Iron ore prices have become a key talking point in markets this year. A rapid surge to five-year highs will do that.

As Australia’s biggest export, the ripple effect has been felt throughout the economy. The federal budget is now expected to reach surplus one year ahead of schedule, while a rally in the big mining stocks helped drive the ASX200 to 10-year highs.

While iron ore is largely the domain of the big three — BHP, Rio Tinto and Fortescue Metals — a select number of small caps have also been lifted this year by the rising iron ore tide.

But on a macro level, the latest round of expert research indicates that current prices may be close to their cyclical peak.

In the short-term, analysts pointed to signs that iron ore exports from Brazil are beginning to stabilise, while Chinese steel demand may slow in the months ahead.

And looking further out, Ben Goodwin – a portfolio manager at Merlon Capital Partners — pointed to some structural changes in China that may fundamentally alter the demand outlook.

The breakdown

When spot prices for benchmark 62% fines topped out at $US108.62 a tonne on Monday, it marked a gain of around 70 per cent since November.

Lower grade 58% fines edged above $US90 — a parabolic increase of almost 130 per cent over the same timeframe. That’s been particularly beneficial for some small caps in the space (more on that later).

A primary driver of this year’s increase was the Brumadinho dam disaster in Brazil in late January, which claimed the lives of more than 200 people.

Since then, markets have struggled to calibrate how iron ore supply out of Brazil will rebalance amid a series of mine closures and ongoing court battles.

But despite the uncertainty, Goodwin says the recent shipping data to China — the world’s biggest iron ore customer — shows exports have moved off their lows.

“The time it takes to ship from Brazil to China is around 45 days,” Goodwin told Stockhead. “Right now, 45 days ago marks the trough in total Brazil shipments.”

With the additional drag of inclement weather, total shipments fell to an annualised rate of around 60 million tonnes in early April — down from an average of 360mt in 2018. “But the latest data suggests it’s climbed back to around 250mt,” Goodwin said.

Goodwin added that Luciano Siani Pires, chief financial officer of Brazilian mining giant Vale, has said he expects the company’s Brucutu mine — a 30mt per year project — to be reopened within weeks after a court suspended operations in early May.

Vale is also exporting around 20 million tonnes from its S11D mine near the Carajás National Forest. It’s the largest iron ore project in the world with capacity of around 100mt per year, leaving room for Vale to ramp up exports if it wants to fill any supply backlogs.

And on the demand side, Goodwin expressed caution on the outlook for Chinese steel production over the second half of the year.

Around 1.6 billion tonnes of iron ore (the key component in steel) are shipped annually and China accounts for around two thirds of that, so a reduction in activity can definitely move the needle.

Goodwin said profit margins for steel mills producing rebar used in residential construction are holding up for now, but he’s not sure if it will last.

For one thing, housing starts are beginning to outpace actual sales, while the Chinese government has halved its annual 20 per cent growth target for shanty town redevelopments.

“That doesn’t seem to have impacted the demand side yet, but you’d expect it to at some point,” he said.

What’s old is new

And on the subject of steel production, recent research from Goodwin highlighted a long-term trend in China that investors should note; the shift away from iron ore-fed blast furnaces to recycled steel facilities.

“This transition is happening now, and is unlikely to reverse,” he said.

“Over the long term, should China’s 10 per cent recycling rate approach the 45 per cent average of the rest of the world, up to 300 million tonnes of steel currently produced using iron ore would switch to being produced using recycled steel.”

Such a shift would significantly alter the long-term valuation metrics of most iron ore producers, which are currently built on “a combination of unsustainably high prices, and unsustainably low capital expenditure. Investors would be wise to consider this in their investment decisions,” he said.

So far in 2019 though, the short list of small cap iron ore producers have happily jumped aboard the gravy train.

Year-to-date gains have been led by high-grade iron ore play Fenix Resources (ASX: FEX), which has almost tripled in value as it advances development at its 9.2mt Iron Ridge project.

With the price surge extending to lower grade 58 per cent fines though, low-grade producer Mount Gibson (ASX: MGX) has also been in the money; up 135 per cent in 2019 and 221 per cent over the past 12 months.

Here’s a summary of how ASX small-cap iron ore miners have performed over the last 12 months and in 2019 to-date:


 

At Stockhead, we tell it like it is. While Fenix Resources is a Stockhead advertiser, it did not sponsor this article.