Could short-term pain give way to long-term gain for iron ore?
Iron ore’s collapse from giddy highs of upwards of US$230/t to under US$100/t appears to have subsided for now as iron ore prices posted a sharp bounce back above US$120/t last week.
The factors that led to the decline are well documented, primarily mandates from the Chinese Government for Chinese steel makers to keep production flat year-on-year after profit hungry mills produced 12.2% more in the first six months of 2021 than they did in 2020.
The 61% fall in iron ore prices that followed May’s highs shook out a number of small, low grade producers who used the tinder provided by high prices to open direct shipping operations, combining with higher than normal freight costs to send their short-lived operations back into mothballs.
Shareholders in the major iron ore miners have responded to the jitters in kind.
BHP (ASX:BHP) shares hit a record high of $54.06 on August 4 but are now 11.57% down year to date at $38.08. Rio Tinto (ASX:RIO) shares were worth $134.40 on the same day and are now trading at $102.26, while Fortescue Metals Group (ASX:FMG) stock fell 47% from record highs of $26.30 on July 29 to $13.91 last Thursday before recovering to $15 yesterday.
However, prices have staged a minor recovery, climbing back to US$123/t on Friday after two weeks of gains ended a three-month decline matched in percentage terms only by the post-GFC crash in 2008.
While some analysts see iron ore falling even lower next year into the US$75-80/t range, there are some who believe short-term pain could give way to long-term gain for the iron ore sector and, particularly, high grade producers.
Fastmarkets index manager Peter Hannah told Stockhead analysts at the price reporting agency see both limited upside and limited downside in the iron ore price.
While curbs on steel factories in China saw prices plunge far below their previous Q4 forecast of US$175/t, Fastmarkets MB’s analysts now forecast prices will average US$123/t in the December Quarter and remain around those levels through 2022.
The last time iron ore really crashed was 2015, when the Pilbara miners went into cost-cutting mode and announced major layoffs to ride out a dive in prices to under US$40/t.
Hannah says 2021 is different for a few reasons.
“Conditions are very different now from the crash of 2015 sort of time where you had the global steel industry, China especially but the rest of the world too, suffering from chronic overcapacity issues,” he said.
“Many were operating with negative profit margin, so it was clear something was going to have to give.
“Now, though, this is more artificially imposed, so conditions are organically pretty strong.
“China produced record levels of steel in 2020, were on track to exceed that in 2021, mills were still making a lot of money because downstream steel prices were even stronger than that.
“And this is essentially an artificial policy to rein back steel production for ostensibly, the reason of environmental emissions and lowering the emissions from steelmaking, but it’s also probably partly a degree of concern around China’s balance of trade with prices that high and trying to lower the prices of their key steelmaking input a little bit as well.”
Hannah said the global cost curve, and particularly the cost structure of China’s domestic iron ore mines, was much higher as well than it once was.
“Once we get down to levels close to US$100/t, then in the world we are in today, you start to feel cost curve pressure at those sorts of levels,” he noted.
“Some of the Chinese domestic mines have got pretty high costs around that sort of level.
“And also, more globally I think, with the ESG issues of today and the cost of consumables, global cost curves will probably be slightly higher as well.”
The potential collapse of Chinese property developer Evergrande could alter the outlook, but Hannah said production cuts had served to lift steel prices, indicating downstream demand was still solid.
“The real danger for iron ore prices is when steel prices drop and margins become compressed or even negative like we saw back in 2014-2015,” he said.
“So if by curbing steel output now for a period of months or even more you maintain the tightness in the steel market and keep steelmakers profitable, then that should keep a bid for iron ore, and especially if in the longer term, the steel demand remains robust downstream.
“Assuming China has not produced as much steel as it’s ever going to in 2020 and 2021, which with their urbanisation still continuing I think is very unlikely, then steel demand will still be there in the years to come.
“The profitability for steelmakers will be as well. So I think that’s the key for iron ore; profitable buyers create profitable sellers.”
Hannah also urged caution on assumptions that supply increases from the major and mid-tier iron ore miners, estimated by UBS to be as much as 190Mt over the next few years, would be as substantial as they claim.
Brazil’s Vale, in particular, has regularly struggled to meet targets since the Brumadinho dam collapse in January, 2019. The recent volatility in prices could also make smaller players more conservative about bringing operations to market.
“The majors out of Australia are still supplying pretty well, but Brazil is underwhelming at the moment,” Hannah said.
“Their September shipments I think were below September last year, and still below the levels before the dam collapse.
“So in the longer term, this price crash will probably mean less new supply comes to market.
“And once the market forces themselves reestablish, maybe a few years out, and these sorts of steel production curbs ease, then I think what we’re seeing now probably sets the stage for slightly better prices for longer into the future.”
It is worth noting that the Pilbara iron ore miners run at operating costs of under US$20/t, meaning they remain extremely profitable at current price levels.
“If I was an iron ore major, I wouldn’t be too concerned about what’s going on right now, I think it actually probably benefits them in the longer term,” Hannah said.
