I remember attending an AICD forum a few years ago when one of the presenters, a non-executive Director of a mining services company, boldly declared “the iron ore price won’t fall below $100/t while I’m still around – trust me”. I hope his health proves more robust than his forecast.
I certainly don’t make light of the incredibly difficult situation for the many individuals who will be hurt by the collapsing iron ore price. But let’s be a little more honest in the conversation.
Even respected commentators like Robert Gottliebsen get a bit excited. He recently wrote that iron ore price hikes of “60 and 70 per cent were common”. Well, actually, twice: in 2004 the price jumped 75% (US$16-$28/dmt); and in 2007 it jumped 70% (US$36-$71/dmt). But it did reach nearly $200/t at its peak. And paying $200/t for a bulk commodity you paid just $16/tonne for just 6 years earlier must have felt like gouging. Your $2 carton of milk just cost $25: not happy Jan! The Chinese were no doubt galled by this.
On top of this, no doubt the Chinese will remember their failure to secure a settlement with the majors in 2007 after having taken over the buyers’ lead negotiator role from the Japanese. Prior to this the benchmark prices had been negotiated annually between the miners and one of the major Japanese steel mills.
What now? There is enormous uncertainty around future pricing and whether we are at the bottom of the cycle. I’m not pretending I have a crystal ball, but consider this. Let’s use the 2003 price of around US$16.50/t as our baseline – it had hovered around that price for a number of years prior. Then a price today of US$50/t represents an annual escalation of around 10% per annum. At the time of writing this the price was US$49/dmt.
But is it realistic to imagine this decade long period of cost and price escalation of 10% per annum will remain baked in? The argument in support of these much higher costs is that mines are getting harder to access and the quality of resources is deteriorating. And yet the World Bank notes[1] that over the preceding decades “technological change has kept extraction costs in check even as the quality of mines and wells declined”. Between 1985-2002 “the real cost of producing a ton of metal … declined by 28% for aluminium and copper, and 21% for nickel” for the median producer. This represents a real cost reduction of around 1.5-2% per annum over more than two decades.
Do we really believe in the ‘exceptionalism’ of iron ore? Even if we had simply maintained a flat real price then the price today would be around $25/t. The world’s lowest cost producer, RioTinto, is reportedly targeting a break-even cost of US$35/t by 2020, but they are ‘only’ $2/t away from that now: perhaps they will go lower still. The long term investor should be very wary about where the price might go.
A global 'giant' in business strategy, Professor Richard Rumelt, recently described growth in commodity industries[2]:
“the growing demand pulls up profit, which in turn induces firms to invest in new capacity. But most of the profits of the growing competitors are an illusion because they are plowed back into new plant and equipment as the business grows … but as soon as the growth in demand slows down, the profits vanish for firms without competitive advantage”
Data from the global gold industry bear this out. The cumulative free cash flow – that is cash available to the investor – in the gold industry over the period 2000-2012 was negative US11B despite a fourfold increase in the price of gold! Good luck recovering that capital.
For all the current angst about the continuing expansion plans of the iron ore majors, let’s also acknowledge that what we are seeing now is the result of decisions and commitments made 3-7 years ago, when world views were very different: it is not about future expansions. The ‘accepted wisdom’ then was for steel production above 1Btpa in China and industry growth plans were predicated on that scenario. But it seems possible that China has hit ‘peak steel’ at about 850Mtpa. So we have excess supply and falling demand. Never pretty in commodities.
Should the majors continue to invest? That’s for them to decide, but let me close with the observation of Professor Allan Trench, a mineral economist, who explains why long term commodity price forecasts always prove wrong. If the ‘market’ believes high prices will be sustained, investors pile in. The result is a cumulative overcapacity, and the predicted high prices do not materialise. Conversely, if the ‘accepted wisdom’ is that prices will fall, investors holds back their capital, ultimately producing a supply shortfall, and so prices spike.
What does all this mean? Investors must be crystal clear on their competitive advantage: it’s the only thing that saves you.
[1] World Bank (2009). Global Economic Prospects: Commodities at the Crossroads
[2] Richard Rumelt (2011). Good strategy, bad strategy. p. 155
