I ended part III of this article series with the following table:
Let’s see where we are now:
As we can see, going short these stocks paid off handsomely. Let’s explore this in some more detail.
Iron Ore Price and Demand
When part III was released the price of iron ore (62% CFR, Tianjin Port) stood near $93 per dry metric ton. Now prices are around $75 and that explains the price decline of most miners. However, the outlook became even more gloomy as the Chinese government took only measured steps of injecting some more liquidity to their limping banking system and announced plans to build even more roads, airport and g-d knows what. The issue is that the scale of these programs, which once used to be enough to move the needle, isn’t enough to this time around.
A growth that depends on investment in fixed assets is tricky. In the beginning it works very well but as time passes by, the amount of investment needed to keep the same growth rate compounds until huge amounts of investments are needed just to stay in place. The infrastructure stimulus program that was recently announced by the Chinese government used to be significant only 6-7 years ago. Nowadays it is just a drop in the bucket.
The situation in the Chinese real-estate market isn’t good to say the least. Inventories are piling in many cities and prices have been declining for a while now. Land sales to developers also trend down and as of now, it seems like the day of reckoning has finally arrived and people in China start to realize that home prices can’t increase by 20% a year every year forever. We will see how the situation unfolds on the demand side.
Also, China recently imposed an import tax on coal and that might be the precursor for a similar move in the iron ore market. Those who hope that China will just close inefficient mines, which will lead to mass layoffs, may have to think their theory again. In the face of that, here is what Mr. Martins, a senior VALE executive thinks:
So I believe that long-term China local production will be around 200 million against the 350 million that they have to be producing before this low price area started.
Let’s wait and see if China’s government will act as Mr. Martins expects, I bet he is dead wrong.
Iron Ore Supply
Great minds think alike and judging by what the iron ore mining bosses are doing it seems that not-so-great-minds also think alike. What would you have done have you been facing a soft demand and falling prices for the commodity that you produce? Here is what the mining moguls are doing:
Vale’s CEO, full steam ahead: First of all, I’m pleased to report that Vale delivered a strong operational performance in the third quarter with record output iron ore, copper and excellent production of nickel.
Total iron ore production, reached a record, sales volume remaining stable and our flagship ferrous minerals, suffered most from the reduction in sales prices which dropped to the overall EBITDA decrease of $1.1 billion versus the second quarter of the year.
…in preparation for an increase in production volumes in the coming quarters…
Iron ore cash cost will decrease even further with the production increase, diluted fixed cost and our internal cost reduction initiatives
The line of reasoning for the mining moguls goes like this: prices are falling due to weak demand, so we have to produce more to make up for the price decrease by volume increase. Also, price decrease is good for us because Chinese miners will go out of business. Well, I don’t know to which business school did they go but I just can’t see how increasing supply in the face of weakening demand and a commodity product can do any good to the shareholders. I think someone has to re-take econ 101.
Here are some nuggets from RIO’s Q2 call:
In the Pilbara, we’ve reached nameplate capacity of 290 million tonnes a year, two months ahead of schedule, leading to new records for shipments and production…
And we continue to pursue the most value accretive pathway, to rapidly increase mine production capacity by more than 60 million tonnes a year by 2017
So we are in a very good place in relation to this and now is not a time for the best iron ore producer in the world to take a step back
I have to give a hat tip to Sam Walch and Rio Tinto. This company is the most efficient player in the iron-ore market as it has the lowest production cost in a commodity business and it is better ran than their peers. This is well reflected by the performance of their shares in the period since my last write-up. Vale has by the far the worst execution and the decision making there is totally unclear to me. Due to it’s leverage, Fortescue has no choice but to increase production and hope for a rebound in prices.
The same tune of increased production repeats when you listen to the executives of Fortescue and BHP. I will save that from my readers.
Anyway, the pattern here is clear: all the big players are increasing production in the face of weakening demand because they believe that Chinese miners will exit the market and that Chinese demand will recover. I guess they all hired consultants who told them what would be the rational to do if all other players don’t change their course of action. So the result is a lot of extra supply coming into the market in the coming years and this supply will meet very soft demand, I guess the date between the two isn’t going to be pleasant.
Obviously, I was somewhat lucky with the timing of my post versus the timing of the collapse in the price of iron ore. However, it seems that the iron ore glut that we are seeing won’t end until iron ore prices will reach to around $50. At this level, a lot of big mines will become unprofitable and some capacity will be forced out of the market. We may see a rebound or two until that happens but give the strategies of the iron ore moguls this seems to be inevitable. For the risk averse, this might be a good time to take some money off the table if they don’t want to deal with he consequences of a rebound in the price of iron ore.
I will update again sometime next year so stay tuned.