Why the iron ore bears will always end up disappointed

Despite iron ore’s well documented economic significance, it faces deep-seated pessimism among industry commentators (writes Mark Eames in The Australian Financial Review).
12th February 2021
Resources Rising Stars

Despite iron ore’s well documented economic significance, it faces deep-seated pessimism among industry commentators (writes Mark Eames in The Australian Financial Review).

The commodity supports 70 per cent of the world’s steel production. Steel is everywhere, underpinning our modern civilisation. Production of the next most significant metal, aluminium, is one-30th the volume of steel globally.

Iron ore generates two-thirds of global mining industry profits.

It’s no surprise that it accounts for almost all the profit in Fortescue Metals Group or Vale, but it does so even in the diversified companies where iron ore is a relatively small part of the asset base.

Iron ore accounted for three-quarters of Rio Tinto’s recent earnings, and two-thirds of BHP’s earnings.

Iron ore is by far Australia’s largest export. At current prices it represents up to 10 per cent of Australian GDP and royalties cover almost 20 per cent of Western Australia’s government revenue.

But despite its significance, a lot of iron ore commentary appears superficial or tentative. There’s coverage of day-to-day news, but analysts seem continually surprised by overall industry trends.

Take price as an example. In the past 15 years, there have been three troughs and two peaks. Long-term iron ore price consensus has moved from $US61 a tonne to a little over $US65 in the last year.

This consensus does not seem realistic, given that as a back test, iron ore prices spent 83 per cent of the time above this level and averaged 55 per cent higher even in nominal terms – and current spot prices are around 160 per cent higher than long-term consensus.

And it does not seem consistent – any investor using this long-term iron ore price to calculate company values would sell every major miner in the world, yet analyst consensus recommendations are “buy” or “outperform” for the major producers.

This deep-seated pessimism is not a new phenomenon.

Morgan Stanley analysis shows both a consistent bias towards pessimism where the majority of forecasts for long-term prices are lower than the spot price at the time, and towards pro-cyclicality, where the majority of forecasts assume price close to the current spot will continue.

About five years ago, one major bank forecast prices as low as $US35 a tonne which, had it occurred, would have led to major losses and cutbacks across the major miners.

The actual price for the period was almost double at $US65. Ironically, the price in the month when the report was published was the trough (and the lowest month in the entire 15-year series) and still above $US40.

So how should we break down iron ore to understand it better?

First, the imminent demise of Chinese steel demand seems to be greatly exaggerated.

We all know that steel demand is driven in large part by urbanisation and industrialisation trends, for which China has been a major player in the last 15 to 20 years. No other steel producer has seen production collapse after industrialisation.

On a simple measure, China’s urbanisation rate has increased from 40 per cent to 60 per cent in the last 15 years. But the United States is at more than 80 per cent and Japan at more than 90 per cent, so China has much further to go to reach the same level.

Second, there are many other sources of potential demand growth. Half the world has yet to urbanise.

While discounted by most observers, India is actually following largely the same macro trend as China. China hit 100Mt steel production in 1996, having doubled in the previous decade, then added 300Mt in the following decade (which nobody expected). India hit 100Mt in 2017, also having doubled in the last decade.

Pessimistic iron ore observers consistently point to low production costs at the major miners and the likelihood of them flooding the market with additional production, but major iron ore expansions, much predicted in the last five years, have largely proved a mirage. And the share prices of prospective iron ore developers remain discounted compared with previous periods of strong iron ore prices.

Even setting aside Vale’s well publicised woes, Australian iron ore exports have increased only marginally. In 2015, Australia exported about 70Mt each month and since then we have seen the ramp-up of the major $10 billion Roy Hill operation and high iron ore prices.

Meanwhile, exports are still stuck around 70Mt per month, despite a massive increase in Chinese demand.

How can we explain both the limited increases and the mismatched perception?

The first thing to understand is that iron ore reserves at existing mines are limited, so the major miners need to spend substantial sums every year just to maintain production.

But the reality is the majors are not investing substantial sums in growth. For example, Rio has only been able to deliver part of the promised volume growth of its last expansion, and in the first half of 2020 invested less than 10 per cent of iron ore EBITDA on “replacement and growth capital”.

The major producers are chewing through reserves while production has essentially remained the same for five years.

Continuing strong demand from China with limited expansion by the majors would lead to a contrarian view of sustained high iron ore prices.

So, if as an investor you don’t share the deep-seated pessimism of many iron ore commentators, there are plenty of investment opportunities that leverage the gap between the pessimistic perception and the robust reality. One sector that has yet to see much institutional investment support is the range of iron ore juniors looking to develop assets.

And as the great investor Benjamin Graham said: “The intelligent investor is a realist who sells to optimists and buys from pessimists.”

 

Mark Eames is the former head of iron ore assets at Glencore and has held senior mining positions with Rio Tinto and BHP.

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