Demand up, but not for any old iron
The iron ore market was worth $512 billion (£324 billion) in 2011, according to Macquarie Research estimates. Strong Chinese economic growth over the past decade has been driven by high rates of metals-intensive fixed asset investment.
This investment-driven growth is highly steel intensive, the production of which relies on iron ore as the key input.
The iron ore market is divided into two areas: domestic Chinese production of iron ore and the seaborne-traded market. China’s iron ore resources are poor quality, with high levels of harmful impurities, and are often relatively deep in the ground and far from transport infrastructure.
The country has therefore been forced to rely on imported high-quality ores, mostly from Australia, Brazil and India to meet its enormous needs.
However, over the past 10 years, as an accompaniment to huge Chinese demand growth, several problems have been encountered on the supply side. (Trends continues below)
The most recent major development was the Indian government’s intervention in the iron ore mining industry, which is the third largest in the world.
Last month the government announced a 50% increase in export duties to 30%, prompting traders to slash their forecasts for exports for the year to March 2012 to about 50m tonnes from 65m. That was already down from 97m tonnes last year.
This is the latest in a long line of policy measures designed to conserve supplies for the domestic steelmaking industry.
Previously the Supreme Court had banned mining in the Bellary district of Karnataka, thus affecting 45m tonnes of iron ore production.
More recently the Indian Supreme Court banned iron ore production and transport in the Chitradurga and Tumkur districts of Karnataka, citing damage to the environment.
These regulatory problems in India are compounded by a failure of the ’big three’ producers – Rio Tinto, BHP Billiton and Vale (which account for a combined 60% of seaborne iron ore supply) – to bring on new capacity at anything like the rate previously forecast.
Brazil’s Vale, the second biggest mining company in the world and the largest private company in Latin America, has been hamstrung by environmental permitting problems around its Serra Sul deposit in the Amazon state of Para.
More specifically, the 3.4 billion tonne deposit lies close to a set of caves, which is considered archaeologically and environmentally sensitive.
In Australia, both Rio Tinto and BHP Biliton have encountered significant cost overruns and delays at its $4.9 billion ’Rapid Growth Project 5’ centred on the iron-rich Pilbara region of Western Australia.
A more general observation, which holds true for the mining industry as a whole, is that cost curves have steepened because of structural supply problems.
From a geological perspective, declining grades have meant that miners have had to mine more just to maintain flat production, which is particularly difficult to do when already operating at full capacity.
Moreover, in certain regions such as Western Australia, there is an acute shortage of skilled labour and especially of key engineering and project management skills needed for project development.
Add to the mix tighter environmental regulations, growing resource nationalism and increasing lead times for equipment, and the full extent of the problem on the supply side becomes apparent.
What is striking is the inability of analysts to effectively account for these problems in their forecasts. The chart below illustrates how analysts’ forecasts have reacted over time as more supply disruptions have come to the fore.
”The 3.4 billion tonne deposit lies close to a set of caves, which is considered environmentally sensitive”
The upshot of all of the above is that high-cost Chinese capacity will need to operate to keep the market in balance until at least 2015 as supply constraints in other iron-rich regions lead to slower-than-expected supply growth.
As such, the iron ore price will be a function of the marginal cost producer in China.
On current estimates, this marginal Chinese production has iron content of about 12-15% and has production costs of at least $150 per tonne (62% iron content equivalent).
Furthermore, given spiralling mining cost inflation of 15% a year as labour and transport costs soar, a higher marginal cost may emerge in the medium term.
This steepening of the cost curve is, of course, not bad news for all producers. Rather, a steep cost curve is advantageous to lower cost producers as higher cost producers insulate the rest of the curve from sharp falls in commodity prices.
The top cost producers should theoretically shut production when in a loss-making position, resulting in supply shortfalls, tighter commodity markets and a stabilising price.
As a rule, industries with steep cost curves, such as iron ore, should therefore deliver better margins over the long run.
This has been the case in recent history for iron ore producers versus aluminium and zinc producers who have suffered, in some cases, severe margin compression.
The key for equity investors is to increase exposure to commodity markets, which are supply constrained and have steep and steepening cost curves.
From a stock selection point of view, it is imperative to trawl for low-cost producers with expanding margins and a growing resource base.
Neil Gregson is the manager of the JPM Natural Resources fund.