Commentary: Is iron ore rally overdone?

Spot prices for iron ore fines delivered to China touched a three-year low of US$87 per tonne in September 2012, before rebounding to US$119 per tonne in December and to the US$158- to US$160-per-tonne level of recent days. The question is: Where will prices for the metal move from here?

John Goldsmith, deputy head of equities at investment management firm Montrusco Bolton in Toronto, says they have nowhere to go but down. “Iron ore has had an absolutely phenomenal rally, but I think it’s time to take money off the table,” he says. “The rally has been long in the tooth.”

In Goldsmith’s view, gross domestic product (GDP) growth in China over the next three years will average 6%, down from the 7.8% the country clocked last year and 9.2% in 2011. He says this estimate is a function of the average 7% GDP growth rate set out in China’s last five-year plan in 2010. And a growth rate of 6%, he says, will have an impact on iron ore demand and prices, given that the economic juggernaut produces nearly 50% of the world’s steel and makes up more than 60% of global demand for seaborne iron ore.

“People are realizing that China will not grow to the moon. It will not have GDP growth north of 8% for the next ten years, and people that think that are dreaming,” he says. “The risk for the iron-ore trade right now is that there is a slowdown in infrastructure spending in China, and it will have an impact on steel consumption use — and that will cascade down to the iron ore price.”

Over the last decade China has consumed more steel than any other country on earth. But that trend won’t continue indefinitely, he reasons. “China has already urbanized more people than any other country in history. It urbanized 200 million people over the last decade and will urbanize another 100 million people over the next decade, so they’re going to use less steel.”

Last year China produced 720 million tonnes of steel, and Goldsmith believes that’s more than enough to meet its needs. “In two years’ time, are they still going to be consuming 700 million tonnes of steel a year? I think that’s close to maximum capacity.”

Looking at equities, Goldsmith believes that anyone who isn’t long iron ore should avoid taking new positions. Higher iron ore prices are already priced into the stocks and are unlikely to surpass their all-time high of US$192 per tonne seen in February 2011, he maintains.

As for potential acquisitions of iron ore projects in Canada, he is doubtful, arguing that the big players like BHP Billiton, Rio Tinto and Vale have announced slowdowns in terms of their own growth projects, and can produce enough of the metal to diminish interest in buying projects or producers in North America.

M&A also isn’t likely to come from any of the intermediate producers like Cliffs Natural Resources, he argues, because of their distressed balance sheets, while Asian companies are becoming shrewd and careful buyers. And if the Asian steel mills were looking to buy iron ore projects, he believes the time to do so was four months ago, when iron ore prices were decimated.

“Where were the Poscos, where were the Baosteels then?” he says. “Where were these monstrous steel companies back in September and October, when you could buy all these iron ore companies at half the price they are today? In September it was like the death of iron ore, nobody wanted to talk about it. Now everybody wants to talk about it, and I can’t believe the balance sheets of these steel companies have gotten any better or worse than they were then.”

Jessica Fung, a commodities analyst at BMO Capital Markets in Toronto, forecasts GDP growth in China this year and next will be above 8%. Among other things, the central planners in Beijing realize they need to keep industrial manufacturing activity at a decent level to ensure that people remain employed, she says. And in terms of steel production, the consolidation that the central government has been trying to implement is taking longer than hoped.  

But at the same time, she believes that steel production in China is likely to peak over the next few years. She also forecasts that global demand growth for steel this year will come in below the 3.5% BMO forecasts for global economic growth. As a result, she explains, “we’re not going to see the kind of double-digit growth in seaborne iron ore demand that we have in the past.”

After a period of restocking iron ore inventories at Chinese ports ahead of the annual week-long break during the Chinese New Year — which she says was responsible for part of the recent, dramatic run-up in prices — she forecasts prices for the metal will normalize in February, averaging US$120 per tonne in the first half of 2013 and US$130 per tonne in the second half. She predicts they will remain flat at US$130 tonne in 2014, before moving down to US$120 per tonne in 2015 and to US$115 per tonne in 2016.

As for potential acquisitions, Fung doesn’t believe there will be as much enthusiasm for them as there was in the run-up to iron ore prices of US$192 per tonne in early 2011. She also notes that Chinese steel mills have been developing relationships over the years with the major suppliers such as Rio Tinto, Vale and BHP, and are comfortable with the quality and consistency of the product. “This is the same process that the Japanese and Korean steel mills went through a couple of decades ago,” Fung explains. “After a while they realized that they could establish strong, long-term relationships and understand the product, and they didn’t need to be out there spending money on infrastructure anymore.”

As for juniors in the Labrador Trough that hope to be bought out one day, she says, distance from markets in Asia is a factor. “The issue with the Labrador Trough is that it is so far away from China, and even though prices for freight are going to come down, it’s still really far away,” she says, adding that many Chinese companies are also looking at projects in West Africa.

