The Future Of Iron Ore
It's Joe Magyer here again, Chief Investment Advisor for
Motley Fool Pro, reporting to you directly from Tianjin, China.
The scale of China's construction boom is off the charts. The country used more cement between 2011 and 2013 than the U.S. did during the entire 20th century, and its voracious hunger for Aussie iron has rained cash on our country.
It's hard to capture with words the enormity of projects here, so I thought it would be useful to count cranes while on the bullet train between Tianjin and Shanghai. I gave up after spotting 53 cranes in two minutes.
Unfortunately, as I'm about to explain, China's building boom has gotten ahead of itself. And those 53 cranes? Every single one was idle.
China devours two thirds of the world's seaborn iron ore. So goes its appetite, so goes the price of iron ore.
You can't get a read on how China is faring by focusing on government-published numbers, though. It's the worst-kept secret in finance that no one trusts those numbers.
Instead, you’ve got to do your own homework, get on the ground, and find independent sources to get a directional health of the economy's health. For example, inventories and accounts receivable are growing faster than sales at the Chinese consumer companies we're following -- a classic red flag of low-quality growth.
And then there's construction, which matters most to Australians. Once again, independent sources paint a darker tale. Chinese steel demand fell 3.4% in 2014, per the China Iron & Steel Association -- the first drop in 14 years. Also, Caterpillar expects the Chinese market to shrink in 2015. Neither surprises us given the vast multitude of idle projects (and Cats) that we spotted.
China has overbuilt.
A well-regarded contact in Beijing told us that another study revealed 28% of the homes in Beijing had not used electricity for six months. In New York, he reckons that number might be more like 4%. Meanwhile, researchers at China's Southwestern University of Finance and Economics found that 49 million (22%) of Chinese apartments sold in 2013 were vacant.
In theory, those homes will fill up as Chinese move from the country to the city. In reality, there are enough empty apartments in China to house 6 years' worth of urban migration. That's more than an entire year's worth of global iron ore demand going up in smoke.
The local market seems to have finally realised its predicament. Home prices in China have declined for four straight months, and this from the government's own data. Not helping confidence among lenders is the recent default by Shenzhen developer Kaisa Group on a $US52 million interest payment, which Anne Stevenson-Yang of J Capital Group pointed out to us was only about 1/10th of the net cash the group supposedly had in the bank.
Combine that lost confidence with the lack of long-term financing for projects in China (typical of most emerging economies) and it’s easy to see how the wheels of construction can so quickly grind to a halt.
All that’s troubling enough as is, but iron ore supply is also growing.
UBS forecasts that iron ore’s oversupply will 6X from 35 million this year to more than 200 million by 2018. The major miners are fixated on gaining market share, and they will, but at the expense of crushing the iron ore price for years to come.
Some analysts think higher-cost supply will come offline in response to lower prices. Again, in theory, that's true. In reality, miners have many motivations -- faith, hedges, survival, and politics -- that will inspire them to keep producing at a loss, ruining the party for everyone. And, speaking of oversupply, now is a good time to zoom out and recall that the iron ore price has spent most of the past 15 years at much lower prices than today;
Growing supply and falling demand is a bad combination.
It’s not crippling if you’re a large, low-cost producer like Rio Tinto Limited (ASX:RIO) or BHP Billiton Limited (ASX:BHP), but it is life threatening for producers with high costs, think Mount Gibson Iron Limited (ASX:MGX), or debt-heavy balance sheets, think Fortescue Metals Group Limited (ASX:FMG).
Even Rio and BHP will find this price environment a bumpy road (just because you're the lowest-cost producers doesn’t mean your profits can’t fall). And mining services companies? They’re not only in the same boat -- they’re tied to the anchor.
