China is the world’s largest iron ore importer — in 2013, it imported 820 million tonnes (you can read about tonnes and tons here) of iron ore, up from 148 million tonnes just a decade ago. Many stakeholders have enjoyed this tremendous growth but can it continue? what does the future bode for some of the mining companies that derive most of their profits from selling iron ore? and the most burning question, how can we profit from it? I will try to answer some of these questions in a series of posts about the topic. With that, let me give you the Twitter version (132 characters): Iron ore seems to be entering an oversupply phase, China’s use of it seems to be excessive. The future is not what it used to be…
First, I should give credit to Ido Meroz, who’s writings and thoughts on this topic inspired me. Ido writes an excellent value investing blog in Hebrew and he is one of the best value investors out there and certainly the best one I know in person. With that, let’s get started…
What is iron ore and what is it used for?
Wikipedia can teach you all you need to know (and then some) about iron ore. Most iron ore that is mined is used to make steel, which is a raw material that is used in construction, infrastructure, machinery, car making and many other things. The geeks among us are invited to watch the 1946 blockbuster movie “The Drama of Steel” that was produced by one of the best studios in the world — The Bureau of Mines. We will need this later, but as a thumb rule let’s say that 1.6 tons of iron ore are needed to produce 1 ton of steel.
How is the price of iron ore determined?
As with any commodity, the price, at least in the long-term, is determined by the supply and demand situation in the market. When demand rises fast supply might fall short and prices increase as a result. That is exactly what happened over the last decade as miners couldn’t keep up with the Chinese appetite for iron ore. Prices went from $14/MT in 2003 to almost $200/MT in 2011 and the price is around $100/MT today.
Oftentimes, people say that even if the demand from China will slow down, other countries can pick up the slack and so on. My answer to that is “forget about it!” Let’s see why…
The slide above is taken from VALE’s 2013 investor day slide deck. It shows us that for the segment that is called “Rest of the World” both steel production and iron ore imports are won’t change much in the time period that began in 2000 and will end in 2020. All the growth has and will come from Asia (primarily China, other Asian countries’ consumption is insignificant in comparison).
So, we know that price is determined by supply and demand. We also know that almost all the projected growth in demand is supposed to come from China so the next things we need to ask ourselves is whether or not these expectations are reasonable.
What does China do with all that iron ore and is it reasonable to expect growth in demand?
The diagram below shows the uses of steel, by industry, in China (link to data source):
Let’s follow my accounting teacher’s recommendation and “look for the fat cows.” It’s pretty obvious that construction and machinery are the fat cows. Furthermore, since a huge portion of the increase in Chinese GDP over the last decade came from investment in fixed assets we know that these two segments, not only are the largest but are also responsible for most of the growth in iron ore demand. It is important to notice that steel demand in the machinery segment is closely related to construction activity — a huge part of it is the steel that is used to make cranes, heavy equipment and other machines that support the construction industry. Next, let’s zoom in on construction, the future of steel demand in this segment should be a good indicator for the overall Chinese appetite for iron ore.
In 2013 China’s steel output was 780Mt (which translates into ~1250Mt of iron ore, mostly imported) up from 418.4Mt in 2007. Below area few common uses for steel:
- A rough average of 80kg of steel are used for each 1sqm of residential construction.
- A skyscraper takes about 30,000 tons of steel to build.
- It takes about 1 ton of steel to make an average car.
In 2012 China built 1.9bn sqm of residential real estate, that translates to about 1.5sqm per capita and is added on top of an already high average of 33sqm/capita of residential real-estate built in urban areas and 37.1 sqm/capita built in rural areas, which are comparable to the figures in many countries with developed economies and GDP levels way higher than China’s. If we add commercial real estate built in that year we get to a total of 2.7bn sqm built and with an average of 80kg of steel per sqm we arrive at 220MT of steel that went into these uses. The difference of 232MT between 58% of the 780MT that went into construction and the ~220Mt that went into residential and commercial uses, can be attributed to infrastructure and also to the timing difference between completions (which is what measured by the statistics I brought there) and new construction timing.
The topic of oversupply in commercial real estate in China has been widely covered by the media, short sellers and even Chinese developers. For the sake of brevity, I won’t replicate that discussion. Those who are interested can carry on with their research on that or leave a comment to this article and I’ll provide more color on that. In addition, except for Beijing, occupancy rate of commercial real estate is very low in China. Regardless of that, there are many new projects that are about to hit the market. I think that given the oversupply situation it is fair to assume that we will not see much iron ore demand growth coming from this segment. It is reasonable to expect that commercial real estate construction would even slow down because the returns on many of these projects are negative.
The situation is similar in residential real estate. Again, you can search the FT or WSJ archives, they all cover that topic at great lengths. About 70% of the residential real estate construction took place in third and fourth tier cities and these cities are flooded with empty homes and exhibit huge inventory of real estate, sometimes even above 100 months of supply. That can’t continue for much longer because many of these projects are financed with debt and a lot of developers are already hitting the wall with their mounting levels of debt.
Having just came back from the US I can attest first hand that the infrastructure in China is not behind in any sense and the marginal utility from building a high-speed train between two third-tier cities is way lower, if not negative, than the marginal utility of the line that connects Beijing and Shanghai. Also, the debt situation is pretty bad in the local governments level because most of these projects do not make economic sense. Let’s see what the Oracle from Omaha had to say about fast trains (Thanks again to Ido for the quote):
Joe, let me give you an interesting fig— let me give you an interesting figure. The 800-and-some miles of rail they’re talking about in California, high-speed rail, I think they’ve talked about a cost of 43 billion for that. We bought the Burlington with 23,000 miles of main route railroad and tens of thousands in sidings and all of that, 6,000-plus locomotives, how many cars I don’t know, tunnels, bridges— we bought the whole thing, counting debt, for about 43 billion. So as you can see, there’s— it’s pretty expensive to build that stuff
It’s hard to believe that the government will push for another stimulus plan and building binge. In fact, just this year a Chinese official said that another stimulus would be like “drinking poison to quench one’s thirst.” He is right, building more empty cities and negative IRR infrastructure projects to pump up the short term GDP doesn’t make much sense. The longer they play this game the worse the ensuing hangover will be. Also, it becomes much more difficult to stimulate the economy — the larger the base is the more spending and building has to take place just to keep up. If in the past a 10% increase in investment in fixed assets meant consuming more 40MT of steel, today thats close to 70MT. The difference, 30MT, can be used to build another 750 Burge Khalifas. What can I say, it is getting tough to keep on playing this game.
You can read articles such as this one and look at projections such as this one:
Over capacity in many segments of the Chinese economy that are responsible for the massive demand surge is obvious and we may even see demand for steel, and thereby imported iron ore, declines. Another thing to note is that Chinese iron ore producers are ramping up their production. In addition, recycling that is responsible for 75% of steel production in the US should also become more meaningful in China. That doesn’t bode well for the global mining giants. Articles such as this and that one suggest that the Chinese government has a clear interest in reducing iron ore prices so that is another force that plays against the global mining companies. It is clear that imports of “foreign” iron ore will suffer from increased Chinese production and increased recycling. So by now, we have a pretty good picture of the demand side for imported iron ore: the prospects are between decline in imports and slow (low single digit growth) in the best case.
Next we need to look at the supply side. In the next part I will review some mining companies, their mining plans and the impact that potentially lower iron ore price might have on their financial performance and hence their stock prices. Stay tuned!