On Part I of this article series I surveyed the demand for iron ore and showed that the important part to focus on is the Chinese demand, and more particularly, the demand in the construction segment. I estimated that going forward, Chinese demand for imported iron ore will grow in a low single digit pace in the best case and will decline or even collapse in a bear scenario. Now it’s time to see how to supply side reacts to these dynamics. As usual, here is the Twitter version (129 characters): “The supply of iron ore is going to grow much faster than demand under any reasonable scenario and this is bad news to the miners.”
The Supply Side
In order to understand the supply side, I read the production plans for the iron ore mining giants (VALE, Rio, BHP and Fortescue) and aggregated their expected production plans in the years to come. For other countries (other Australian miners, India and the rest of the world), I relayed on external sources. If someone is interested to see the detailed calculations then feel free to let me know in the comments section below and I’d love to share that. For now, let’s look at the bottom line of what I found:
The table above shows that in the face of soft demand, the next two years will see huge increase in iron ore production by the mining giants. Unfortunately for the miners, those increases will lead to oversupply even under very optimistic assumptions.
All the mining companies looked at the same data, saw that Chinese demand is expected to rise (and back when they decided to expand capacity, rising it was) so each one of the giants made a rational decision to expand capacity. What they probably missed, is that other players are thinking along the same lines and paying high amounts of money for smart consultants who look at the same data and arrive at the same conclusion. Add that to compensation plans (and Rio is an exception here) that encourage executives to increase production and what you get is exactly the picture painted by the table above — over supply.
While Rio Tinto’s CEO compensation plan isn’t designed to push for capacity expansion, he still made the following comment in an article titled Despite Slowdown in China, Rio Tinto Stays Committed to Mining Plans:
“As long as the world is continuing to develop, it is going to need us”
Well, guess what, the world is going to need you, but it probably won’t need that much of you. His statement reminded me of the famous “As long as the music is playing, you’ve got to get up and dance” by Charles Prince, Ex-Citi CEO, who explained why Citi couldn’t be the only bank to stop highly leveraged subprime lending.
Not sure how many analysts read the risks section in VALE’s annual report, but the company explains that it’s dependency on China goes beyond only iron ore (I added the underlines for emphasis):
Adverse economic developments in China could have a negative impact on our revenues, cash flow and profitability.
China has been the main driver of global demand for minerals and metals over the last few years. In 2013, Chinese demand represented 64.3% of global demand for seaborne iron ore, 50% of global demand for nickel and 43% of global demand for copper. The percentage of our net operating revenues attributable to sales to customers in China was 40.5% in 2013. Therefore, any contraction of China’s economic growth could result in lower demand for our products, leading to lower revenues, cash flow and profitability. Poor performance in the Chinese real estate sector, the largest consumer of carbon steel in China, would also negatively impact our results.
The writing is on the wall. The explicit reference to the Chinese real estate sector did not appear at all in 2007’s report. In 2008’s report it appeared very indirectly. An explicit reference first appeared in 2009’s report after it became clear that the huge stimulus program created a huge dependency for iron ore demand on the real estate industry.
Impact on the Mining Companies
For companies like Rio Tinto, almost all the underlying earnings (which is a controversial measure for earnings) are derived from the iron ore segment (96% in 2013 and similarly high numbers in other years). As such, changes in this segment are detrimental to the bottom line number that seems to be the number that analysts use.
A word about “underlying earnings”: this term excludes about $26bn of asset impairments that were done over the course of the last three years alone. While sometimes ignoring impairments can make sense, those impairments seem to be an on-going cost for Rio Tinto as it shows that it was either too optimistic in assessing the value of its assets in the past or that it paid too much for acquisitions — not just once, but time and time again. Anyway, I will go with the flow here and use “underlying earnings” as the measure for profitability.
In 2013 the average selling price of a dry metric tonne grade 62% fe in Rio’s iron ore segment was $126. According to Rio’s sensitivity report, every 10% change in the price of iron ore will lead to a change of $1.2bn (p. 52) in its underlying earnings. If iron ore prices will average $100 this year, Rio’s earnings will take a hit of more than $2.4bn just from the iron ore segment. Note that I assumed linearity but in reality, due to the high fixed cost base, an additional 10% drop beyond the first one would damage the bottom line much harder. Other segments may show loss because as we have seen, demand for other base metals is a derivative of the demand for iron ore so the total impact may be serious.
We can even think of a double whammy scenario in which not only price is impacted, but also the volume. Should demand slow down, imports is the first supply source to get cut due to the Chinese government policy of sustaining employment. The Chinese will not rush into closing their low-/negative-profitibility mining operations and buy iron ore from Brazil or Australia. If both volumes and prices will take a hit then we may see some of these companies losing money.
To conclude, I feel that the iron ore market is on the verge of being over supplied due to both no/low growth in demand and a double digit growth in supply over the next two years. My guess is that the mining companies will suffer from this through lower iron ore price and even, maybe, lower volumes that will come on a high fixed cost base.
How Can We Profit From It?
If we are going to bet against the mining companies we first need to understand how the market views them and what scenario is baked into their current valuations. We can benefit from betting against them only if:
1. We are right
2. The market is wrong
1+2 means that our view has to be different than the market’s view. On the next part we will see if these two conditions hold and try to identify where the best opportunities lie.
I may have missed something in my analysis or you may disagree with it. So, I welcome you to leave a comment below and start a discussion. I started this blog both to share knowledge but also to learn from others so please feel free to challenge anything that you read here. See you in Part III.