The proxy, in this case the iron ore price, serves almost exclusively as the variable determining the investment community's sentiment towards the sector. This is the rational approach of course, but what if, for a moment, we were to think not like shareholders, but like business people.
What if the Iron Ore price were to drop below the $50 level this year, and stay there for a protracted period of time? I'd imagine that most of you, given the phrenic constructs you have already put in place, would postulate that margin compression would render investment into the sector unfruitful for a number of years. Seems logical, but the thing is, the worlds biggest and baddest producers disagree. At the very least we should ask why.
So lets start by analyzing the state of the current market:
The US Dollar: Headwind - A 23% appreciation against a basket of global currencies in the last year, placing considerable downward pressure on all commodity prices, not least of all, Iron Ore
The Aussie Dollar: Tailwind - Having depreciated by 19% in the past 12 months, the currency has gone a long way in cushioning the blow experienced by the self-imposed 56% drop in the Iron Ore prices.
Interest rates: Tailwind - Swaps currently suggest a 74% probability that the Reserve Bank of Australia will cut interest rates next month.
Steel Production: Tailwind - Growth of just 1% per year in China would be required to reach 1 billion tonnes of crude steel production by 2030.
China Supply: At first glance, it would appear that the deliberate oversupply, and ensuing price decline brought about by the majors is bearing fruit. Almost 90 million tonnes of iron ore production cuts have already taken place in China, with the country now sourcing only 20% of total demand from its 4037 domestic suppliers, down from 50% last year. These Chinese producers would be in a worse state still, were it not for accommodative local governments fortifying local operations through tax breaks and other forms of palliation. In fact these synthetic competitive advantages have been efficacious enough to have already facilitated a production increase of 7% for the first half of the year, taking total production for the first six months of 2014 reaching 710 million tonnes. Chinese mines are however operating at an average of only 40% of total capacity, down from 75% last year, with 75% of existing Iron Ore production operating at a loss. Sustained price action below $80 would result in further substantial Chinese production cuts in the region of 125 million tonnes, according to Rio Tinto's Chief Executive Officer Sam Walsh.
China Demand: The "disappointing" economic data released recently diverts from the fact that for the first time, strong growth in the services sector means that services now account for more than half (51.6%) of GDP in the first quarter, indicating that the desired shift from a manufacturing led, to a consumption led economy is beginning to take shape. “The latest GDP report underscores offsets coming from China’s services-led transformation, a key underpinning of consumer demand,” said Stephen Roach, a senior fellow at Yale University and former non-executive chairman for Morgan Stanley in Asia. “I suspect the economy is close to bottoming and could well begin to pick up over the balance of this year.”
Australia: Production now tops 1.1 billion tonnes, and accounts for 83% of global production. Governments hands off approach has however seen the suspension of junior miner Atlas Irons 13 million tonnes of production, along with a 40% production cut at Odisha Iron Ore and Sinosteels closure of its Blue Hills operation. UBS estimates that all Australian miners would be operating at a loss under $34 a tonne. At present however, we find BHP Billiton announcing a 19% production increase, Rio Tinto an 18% increase, Vale a 13% increase, and Fortescue, Australia's fastest growing producer, a 54% increase. So all in all, it seems to me for one, that everything is going according to plan. Local government, along with a large number of smaller producers have however begun to weigh in on the matter, with Nev Power of Fortescue, seemingly on the verge of requesting government intervention. "I am not sure what they [BHP Billiton and Rio Tinto] are doing but all I can say is that the current state of the iron ore industry has been a disaster for everyone. It's has ripped the heart out of the industry, it's ripped the heart out of the suppliers and contractors to the industry, it's ripped out the heart out of the communities, and there are absolutely no winners out of any of this, only losers". It also seems that given a $1.3 billion Western Australian budget shortfall, and a second credit rating downgrade looming, Premier Barnett is well-incentivized to do so. They are socialists after all.
The route cause of any deliberate market share consolidation is the conscious decision by major suppliers to substitute higher margins with higher volumes in the hope that the vector of price reduction will be more shallow than the vector of volume increase, thus increasing net profitability.
Which companies then, if any, will survive this transition from margin-focussed sales, to volume-focussed sales, and emerge with a considerably larger market share than before?
In the short term, the actions taken by the majors does have its downside. 46% of BHP Billiton's profits are paid out in the form of dividends, and with those yields over 5% in the case of both BHP Billiton and Rio Tinto, the maintenance of the progressive dividend policies common to the majors is now threatened. Given the fallout and management changes resulting from the financial crisis dividend cuts, it is unlikely that current dividends would be reduced before, at the very least, the Iron Ore price reaches the lower half of current range estimates. The gap will therefore need to be filled in the interim by a combination of borrowings and spending cuts, both of which increase cost of funding and the probability of a ratings downgrade.
