stock doesn't look as overbought. Iron ore makes up for 60% of group EBITDA, and over the last five years, they have halved their unit costs and increased production by c.20%. They are also one of the most consistent dividend payers with a minimum 50% dividend payout and dividend growth of 101% over the last 3 years. The current dividend yield is a useful 5.47%.
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Comments (5)
Another pure play IO producer to consider is Champion Iron out of Quebec.
CIA
CHPRF
