For Rio Tinto, BHP, Fortescue and Josh Frydenberg, there are billions of dollars riding on the sustainability of current iron ore prices. The settings that drive the price are, however, fluid and challenging.
The iron ore price has surged this year, from about $US70 a tonne at the start of the year to recently trading at about $US120 a tonne. That is producing a windfall for the Pilbara miners, and the Commonwealth government’s coffers.
Rio’s shares have risen 32 per cent this year, BHP’s 21.5 per cent to near-record levels and Fortescue’s have more than doubled.
Given that a $US1 a tonne movement in the average price adds $US225 million to BHP’s earnings before interest, tax, depreciation and amortisation (EBITDA) and a 10 per cent movement $US1.6 billion to Rio’s, their leverage to the price is obvious and has been reflected in their share prices.
The federal government, too, has a leveraged exposure. It has budgeted very conservatively for a price of around $US55 a tonne. With each $US1 a tonne increment in the price adding several billion dollars to its revenues, the longer the price remains at current levels the easier it will be to deliver the promised surplus.
The driver of the price rise has been interruptions to supply, most notably the collapse of another Vale tailings dam in Brazil earlier in the year which took more than 80 million tonnes of production out of the market.
While, more recently, it has been allowed to bring one of the affected mines back into production - the 30 Mtpa Brucutu mine - it could be several years before Vale is back to its full production of around 400 Mtpa.
Cyclone Veronica and a fire at Cape Lambert in the Pilbara early this year took about 14 million tonnes of Rio volume out of the market, about six to eight million tonnes of BHP volume and 2.5 million tonnes of Fortescue’s. Operational issues within Rio’s mines caused it to lower its guidance again, from a range of 333 million to 343 million tonnes to between 320 million and 330 million tonnes.
The various natural and operational problems have, therefore, taken more than 100 million tonnes of annualised production out of the seaborne trade.
Even if Brucutu returns to full capacity and the Pilbara miners don’t have any more issues, the loss of about 50 Mtpa of low-cost and high-quality ore from the market for the next couple of years, at least, ought to put a floor under the price.
In effect, and not by design, the impact of the current iron ore market on the bottom lines of the miners perfectly illustrates the argument that Glencore’s Ivan Glasenberg makes forcefully: that value should be prioritised over volume.
The key question is whether the current price is sustainable.
The return of some of the lost supply from Brazil and the Pilbara could be expected to be a moderating influence on the price but prices should still remain well ahead of where they might otherwise have been as long as demand, most notably from China, holds up.
So far, thanks to the stimulus China has injected into its economy to counter a slowing of growth caused initially by centrally-directed attempts to restructure a shaky financial system and more recently in response to the Trump administration’s tariffs, demand has held up.
China’s imports of iron ore are running ahead of last year because steel production has also risen. A concern, however, is that steel mill margins are being crunched by the higher raw material costs and a softening of industrial activity within China.
The mills aren’t happy. The China Iron and Steel Association has urged the Chinese government to investigate the iron ore market to "maintain normal iron ore market order" while the largest of the mills have formed a group of their own to investigate "non-market factors" they believe could be contributing to the price surge.
For the moment, the pause in the trade war between the US and China is helpful for both the miners and the mills, although the existing tariffs on China’s exports do appear to be damaging China’s manufacturing sector.
A resumption of hostilities, which appears more likely than a trade deal acceptable to both the US and China, would be good for neither volumes nor prices.
While, Donald Trump willing, the near term outlook for the commodity and the Pilbara miners appears far more positive than it did at the start of the year, the likelihood that Brazilian supply will gradually rise over the next two or three years and that China’s demand will plateau, or even shrink, over that period complicates the decision-making for the miners.
Racing to get more volume into the market by adding capacity – as they did during the post financial crisis boom – would be destructive. Similarly, assuming the windfall profitability can be sustained beyond the near term would be dangerous.
This year, so far, looks like an aberrational bump in the cycle for the iron ore miners rather than something sustainable. Responding to it within an environment laden with uncertainties isn’t necessarily straightforward, but it is a nice problem for the companies, and their shareholders, to have.
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