Joe Hockey caught in the 'dance of the elephants' on iron ore
Joe Hockey insists he doesn't want to "get caught in the dance of the elephants" on iron ore. But that's precisely where he is caught – or, more correctly, trampled by elephants fighting rather than dancing.
The Treasurer estimates every $US10 fall in the iron ore price cost the budget $2.5 billion in lost revenue. That figure only includes a small proportion of all the indirect costs of jobs being lost, contractors being forced out of business or having their own prices forced way down and former boom-time towns heading into bust times. Not to mention the billions of dollars being taken off state royalties.
of this will get much worse assuming Hockey's right in his gloomy prediction the price has further to fall and there seems to be no floor. Saying the government is contemplating a price as low as $US35 a tonne won't win Hockey many thanks from iron ore companies trying hard not to further spook a badly spooked market. It's a remarkably blunt statement for an Australian treasurer.
But it also reflects the plight of the Australian iron industry and the mounting problems created by the majors to keep adding to supply despite the extraordinary price fall. So far, market decimation has made no difference to their determination to continue expanding production.
This might put a Treasurer who affirms his belief in a free market in an awkward position. Hockey tells The Australian Financial Review he's reluctant to tell people how to run their companies. He finds it difficult to stop into the heads of chief executives, he says, because a number of them are quite short term in their thinking. (As opposed to senior politicians, presumably?) The government's job, according to Hockey, is to make sure they've got "fair access to market".
But he is more coy about that whether he believes "elephants" such as BHP Billiton and Rio Tinto are pursuing a longer-term strategy of trying to drive competitors out of the market.
"There's no doubt there were people that were banking on – literally banking on – high iron ore prices for a long time," he says.
THE DIZZYING SPIRAL DOWN
Those who were banking on a higher price include Hockey and Treasury, of course, scrambling to fill the increasingly large hole in the budget and national income. It also includes a furious Western Australian Premier Colin Barnett, savagely indicting the strategy of BHP and Rio as totally counterproductive for the companies as well as for the state.
Then there are all the smaller Australian iron ore producers such as Atlas Iron which has just announced it is mothballing its assets to stop losing more millions of dollars. The larger Fortescue Metals Group is engaged in its own desperate race against the falling price to ensure its costs stay just in front of the dizzying spiral down.
But those who were banking on a higher price also seem to include the three giants BHP, Rio and Brazil's Vale – despite their tough talk now. Their argument that they still make money on every tonne due to lower costs is increasingly savaged by analysts and other players.
The big catch, as repeatedly pointed out by an aggrieved Fortescue, is that making a profit on each incremental tonne doesn't stopping trashing returns on overall capital as the price for every tonne falls. That affects shareholders in BHP and Rio as well as Fortescue.
Hockey recites the mantra that production is where companies make money and that Asia is going to spend $7 trillion on infrastructure over the next decade, putting Australia in a better position than many others.
But Bank of America Merrill Lynch noted last month that free cash flow generation at BHP and Rio is below their dividend payments and that each year commodity prices remain at current levels reduces the companies' net present value by around 5 per cent. The iron ore price has fallen considerably since then.
'ABSURD' ARGUMENTS
AllianceBernstein analysis, also last month, said the majors' arguments were "mistaken" on several counts, emphasising the half a trillion dollars of value wiped off the market capitalisation of the iron ore industry.
"Some senior figures in the industry have so far as to claim, rather absurdly, that they foresaw the current price environment and that in fact everything is going according to plan," the analysis said. "If this is mining according to plan it is hard to imagine what the situation would look like if something had gone genuinely wrong with the industry."
There can be no mistaking that it means something has gone genuinely wrong for the government and any hope of having the budget look even vaguely respectable.
"The big issue in China is whether they're prepared to close their mines and their domestic, expensive production," Hockey says. "There was an anticipation by, I think, a number of iron ore producers in Australia that the Chinese would be much harder on the domestic suppliers."
But although some of China's higher cost production has gone with more expected to follow this year, the Chinese government has just halved the rate of tax on domestic iron ore. A cut of about $US1.25 worth of tax is minor in a market where the price has fallen to around $US46 to $US48 a tonne from a 2011 peak of over $US180. It's still another signal the Chinese aren't rushing to shut down production even at these prices.
Fortescue tells the Financial Review it won't produce more than its current rate of 165 million tonnes a year. BHP is apparently still intent on lifting from 245 million tonnes to 290 million tonnes by mid 2017 and Rio to 360 million tonnes. Vale plans to expand from 340 million tonnes this year to 450 million tonnes by 2018. That's the sound of elephants stomping.
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