The Lordlings of Iron Ore: How Can We Profit From Their Folly – Part II

By | May 28, 2014

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:

Screen Shot 2014-05-26 at 10.18.44 am

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.

 

13 thoughts on “The Lordlings of Iron Ore: How Can We Profit From Their Folly – Part II

  1. Mark

    Hi Yaniv,
    Really great write up about the iron industry.
    I need to admit that I also bet against (RIo) not with big sums.
    My concern that China government may continue another several years with lousy infrastructure projects – what do you think? May this bubble continue for more several years?

    Reply
    1. Yaniv Uliel Post author

      Mark – stimulation is always a concern but it seems like this leadership understands that stimulating by building more is like “drinking poison to quench one’s thirst.” In addition, it gets more and more difficult to make an impact by stimulating because the base is so large. It’s one thing to stimulate an economy that consumes 400mt of steel a year and totally another thing to stimulate an economy that consumes 820mt. As with everything, there is also a decreasing marginal utility to it: even if they try to stimulate on a larger base the impact on the GDP will be lower than in previous stimulations.
      So in my opinion a stimulation is not so probable but even if it does take place it shouldn’t hurt us in the longer term… I might be wrong on this so make sure to manage your exposure and run your own scenarios.

      Reply
  2. Miki

    Yaniv, I will use this stage to continue the thread from your previous post.
    First Kudos for the research. Your post and Ido’s post encouraged me to run my own study over the Iron Ore market and the mining companies.
    From what I have looked I found that Iron Ore prices averaged about 135$/mt. I looked at this index: http://www.indexmundi.com/commodities/?commodity=iron-ore&months=12
    Am I wrong? Should I be looking at a different one?
    Thanks, great post.
    Miki

    Reply
    1. Yaniv Uliel Post author

      I’m not sure about the website you looked at as the last quote there is from April and current prices are below $100/mt but the best source for it is from Bloomberg and the index you should refer to is either “China import Iron Ore Fines 62% fe spot (CFT Tainjin port)” note that there is a similar index with 58% fe. Maybe Ido can refer you to a free site with good quotes I have access to Bloomberg so I just get it from there. A good way (and quick) way I can think about is to search for “Iron Ore” on http://www.bloomberg.com and there is always a recent articles that give the right quote, for instance:
      http://www.bloomberg.com/news/2014-05-28/iron-ore-tumbles-to-lowest-since-2012-as-global-glut-widening.html

      Reply
  3. Amir

    I tried to check some put options for Rio Tinto. They are very expensive
    So it seems the market is not that positive for the company

    Reply
  4. S Bury

    Hey Yaniv, I’m just catching up on your blog just now 🙂 Great analysis on IO. The writing has been on the wall for a number of years. On the demand side, as you have covered in the previous post, we will certainly not continue to see the sustained high levels of steel production in China, and certainly not beyond a billion tons per year. A clear indication of this is also to look at how much idle steel capacity is in China. I don’t know the number off the top of my head, but it is HUGE. Second, the miners are still acting as if the push for a billion tons of steel and beyond is going to happen and will be sustainable for another 10-20 years. Yet, if you look at how many projects have been canned in Africa, plus the cutting back of Capex in mineral’s exploration by miners, it is a clear indication that even they are starting to realize the party is over. What will make it a double whammy, especially for Australian miners, is that they’ve let their costs creep up significantly during the boom, which is really going to erode their margins over the next couple of years.

    Reply
    1. Yaniv Uliel Post author

      Hi Stefano, thanks for the comment and welcome to the blog, the INSEAD crowd will definitely make the discussions more interesting 🙂
      I totally agree with everything you wrote, great insights! I think the big players came to recognize the change too late as early signs for tough times (Chinese demand) started to show as early as 2011. Anyway, utilization rates of Chinese steel mills are around 70% and this is tough in a such a high fixed-cost business. Just to provide some perspective, POSCO runs at almost a 100% utilization rate…

      Reply
  5. ofer

    Rio’s report from today looks (too) good. Don’t understand the demand source.
    It is still huge.

    First-half shipments of iron ore – up 23%.


    The growth of our Pilbara iron ore business has enabled us to deliver additional Pilbara Blend iron ore
    volumes to Asian steel markets, providing our customers with reliable, long-term supply of stable quality.
    Our Yandicoogina and Robe Valley products remained in high demand from major steel mills in Asia.

    Approximately 25 per cent of sales in the first half of 2014 were priced with reference to the prior quarter’s
    average index lagged by one month. The remainder was sold either on the current quarter average,
    current month average or on the spot market.
    Second quarter sales set a new quarterly record of 71.8 million tonnes (100 per cent basis), 27 per cent
    higher than the same period of 2013.

    Reply
  6. Yaniv Uliel Post author

    Vale released it’s production report too:
    http://www.bloomberg.com/news/2014-07-24/vale-posts-record-iron-ore-output-for-2q-as-prices-fall.html

    It is very nice to see how all the miners boost their production while prices are falling and inventories at Chinese ports are at a record high. I wonder what the outcome of this dynamic is going to look like.

    Seems like the big miners are still playing catch up with high levels of production targets, which in my opinion, will exacerbate the oversupply situation even further. Bearing in mind that price times volume equals revenue, some miners saw an increase in volume that outpaced the decrease in price. This game can’t be played for too long, unless unexpected demand for iron ore hits the market, a demand that at current levels it is hard to see coming.

    Reply
  7. ofer

    I don’t see yet vale iron shipments but I’m trying to understand how RIO shipments (not production) increased.
    Any idea where such demand rising delta came from in such conditions (opposite to the price and to china details) ?

    Reply

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