“For the [Canadian] juniors, the question is going to be: Are they going to come here or go to West Africa, or continue to invest in Brazil and Australia?” she says. “I think the Chinese steel producers are going to diversify geographically.”

In a Jan. 10 commentary from Macquarie Bank, London-based analyst Colin Hamilton writes that prices for iron ore are “running ahead of current fundamentals and looking overvalued against both scrap and domestic ore, while with small mill inventory cover back at thirty-three days, the Chinese restock is set to lose steam.”

But this doesn’t mean the price will collapse in 2013, he adds, because “a rise in Chinese steel output to 740 million tonnes per year in [the first quarter] means that more Chinese domestic ore will be required than at any point last year.”
Hamilton sets a fair price of iron ore at US$140 per tonne, and notes that “rebar margins in China look extremely weak,” and that he expects steel prices “to outperform iron ore moves over the coming month.”

Analysts at New York-based investment bank Dahlman Rose & Co. believe that higher prices for Chinese steel or a drop in iron ore prices will be required for Chinese mills to continue at their current production levels.

Margins at Chinese steel mills “have been under pressure since peaking at US$280 per tonne in early October,” they point out in a Jan. 4 research note, adding that since that time, “iron ore prices have surged higher by more than 35%, while rebar prices have declined slightly [1% to 2%], bringing steel mill margins to a level that has historically served as a catalyst for a directional change in either iron ore prices or steel prices.”

Dahlman analysts Anthony Rizzuto and Joseph Giordano predict that a “more likely outcome” would be lower iron ore prices. “We are not seeing the necessary catalysts at this time for a steel price-increase announcement, and view Cliffs Natural Resources and Vale as the most exposed, should input prices reverse course,” they say.

Chinese iron ore imports in December increased nearly 8% from the previous month and 11% year-on-year, reaching 70.9 million tonnes, according to figures from Dahlman published on Jan. 10, and the increase is in-line with the restock seen at the mills and the rise in prices for the metal, the investment bank says.

“We believe the sharp ramp in iron ore prices has run its course and see risk of a quick reversal,” Dahlman analysts comment in a Jan. 15 note. “Though we are increasing our 2013 iron ore price estimate to US$130 per tonne from US$115 per tonne to reflect current prices, we see potential risk of a sharp reversal in the spot market, as traders unwind speculative positions, should prices show weakness. Further, we believe the industry’s supply response will be more than adequate to meet incremental demand.”

Johnson Imode, a metals analyst at S&P Capital IQ in London, noted on a Jan. 15 conference call that he expects a balanced market in 2013, which he believes will support historically high prices — forecasting US$130 per tonne this year.

He cites “the improving economic sentiment in China with the change in leadership,” and says there is a limited new supply of iron ore coming on stream from the major players. He also points to lower iron ore exports from India. He sees “threats in 2014 from increased supply,” but argues that “even in 2014 and 2015, we don’t see prices returning to what we had seen in pre-fixed days.” (Up until about two years ago, iron ore prices were negotiated and fixed annually between Japanese and Chinese steel mills and iron ore producers. After April 1, 2010, the majority of contract pricing switched to an average of the spot index price over the previous three months, in a mechanism known as index-linked pricing.)

According to a report in the first week of the new year from Fitch Ratings, iron ore production “will be managed to just meet demand through 2013, with potential for modest excess supply from new builds beginning in 2014.”

The report continues that “should Australian expansion be curtailed, or China’s steel production grow above expectations, prices could rebound and continue at higher levels beyond 2014.”

Fitch forecasts that after a period of “severe destocking” in 2012, raw steel production in China will grow 3% to 4% in 2013 — but Chinese steel demand has likely “peaked,” and should grow at less than 5% a year going forward.

Producers of seaborne iron ore with medium costs should reap earnings before interest, taxes, depreciation and amortization margins of 35% on average over the next two years, the ratings agency predicts.

Fitch also forecasts that many of the iron ore projects that the United Nations Conference on Trade and Development says are expected to come on stream between 2012 and 2014 — about 796 million tonnes of additional capacity — are likely to be delayed.

At the same time, Fitch says producers of seaborne iron ore in Australia, Brazil and Africa “are expanding low-cost production that will result in excess capacity,” and “cumulative capacity increases beginning in 2012 through 2015 are estimated at 377 million tonnes.” Roughly half of the new iron ore production during this time will come from Australian projects, the rating agency says.

India may also become a net importer of iron ore during its next fiscal year. A mining ban was in place from August 2011 until April 2012 in Karnataka state, while illegal mines in Orissa were shut down. There was also a recent ban on mining in Goa. Before the bans, Goa and Karnataka together accounted for 65% of the country’s iron ore exports.