iron ore exports to china hit record levels

Throughout the globe, international trade began a freefall that is only now starting to stabilize. There is one trade relationship that remains robust and experiencing new highs. Exports of goods from Australia to China hit an all time high in March according to the latest data from the Australian Bureau of Statistics. The export of Australian goods exceeded A$4 billion in March on the back of robust shipments of coal and iron ore. All indications are that this trend continued in April as well.

Australian has long since been the provider of natural resources to developing Asian countries. It played this role for Japan in the 1960s and 1970s, then did the same for Korea in the 1980s. Australians believe they are less than halfway through a multi-decade resource consumption boom fed by Chinese and Indian industrialization. While bilateral trade has plummeted around the world, Chinese imports of raw materials began picking up from the beginning of the year thanks to government stimulus spending.

Chinese steel production is returning but exports remain weak. Chinese industrial production figures from April show a stark difference between heavy industry related production and consumer export related production. Of the roughly 70 categories tracked, most of the ones with highest year over year growth in April are either capital goods or industrial related. The worst growth categories relate to consumer goods for export or local consumption.

Best YoY Growth in Chinese Production

Worst YoY Growth in Chinese Production
Category

Growth

Category

Growth
Large-sized Tractors

50 %

Fax Machines

-38.9 %
Industrial Boilers

30.3 %

Power Equipments

-26 %
Hydro Power Generating Capacity

18.9 %

Integrated Circuit (semiconductors)

-23.7 %
Civil steel ships

18.4 %

Room Air Conditioners

-20.5 %

Thus, the idea that the Chinese consumers could pick up demand slack left by the American or global consumer has proven to be wishful thinking. The Chinese government has considerable control of the economy but it appears ineffective in getting consumers to spend. The opposite is true for infrastructure spending and industrial retooling where government control of spending can be fairly direct. The powerful stimulus effect can be seen in steel production which is not demonstrating high YoY growth but has returned to 2008 peak levels, a remarkable accomplishment.

Steel production, iron ore imports up but ore prices down. Prices of iron ore, the main input to steel production, surged in mid-2008 to over US$150 per ton on the spot market, allowing the miners to lock in annual price increases of more than 80% to about $90/ton. An observant reader should question, “Why are iron ore imports to China at record highs when steel production is simply flat with last year?” The answer is that Chinese miners who have higher cost structures can no longer compete with spot prices today down to around $65/ton. Many have stopped producing. This price pullback has yet to bring a reduction in profits for the big three producers BHP Billiton (BHP), Rio Tinto (RTP), and Brazil’s Companhia Vale do Rio Doce (VALE) but it will from now. However, the silver lining for these mining giants is the share gains they are reaping as Chinese competitors shut in supply.

Tense negotiations on future pricing continue. While Rio, BHP and Vale have the Chinese mining companies on the defensive, the same is not true for their customers. Citing excess global supply of raw materials, steel mills throughout Asia are pressing for price cuts of up to 40% (back to 2007 levels) in the annual contracts presently under negotiation. A reduction of contract pricing to today’s spot price would represent a cut of 30%, such a reduction is looking fairly likely at this point.

The negotiations continue to drag on despite some contracts expiring in the coming weeks. Miners are loath to lock in prices at a steep discount as iron ore is presently BHP’s most profitable product and a 30% cut would take almost half the profit out of that business line. In a classic tactic of negotiating via the public media, BHP, for its part, has been talking up the potential of switching to the spot market, suggesting a break from annual contract pricing might not be so bad. The Singapore Stock Exchange introduced over-the-counter clearing of iron ore futures contracts last month, making this threat marginally believable. This is more likely a stance aimed at keeping cuts to only 30% rather than a shift in strategy.

Before you become too sympathetic of the big miners, consider this: Profits only cut in half, market share increases at the expense of domestic competition; plenty of industries have it worse out there these days.

Chinese stimulus spending can keep Australia afloat but not the whole world. It is true that stimulus spending is offsetting declines elsewhere in the Chinese economy. It is also true that it disproportionately helps the Australian and Brazilian economies. For those that think that China can be the growth engine that fuels global growth need only look at the chart below. The slide is part of BHP’s recent investor presentations and characterizes how much China growth offsets global declines. The conclusion is clearly: “not enough”. Chinese production returning to peak levels in the face of a one-third decline in production from the rest of the world only puts total output back to 2004/5 levels.

The exports of raw materials from Australia to China validate that Chinese stimulus spending is effectively generating economic activity. The run up in copper prices also support that conclusion. However, it would be wrong to assume that demand has returned and we are off to races in global growth and commodities prices. In fact, iron ore prices are on the verge of this 30% drop which will drive the profits of BHP, RTP, and VALE lower later in the year. Long term, these companies have bright futures. If you have missed the run up, though, fear not, stock prices are likely to pull back on weaker iron ore profits later this year. Chinese demand has spared BHP, Rio and the Australian economy as a whole from what otherwise would have been a savage collapse in profits.

Australian miners need Chinese capital to survive. Another story that has unfolded during this global credit crunch is the need by Australian mining firms for substantial investment. BHP avoided the need for more capital but Australia’s #2 (Rio) and #3 (OZ Minerals) miners have had to turn to Chinese miners for capital to survive. OZ Minerals recently sold itself to Minmetals of China and Rio is still in talks with the Aluminum Corporation of China (ACH), commonly known as Chinalco, for an investment well in excess of $10 billion. The once-clear investment details are now becoming vague as the deal may need to be restructured.

Rio-Chinalco deal hits political roadblocks. Australia is not immune to nationalistic tendencies during periods of economic stress. The deal has faced stiff opposition from shareholders, regulators, and Australian politicians. Rio took on mountains of debt to finance its purchase of Canadian aluminum giant, Alcan. With capital markets still weakened and aluminum prices still depressed, Rio needs an injection of capital to repair its balance sheet. The Chinalco deal can bring some economies of scale but many fear that it will erode Rio’s pricing power well selling into China in the future.

Ultimately, the Australian mining industry needs this kind of investment. Although Australia ran no government deficits before the global recession hit, the country has the Anglo-Saxon disease of low public savings and large current account deficits. The net result is that foreign capital is the only option for Australian industry. In order to salvage the deal, Rio management has been talking up the fact that foreign capital in nothing new:

The run up in Australian exports to China in the midst of a global recession demonstrate the effectiveness of Chinese government stimulus spending, at least in the areas of infrastructure and industrial retooling. The recent and pending inflows of investment capital from China to Australia reflect a symbiotic relationship between the two countries. Australian mining giants (as well as Vale in Brazil) are excellent ways to play the long term China growth story. However, I do not yet believe it is time to say, “all clear” and pile into commodities as an inflation hedge. Global demand remains weak and Chinese demand can not offset that.




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