13/03/2012 - 09:14

Analysis: the real iron ore issue

13/03/2012 - 09:14

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The price of iron ore in China, not the antics of the iron ore rich Rinehart family, is what Australia should be watching because signs continue to emerge of a big future price fall.

When the price drops, not if, the effect will be felt across the economy, slashing the Rinehart fortune and the tax revenue of the WA and Commonwealth governments.

The only unknowns as iron ore heads into a period of slowing demand and rising supply are how far the price will fall, and precisely when.

Right now, perhaps because of market manipulation by Chinese traders, the price is holding at around $US140 a tonne, high enough to leave the major miners, such as Rio Tinto and BHP Billiton, with their low costs, on a whopping gross profit margin of close to $US100/t.

But, if you look forward there are forecasts of a price at almost half that level, including the latest from the big investment bank, Goldman Sachs, which last week refreshed a forecast for an iron ore price of $US77/t from 2016 onwards – a 45 per cent fall from today.

If correct, that means Australia’s iron ore boom has little more than three years left to run before rising supply from expansion projects around the world satisfies what appears to declining demand in China.

That price tip, from a firm which is arguably the top money manager in the world, means that iron ore profit margins will be slashed at the big miners, and devastated at high cost miners which will suffer the pincer squeeze of falling income and rising costs.

As for the Rineharts, they will suffer a sharp fall in royalty payments from Rio Tinto, a fall in profits from their half-share in the Hope Downs mine, and a bigger than expected challenge in attracting partners and capital to pay for new mines.

It is the iron ore price outlook, as much as the need to promote a “business as usual” image, which prompted today’s optimistic leaks to the media that the $7 billion Roy Hill mine will proceed with the introduction of new partners.

The challenge for new, and expanding mines, is to catch the current high iron ore prices before they retreat, a process which will make investors and bankers think twice before committing capital to a project which could be buffeted by a price correction.

It is possible that the gloomy outlook of Goldman Sachs will be proved wrong, in which case the good times will roll on, but it would be a brave investor who assumes that a boom can last forever, a theme in this column for some time and one supported by the latest economic data from China.

The most highly-publicised clue that China’s period of hectic, commodity-intensive expansion, is slowing came with the forecast from the government that national economic growth this year would slip to around 7.5 per cent, still high by world standards, but the first time under 8 per cent since 2004.

Other clues pointing to a sustained slow-down can be seen in the surprise $US31.5 billion trade deficit for the month of February thanks to a slide in exports and a high import bill for commodities such as oil and iron ore.

But the biggest hint of trouble ahead has come from the controversial China Iron and Steel Association (CISA) which is forecasting a fall in the annual growth rate of steel production from 8 per cent to 4 per cent.

That warning from CISA, which has an obvious interest in talking down iron ore prices on behalf of its steel-mill members, has reverberated around the world because it matches equally cautious forecasts from other observers of the Chinese economy, such as the Swiss investment bank, UBS, which expects a “double digit decline” in apartment starts this year.

If apartment building does fall that sharply it means a big drop in demand for construction-quality steel.

Tougher times for iron ore are not here yet, but some people can see the signs on the horizon.

  • As a footnote, it’s worth looking back to a column published on September 14 last year when I observed that: “Rinehart v Rinehart is more than a family affair” ..  it is a dispute with profound implications for WA in what is the State’s fourth biggest business and Australia’s 20th biggest company. That column drew a vitriolic reply from Rinehart business interests, but it can now be seen to be an early warning about what has happened in the past week. Perhaps the same will be said about today’s iron ore price warning in another few months.

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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