Monday, July 30, 2012

Commodities Australia: Iron-Ore Price Floor Could Be Flawed Thinking

The words “floor” and “flaw” sound identical to the human ear, but their meanings could not be more different as far as Australia's multi-billion dollar iron ore industry is concerned.

The iron ore sector will have one of its most widely-accepted truisms tested in coming days as the benchmark price for the bulk commodity sinks to levels that are widely considered to be its “floor”.
And the stakes couldn't be higher if that floor turns out to be a flawed assumption that has underpinned the entire industry for years.

Companies, investment banks, governments and anyone else with an interest in the sector have long worked to the assumption that there is a floor beneath the benchmark iron ore price somewhere around $US110 per tonne.

Gina Rinehart has been allowed to import more than 1700 foreign workers to help build a massive iron ore project in Western Australia.
Falling iron ore prices are testing some of the accepted wisdom about the bulk commodity. Photo: Reuters


The words “floor” and “flaw” sound identical to the human ear, but their meanings could not be more different as far as Australia's multi-billion dollar iron ore industry is concerned.

The iron ore sector will have one of its most widely-accepted truisms tested in coming days as the benchmark price for the bulk commodity sinks to levels that are widely considered to be its “floor”.
And the stakes couldn't be higher if that floor turns out to be a flawed assumption that has underpinned the entire industry for years.

Companies, investment banks, governments and anyone else with an interest in the sector have long worked to the assumption that there is a floor beneath the benchmark iron ore price somewhere around $US110 per tonne.

This price range is where a large number of high-cost Chinese iron ore producers are believed to have their financial threshold: meaning they would become uneconomic and go out of business should the price fall below $US110 per tonne for a sustained period.

These producers are believed to supply about 30 per cent of China's iron ore needs, so if the theory is correct, a dip below that floor price could leave China's steel producers without a decent proportion of their prime ingredient.

The floor theory is hard to prove from this distance, but it has become an article of faith for the iron ore industry and the banks, all of whom have sophisticated intelligence networks.

The theory has also been supported by correlative evidence in recent times, most notably in October 2011, when a major slide in the iron ore price was finally arrested around $US116 per tonne, from where it immediately soared higher.

Just last week HSBC published an interesting report on this topic. They suggested that the floor might be even higher than first thought.

“This year has been a test of the thesis that Chinese high-cost iron ore supports the iron ore price … prices have largely held above $US130 per tonne, indicating that the size or cost of low-grade Chinese ore might be larger than expected,” the bank wrote.

“We continue to believe that around one third of Chinese domestic iron ore production is very low grade with a cash cost of production of approximately $US120 to $US130 per tonne.”
But now the floor is being tested once more.

The benchmark iron ore price has been sliding for two weeks now, and in the past 24 hours it slipped to $US118 per tonne.

Some might suggest that slip already disproves HSBC's theory, but such a judgement would be premature: the lower level would need to be sustained for some period to disprove HSBC's view.
But what is certain is that the price movements in coming days and weeks will be keenly watched by a sector that would have to rethink its approach to business should the floor theory be disproved.

Australian companies with the most exposure to the iron ore price include the pure-plays like Fortescue Metals Group and Atlas Iron, both of which have been savagely sold down in recent times.
Atlas shares have lost 20 per cent of their value in the past three weeks, and at $1.63 the stock is a shadow of the $4.21 it was fetching one year ago.

Fortescue has also shed 20 per cent of its value in the past month, and more than a third of its value over the past year.

That's music to the ears of Fortescue's army of short-sellers, who have been inspired by the opinions of American short-seller Jim Chanos.

Fortescue has the added worry of needing the iron ore price to stay strong to service its $9 billion in debt.

None of the analysts from the major investment banks expect Fortescue to have a problem meeting its debt repayments, but all of those analysts subscribe to the theory that there is a floor beneath the iron ore price.

They, like most people in the mining sector, will be hoping the floor theory does not turn out to be a case of flawed thinking.