Goldman estimates that at an Iron Ore price of $40 or below, Billiton, Rio, and Anglo American would have to reduce dividends, and Kumba Iron Ore would have to suspend its dividend completely. At that price, all Chinese production will have ceased, BC Iron and Fortescue, with costs of production at $39 will likely also have ceased production completely. The majors would remain operationally profitable at that stage, but with both government and shareholder related pressures weighing even more heavily on management by then, we can reasonably assume that cuts would be a very real probability.
In conclusion, with Citi having recently lowered its price forecasts to an average of $37 a tonne for the rest of the year, its survival of the fittest, and with production costs at Kumba's Sishen mine at $30.60 a ton in 2014, and $24.84 at Kolomela, representing its two largest operations, it is clear that Kumba's metrics far more proximately resemble those of the majors than the minors. With both operational and production costs in the lower percentile of global producers, accommodative Chinese and Australian policies pending, eventual production cuts, and a lower competition environment moving forward, Kumba in fact stands to benefit from the very market share consolidation designed by the majors to destroy its counterparts. A windfall that would not have been accessible were Kumba not the quality operation it REMAINS today.
You can follow our Guest Writer on Twitter @Mercedarians
Australia: Production now tops 1.1 billion tonnes, and accounts for 83% of global production. Governments hands off approach has however seen the suspension of junior miner Atlas Irons 13 million tonnes of production, along with a 40% production cut at Odisha Iron Ore and Sinosteels closure of its Blue Hills operation. UBS estimates that all Australian miners would be operating at a loss under $34 a tonne. At present however, we find BHP Billiton announcing a 19% production increase, Rio Tinto an 18% increase, Vale a 13% increase, and Fortescue, Australia's fastest growing producer, a 54% increase. So all in all, it seems to me for one, that everything is going according to plan. Local government, along with a large number of smaller producers have however begun to weigh in on the matter, with Nev Power of Fortescue, seemingly on the verge of requesting government intervention. "I am not sure what they [BHP Billiton and Rio Tinto] are doing but all I can say is that the current state of the iron ore industry has been a disaster for everyone. It's has ripped the heart out of the industry, it's ripped the heart out of the suppliers and contractors to the industry, it's ripped out the heart out of the communities, and there are absolutely no winners out of any of this, only losers". It also seems that given a $1.3 billion Western Australian budget shortfall, and a second credit rating downgrade looming, Premier Barnett is well-incentivized to do so. They are socialists after all.
The route cause of any deliberate market share consolidation is the conscious decision by major suppliers to substitute higher margins with higher volumes in the hope that the vector of price reduction will be more shallow than the vector of volume increase, thus increasing net profitability.
Which companies then, if any, will survive this transition from margin-focussed sales, to volume-focussed sales, and emerge with a considerably larger market share than before?
In the short term, the actions taken by the majors does have its downside. 46% of BHP Billiton's profits are paid out in the form of dividends, and with those yields over 5% in the case of both BHP Billiton and Rio Tinto, the maintenance of the progressive dividend policies common to the majors is now threatened. Given the fallout and management changes resulting from the financial crisis dividend cuts, it is unlikely that current dividends would be reduced before, at the very least, the Iron Ore price reaches the lower half of current range estimates. The gap will therefore need to be filled in the interim by a combination of borrowings and spending cuts, both of which increase cost of funding and the probability of a ratings downgrade.
Goldman estimates that at an Iron Ore price of $40 or below, Billiton, Rio, and Anglo American would have to reduce dividends, and Kumba Iron Ore would have to suspend its dividend completely. At that price, all Chinese production will have ceased, BC Iron and Fortescue, with costs of production at $39 will likely also have ceased production completely. The majors would remain operationally profitable at that stage, but with both government and shareholder related pressures weighing even more heavily on management by then, we can reasonably assume that cuts would be a very real probability.
In conclusion, with Citi having recently lowered its price forecasts to an average of $37 a tonne for the rest of the year, its survival of the fittest, and with production costs at Kumba's Sishen mine at $30.60 a ton in 2014, and $24.84 at Kolomela, representing its two largest operations, it is clear that Kumba's metrics far more proximately resemble those of the majors than the minors. With both operational and production costs in the lower percentile of global producers, accommodative Chinese and Australian policies pending, eventual production cuts, and a lower competition environment moving forward, Kumba in fact stands to benefit from the very market share consolidation designed by the majors to destroy its counterparts. A windfall that would not have been accessible were Kumba not the quality operation it REMAINS today.
You can follow our Guest Writer on Twitter @Mercedarians
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