It's happening again. Nobody is watching. Nobody is talking about it. But they will. They will have no choice.
Iron ore is crashing again, down 16 per cent in a month with falls accelerating.
How can this be, you might rightly ask yourself. A few short weeks ago, Australia's No.1 commodity export was powering towards new highs. Last year's crash was forgotten. China was leaping into recovery; it's new government was priming the stimulus pump, and its steel-hungry real estate sector was rising.
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The answer to the question is fourfold.
As most informed onlookers have argued, the iron rally was never what it appeared to be. The big rise in prices in the new year was a confluence of two events. The first was a large restocking cycle by Chinese steel mills, which had depleted their reserves during last year's freeze in China's heavy industrial economy.
The second influence was the sudden decline in Indian exports of iron ore as its courts closed down large sections of its mining industry to clean up illegal mines, squeezing supply at a critical moment.
The first of these influences has now passed. China's mills are back to regular supply levels for iron ore and for steel products, so demand has diminished. The shortage in India supply is still in effect, but it suddenly isn't looking so important. The reason why is simple enough.
As this year progresses, a very large amount of new iron ore supply is scheduled to come on-stream for the seaborne market. How much more? Nobody knows for sure but around 150 million tonnes is a fair estimate. It's the same the year after, and the year after that. India supply was about 50 million tonnes last year and will drop to 20 this year.
So despite Indian woes, supply is set to expand by 10 per cent-plus for the next three years, versus steel output growth of perhaps 5 per cent.
That brings us to our third reason for renewed iron ore weakness. The Chinese government and its central bank have declared very firmly in the past few weeks that it will not allow Chinese real estate to run away again. And they have issued new fiscal and macroprudnetial directives to ensure it, including a 20 per cent property tax on investors. (Imagine what that would do to demand if it were done here!)
The ANZ estimates that 30 per cent of Australian iron ore ends up in Chinese real estate (the RBA estimates half that), so this has markets very concerned that the recovery underway in heavy industry will not expand to private-sector development.
Rightly so, accompanying the new directives, the Chinese government has also announced a reorientation of its urbanisation plans away from "hard" to "soft" infrastructure, such as welfare safety nets. The bridges, roads, railways and houses will still be built, but they'll be a shrinking portion of outlays.
The final reason for recent price weakness is that the iron ore market is itself transforming. After decades of annual contract pricing that made prices predictable for customers and the long-term capital outlays of producers, BHP broke away in 2007 and insisted on shorter-term contracts priced against movements in the spot market. Since then, prices have been consistently very high as Chinese demand growth raced ahead of supply.
In the past 18 months, however, the supply and demand balance has come into balance, and as a result the spot markets that determine contract rises have increased in volatility around inventory cycles in Chinese steel demand. Moreover, the iron ore spot price has been increasingly influenced by the speculators and derivative markets that are burgeoning around it, such as swap contracts or steel futures.
Some of these derivatives got very excited in January and February on the assumption that the Chinese recovery would take hold more broadly and demand for iron ore would again pressure supply. All of these have now lost their 2013 gains and are still falling.
The economic implications of this volatility should not be underestimated. Iron ore and metallurgic coal (its twin in steel-making) make up roughly 35 per cent of Australia's exports earnings. When they fall they have a big impact on the economy. The crash of 2012 effectively ended the mining boom; by itself it is now forcing national income to fall and has triggered several rate cuts already. We can expect such volatility to continue as new supply comes online and China continues to shift its development path.
Other nations with similar dependencies – such as Chile, which relies upon copper for about 40 per cent of its export earnings – have installed high mining taxes and sovereign wealth funds to help stabilise government revenues and national income amid such volatility. It is not at all clear that Australia's method of letting the bull run and then somersaulting over the horns when it gets spooked is preferable.
David Llewellyn-Smith is the editor of MacroBusiness
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