Since late last year, the iron ore price has rallied by more than 50%, increasing from less than $40/tonne to approximately $60/tonne today. It has coincided with renewed optimism (by some) over a return to the credit-fueled fixed-asset-investment-led growth model that has characterized China over the last decade. Should Chinese policymakers instruct their banks to fund new infrastructure and property projects, then demand for steel and iron ore will accelerate.
We have seen a small burst in activity over recent months with an uptick in electricity consumption growth in China, as shown below. The question is: will this uptick mark a new sustained period of fixed-asset investment growth? Or will it be a temporary uptick that peters out over subsequent months?
We are very much in the camp of the latter. The current uptick in activity reminds your author of the month of August in 2013. During this period, we observed a sharp acceleration in electricity demand and even steel consumption growth in China. It took the entire market by surprise and did not make sense with the overarching picture of deteriorating fundamentals in the Chinese economy. Of course, as months passed, the underlying fundamentals took over and consumption growth in commodities slowed and eventually turned negative.
For those believing this is the beginning of new sustained period of Chinese fixed-asset investment growth, this view seems to overlook the issues this would create in the Chinese banking system. We are already seeing the loan quality within Chinese banks clearly deteriorating at an accelerating rate. (More on this in a subsequent blog post).
So what if this price rally is temporary, just as it was in August 2013, and there is no sustainable uptick in Chinese steel consumption to follow? Well, in this scenario, the iron ore price should fall back below $40/tonne. The chart below illustrates the all-in cash cost of production to deliver iron ore to China for each producer. All-in costs include on-mine costs, maintenance capex, head office costs, transportation costs from the mine to port of origin, royalties, net interest expense, freight from port of origin to port of destination (China), lump/pellet ratios, iron content (grade) relative to 62% benchmark, moisture and impurities.
The horizontal axis of the chart above illustrates the volume of production capacity for each producer. And it is important to remember that these volumes (the width of the boxes) will even be increasing over the coming years for the likes of Rio Tinto, BHP Billiton and, most substantially, for Vale. (Vale is set to increase its production capacity by c25% beginning later this year).
The combination of this expanding base of production capacity combined with a level of global steel consumption (which is currently contracting) leads one to the following conclusion: absent some enormous and sustained uptick in Chinese fixed-asset-investment, the marginal suppliers of iron ore over the coming years will likely be Fortescue and Vale.
If this hypothesis turns out to be true, then the following two corollaries follow:
- The iron ore price will fall to a level that approximately reflects the cost of production for these two producers (sub $40/tonne); and
- The profit generated by these two producers will be approximately zero.
While we certainly cannot predict the behavior of Chinese policymakers, our hypothesis is that they will not pursue the enormous fixed-asset-investment stimulus that is being priced in by the equity markets. Not only would such a stimulus run counter to public statements that have been made by Chinese economic leaders over recent years, it would genuinely risk impairing the Chinese banking system – pockets of which are already surely insolvent.
If we are correct on this hypothesis, then the iron ore price will fall significantly. And so too will the stock prices of many iron ore producers. We continue to monitor the situation closely.
Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.