UBS is one of a number of investment banks who think the increased supply of iron ore from African nations backed by China, principally from Guinea’s Simandou deposit, will be felt as a headwind in the market long-term.
They see as much as 100-200Mt of high grade iron ore entering the seaborne trade from the multi-billion dollar Simandou mine from 2025 onwards, when the first two blocks owned by a Chinese-French-Guinean consortium are supposed to come online.
The other portion is partly owned by Rio Tinto.
Hannah is less confident about the potential for iron ore out of West Africa unseating Australia’s position as China’s dominant source of iron ore.
“The iron ore business is about creating or building essentially a proverbial conveyor belt of rocks across an ocean from one continent to another,” he said.
“And Australia has proven itself exceptionally reliable in doing that where other origins haven’t. And I think that is, you know, to be ignored at one’s peril.
“Even talk about Simandou, I’ve seen some estimates from people who understand more about these things than me of what it takes to build production at grand scale.
“And I think we have to expect or almost plan for the base case that it will take longer and cost more than the current projections for supply from around 2025 make it out to be.
“And beyond that I think we have to be prepared for supply to be less reliable over the longer term if it’s coming more from places like Guinea.”
The steel industry generates around 8% of the world’s carbon emissions, and as it looks to reduce its environmental impact, the importance of high grade iron ore is only set to rise.
Regardless of whether ‘green steel’ technologies like direct reduced iron become favoured over blast furnaces down the line, high grade iron ore will be essential for steel mills to meet emissions reduction targets.
“The steel industry, people are often quite shocked to hear this statistic, but it produces more carbon dioxide than it produces steel at the moment,” Hannah explains.
“So to bring that down and actually meet the decarbonisation targets, first of all, you’re going to need a period of optimisation of the existing blast furnace technology, where the blast furnace is going to need to consume more higher grade product.
“And then eventually, in maybe a few decades, you will see a big shift towards direct reduction, which absolutely requires material of very high grade.”
Despite the recent contraction in iron ore prices, Hannah said high grade product remained in demand and steelmakers were still willing to pay premiums over the top of the benchmark 62% iron ore price to get their hands on it.
Concurrently, discounts for impurities like silica and alumina which reduce the efficiency of the blast furnace processes (where coking coal is a reducing agent to convert iron ore into crude steel) are wider than ever before.
“Even in the current environment, we’ve still got quite high quality differentials, so the 65 versus 62 spread is still at quite a historically high level, it’s about $23 at the moment,” Hannah said.
“Part of that is down to the high coking coal costs or met coal costs, which are likely I guess, to be more transitory.
“But you know, just as an observation of the moment, the combined discount for both silica and alumina 1% differentials are at the highest levels they’ve ever been so per percent of silica and alumina you have in your ore, you’re getting a bigger discount for additional impurities than ever right now.
“So it tells you the grade is as important as it’s ever been right now in the current conditions.”
Iron ore market expert Mark Eames, currently the technical director of ASX-listed iron ore company Magnetite Mines (ASX:MGT), said ESG pressure from investors will force suppliers to shift their focus to higher grade product.
Magnetite is aiming to produce a 68% plus product from its Razorback iron ore project in South Australia, which would attract a premium beyond the 65% index generated by high quality Brazilian fines.
“There’s been a real change in the last three to six months,” he said.
“There’s very few long term sources available … we talked to some long term iron ore investors (who) have basically said to us, now, they won’t think about a low-grade investment, and they won’t think about investment unless it’s got a pathway to lower emissions.”
While mining companies are working to incorporate renewable energy into their sites to reduce Scope 1 and 2 emissions they are dwarfed by emissions generated by customers.
BHP for instance estimates its own operations release roughly 16Mt of CO2 into the atmosphere each year.
Its customers generate more than 400Mt, around 65% of which is attributable to iron ore used in the steelmaking process.
“It’s the producers particularly of the lower grade ores, who’ve got to really do some hard thinking about how they’re going to operate in a world of constrained emissions,” Eames said.
While China has clear aims about steel output for 2021, what happens beyond the Beijing Winter Olympics in February and Chinese New Year is less clear.
“In the near term for iron ore our analysts are predicting limited downside, but also limited upside; there’s still goals for China ahead with things like the Winter Olympics, trying to have blue skies for that,” Hannah said.
“So I think we’re not going to get a very clear signal on where iron ore goes, or how these steel production curbs progress, whether they’re eased, or whether they’re not until maybe after Chinese New Year next year.
“But further out from that, infrastructure is still a big component of the current five-year plan in China.”
Eames noted prices remain around 20% above the long-term average.
“I think the funny thing for me is I’ve read all these headlines about things like you know, the worst three months in iron ore history,” he said.
“You read the headlines you would think that iron ore was in terminal decline.
“In practice it’s one of the best markets we’ve seen in years.”
At Stockhead, we tell it like it is. While Magnetite Mines is a Stockhead advertiser, it did not sponsor this article.