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Australia's Oil Price Advantage In Iron Ore
FN ARENA NEWS - 05/06/2008


The surge in spot iron ore prices in the first half of 2008 suggests China will take just about any iron ore it can get its hands on at present. While the big global producers of Brazil and Australia have been fighting it out with Chinese steel makers over annual contract prices there has been a surge in exports to China from the likes of India, as well as Ukraine, Russia, Thailand, Indonesia, Mexico and Iran.

At the same time, and despite Brazil experiencing unexpected production delays, exports to the other big steel-making area of Europe have actually fallen 6-7% this half, Macquarie reports.

Macquarie expects an even greater surge of exports into China in the second half of 2008, this time from the big producers, as all have meaningfully been increasing their production capacities. Normally exports over this period drop off, with the Indian monsoon season closing down activity there, but this year there is a new player on the block to make up the difference - one Fortescue Metals (FMG).

Based on announced plans to raise production, notes Macquarie, exports from Vale (Brazil) and Rio Tinto ((RIO)) should be much higher in the second half than the first, and with other Australian producers chiming in, as well as other producers from Brazil, India and South Africa, year-on-year growth in 2008 seaborne exports could be as high as 150mt, assuming no disruption.

Which brings us to an interesting point.

As we speak Rio and cohort BHP Billiton ((BHP)) are in China standing fast on price negotiations for this year's iron ore contracts. Brazil has already settled on its price rise, but the Aussies are holding out for more. The argument is not over the base iron price, as that is a simple case of strong demand and restricted supply. The argument is over freight rates.

On a longstanding arrangement Australian iron ore producers receive less for their iron ore than Brazil does because they once agreed to absorb more of the freight cost to China. As Australia is much closer to China than Brazil, it costs a lot less in bulk carrier freight costs to get it there from Australia, which should naturally put Australian producers at an advantage. But actually they are at a disadvantage because of this previous arrangement.

Vale is the world's biggest producer of iron ore. Usually Vale sets the price first, and the Aussies then humbly fall into line behind that price, accepting the fact that they'll actually receive less because of the disadvantageous freight differential. As we all know, BHP plus Rio is greater than Vale, and in the past, indeed right up to last year, BHP has tried to get Rio to collude on price negotiations with the Chinese. If the two were to stand fast together then China would have little option but to bow to a new freight arrangement.

But Rio has always capitulated and leverage has been lost. This year Rio has a new CEO, and he's "Broken Hill Tinto" all the way, at least as far as price negotiation is concerned. China is infuriated, and that's before any talk of the two actually merging. In the Chinese culture you do not go back on a deal, and the Chinese have insisted that they will not accede to Australian demands for a better deal on freight. However, China now has little choice. It's been paying much, much higher spot prices for lower grade ore from elsewhere while it continues to bang chests with the Aussies.

In the meantime Twiggy Forest is sitting back in Perth reading the BRW Rich List and waiting for the big announcement that China will pay 100%+ more for ore this fiscal year.

On the assumption that BHP/Rio do break the Chinese resolve, then a whole new precedent will be set. That precedent means that Australia will simply receive more for its seaborne iron ore than anyone else, because it's closest. The cost of shipping ore from Port Hedland to China will be the least. And this is a very important factor in the context of today's oil price.

Ten years ago, notes GSJB Were, when the long term price of oil was marked as US$18/bbl, the freight differential on seaborne iron ore was US$5-8/t. If we assume, as most do, that the long term price of oil has now quadrupled, this implies a freight differential of US$20-32/t. If BHP/Rio win the negotiation, then Australian iron ore producers have that much as an advantage in price. Thus, says GSJB Were, the biggest winners in the global iron ore space will be those Australian producers with long-life assets and the ability to expand those assets.

The main beneficiaries are thus BHP, Rio and - of course - Fortescue. Other Australian producers will not miss out either, noticeably Mt Gibson ((MGX)), Murchison ((MMX)) and, to a lesser extent, Portman ((PMM)), which exports from way down in Esperance.

In playing the "whaf if" game, Weres notes that a US$20/t freight differential increases Fortescue's net present value from $5.95 to $10.46. If Fortescue then uses the increased margin to expand production to 200mtpy as planned, NPV rises to $17.53. Throw in a 20% increase in the long term iron ore price, and that becomes $20.92. Weres currently has a 12-month price target of $12.99 on the stock.

These assumptions about freight rates are only based on the oil price. But Macquarie introduces another factor. Given the big jump in new iron ore production across the globe in the second half of this year, bulk carriers will be in very tight supply. In fact, demand should easily exceed supply, such that there simply won't be enough ships. This will likely push freight rates through the roof, which again provides the advantage to whoever is closest.

At the same time, Macquarie suggests a lot of the Chinese buying will be to replenish much diminished stockpiles, and when these are refilled there will actually be more seaborne iron ore for sale than China needs.

But don't panic - the imbalance won't last long. This little supply growth blip (which includes Fortescue coming on line) won't last long, and production growth rates will settle back once more. Chinese demand will continue to grow steadily, and catch up again in 2009.

One presumes there will also be a rush across the globe to build more bulk carriers. What do you need to build more ships? More steel! And what do you need to make more steel? More iron ore!

This could go on for a long time yet.