The iron ore spot price has collapsed from $135 per ton to $111
per ton in just two weeks thanks to steel de-stocking, despite a
broad-based commodities rally that began in July. Unlike copper (
JJC
,
quote
), iron ore can't be stored and in an overcapacity situation,
producers have to sell distressed stock.
[caption id="attachment_70120" align="alignright" width="300"
caption="A laden truck deposits its load of iron ore into a
pocket."]
[/caption]
While $120 per ton is the marginal cost of iron ore in China
(which should provide a theoretical price floor), Citibank analyst
Scarlett Chen argues that iron ore could go as low as $90 per ton,
driven by steel de-stocking. Scarlett believes the excess
capacity situation is out of control and that steel companies are
set to see losses for every single quarter of 2012 - the first time
in history.
China has been running steel production at a very high level --
720 to 750 million tons -- partly to do with over-exuberant
expectations of a big stimulus, and partly because smaller steel
mills further up the cost curve start producing every time price
ticks up marginally, with no real rationality behind it.
But current demand just isn't there to justify this production,
and Chinese authorities have expressly stated that any new round of
stimulus will be much smaller than the ¥4 trillion stimulus of
2008, and focused on domestic consumption, not infrastructure.
Citigroup Global Equities Team Vice President Anita Tanna argues
that the actual level of steel production over the longer-term
will be closer to 350-400 million tons as the Chinese economy
adjusts away from an investment-led model to a more consumption-led
model.
Miners are taking the hit
Mining equity earnings have been downgraded by 18% in the last
five weeks alone. Normally when commodity prices weaken, so does
the Australian dollar. But the Aussie remains strong, and combined
with high oil prices, strong foreign exchange pressure and weak
commodity prices, the cost base for mining companies is up 15% over
the last month says Tanna -- not pretty.
The earnings downgrades are already taking their toll on
cashflows. Rio Tinto (
RIO
,
quote
) funds its capital expenditures and dividends out of operating
cash-flow, which is now just $3.2 billion -- less than in the
2008-09 crisis -- meaning it may not be able to cover capex and
dividends.
Wait - mining equities have rallied 10% in the last two
months; what's going on?
European miners (
SXPP
,
quote
) have rallied 10%, so are we missing something here? Yep. Mining
equities were down almost 40% in the last 12-18 months before the
July rally, so they are vulnerable to squeezes / dead cat bounces
on pure China policy easing hopium. But the trendlines are in a
downward direction and recent excitement about policy easing is
overdone.
British miner Anglo American (
AAUKY
,
quote
) recently delivered its worst return on equity since the Great
Depression. The only company to have shown real signs of
reevaluating its capex spend thus far is BHP Biliton (
BHP
,
quote
), which remains Citigroup's preferred name versus the rest of the
sector.
Again, it's very concerning that despite the rally in many
commodities, core "building blocks" like iron ore and coal
can't get going. This truly tells you if the global economy is at
work. Iron ore is a leading steel indicator, and it is plunging,
not stabilizing like steel prices should suggest.