Stealth demand for iron ore drives boom
The reason why iron ore is at near record highs after the worst year for the global economy in a decade is: Chinese property developers (writes fund manager James White in The Australian Financial Review)
18th December 2020
Resources Rising Stars
The reason why iron ore is at near record highs after the worst year for the global economy in a decade is: Chinese property developers (writes fund manager James White in The Australian Financial Review). They are building 14,000 Eureka Towers per year.
The rise in the iron ore price over 2020 has been the one positive economic shock for Australia in this strangest of years. The return to 2012 levels has come with little fanfare and considerable uncertainty.
How can the worst year for the global economy in a decade drive near record highs for red dirt?
There is a simple, and broadly correct, explanation for the rise in the iron ore price. It is “big numbers”; the idea that regardless of economic cycles, China requires an enormous amount of anything to accommodate its population.
The best rebar and cement example is the property sector where last year 1.7 billion square metres of property was sold.
To put this in context, the Eureka Tower is one of Australia’s largest residential towers at 123,000 square metres.
If China’s annual residential property sold was built in Eureka Towers (14,000 of them) and one constructed every 65 metres, it would line the Hume Highway from Sydney to Melbourne.
In terms of population, 14,000 Eureka Towers, with 556 apartments and an average two occupants per apartment, is equivalent to 15 million people, matching annual urbanisation of one per cent or 14 million people.
Of course, there are economic and monetary cycles, and these do influence demand for iron ore. But in this cycle, there is an absence of any signal from economic growth, monetary policy or speculation.
Economic growth has re-accelerated but only towards the pre-pandemic trend. Financial conditions are stable, according to the Goldman Sachs Financial Conditions Index, relative to the last three years. Speculation, represented by inventories, is muted.
The explanation for iron ore’s strength is a sophisticated version of the simple, “big numbers” theory. Price strength is driven by a desire for stability amongst market participants, the financial authorities, miners and property developers.
There has been no sign of either a new monetary or fiscal expansion in the last three to four years. Indeed, while financial conditions are looser than in 2016-17, fiscal expenditure in China in 2020 has been flat relative to 2019, despite the pandemic.
Similarly, the large Australian miners, with the assistance of Vale’s troubles, have been disciplined in restraining capacity. Indeed, 2019 capital expenditure amongst the large Australian miners was one third of the 2011 or 2012 peak.
Sales to capital expenditure ratios are around 7 times today compared to 2 to 4 times in 2012. Stable supply growth has been a key to creating long-term, upward price pressure.
The least discussed, and most important, change has been the increased stability in the Chinese property cycle, driven by the listed property developers.
It’s easy to miss the strength of demand for iron ore from property when two of the key indicators, property sold and property completed, show a stable to falling market.
But a third indicator, property under construction shows the strength of demand and the change in developer behaviour.
The previous cycle was a near-death experience for many developers. Policy tightening made access to finance near impossible, saw an increase in defaults and profitability suffered in the rush to build.
This cycle, however, has been characterised by sector consolidation, stronger balance sheets, better earnings and improved access to capital. Essential to the stable cycle has been a move by developers to stagger the delivery of property to manage cash flow.
This change in behaviour is seen in the lag between an apartment’s sale and the revenue from the sale being recognised by the developer.
At the tail-end of the last cycle, property developers were selling property as it was constructed and immediately recognising sales as revenue.
By contrast, from 2015, construction has been delayed by up to three years to improve balance sheet liquidity and strength. For a sample of large, listed developers, deferred revenue, a balance sheet liability of developers, has risen four-fold.
Financial data from property developers matches economic data indicating property sold runs ahead of property completed.
Property developers have slowed construction of apartments to create a more even path for earnings and cash flow. This enables them to create shareholder value and lower their balance sheet risk. It also provides a strong indicator for miners that there remains strong demand for iron ore.
The increased stability in the property market, driven by developers, is a prerequisite for the delivery of 14,000 Eureka Towers per annum. This quantum of property cannot be sustainably delivered any other way.
For Australia, this industry dynamic is creating support for an iron ore price that seemed impossible three years ago and is very welcome today.
Image credit: Rio Tinto
© 2021 Resources Rising Stars All Rights Reserved