Sun’s not as bright over the horizon

FOR much of 2007, iron was the mineral of choice for speculators. Companies like Midwest, Atlas, and Sundance Resources all rose like phoenixes out of the ashes, with paper fortunes made and more recently lost, as share prices tumbled. During this time, market leader Fortescue Metals rose from an effective $1 per share in late 2006 to trade at more than $12 per share, prior to its recent retreat to around $6.40 per share.

Weakness in global capital markets means that access to capital may now prove to be a limiting factor in new iron ore project development. Chinese steel mills have been aggressively positioning themselves as partners or part owners of projects in Australia and globally, but still face long logistical paths to project approval and eventual production.

So the short-term market in iron ore remains tight. Despite the best efforts of miners from Canada to Timbuktu to lift output, recent equipment issues in the Pilbara and marketing issues out of Brazil have conspired to keep global inventories tight and spot prices high.

In Australia, a cohort of more than 40 companies is now jostling for air in the iron ore space, but Briefcase sees that there will eventually only be oxygen to support a few hardy survivors. This amazing bubble of iron ore activity comes after decades of more or less stable production from the Pilbara mines of BHP Billiton and Rio Tinto, which were initially set up in the late 1960s and early 1970s, with the help of Japanese finance and off-take agreements.

In much the same way as China's growth surge of the 21st century now impacts on mine developments in Australia and elsewhere, Japan's industrialisation of the 1970s was also fuelled by raw materials from Australia and Brazil. The Japanese took a global approach and effectively engineered an oversupply of iron ore from both Australia and Brazil. This policy resulted in stable and low iron ore prices for the decades that followed.

As recently as 2003, Australian iron ore was being shipped out for less than $30 per tonne, which compares to today's heady values, ranging from $100/t for fines to more than $150/t for high-grade lump product. Meanwhile, the recent weakness of the Aussie dollar against the greenback has delivered a 15 per cent price rise to local producers. Some of the new players are working towards projects which would support operating costs of around $60/t of product, so clearly these new players would not even have dreamt of a project in the bad old days of $US25-$30 per tonne, as recently as four years ago.

The irony of this situation is that iron is not at all a rare element; in fact it is found almost everywhere. The vast deposits which now underpin Fortescue's 40 million tonne per annum operation were previously discarded by the major players as being sub standard and having no value. Well, at the then prevailing iron ore prices, they were valueless, but the emergence of China, which over the past 10 years, has singlehandedly doubled the global seaborne trade of iron ore to over 820mtpa, has changed the market dynamic for ever.

Small exploration companies, which originally listed to search for gold or nickel, have found themselves looking for hematite or magnetite, the magnetic version of iron oxide minerals, while a scramble for permits and funding has ensued.

Late players on the scene include the Russians, who are playing a more corporate role in the big poker game, rather than being actual end customers for the raw material. Russians appear to see a dollar to be made by turning assets over rather than developing mines. A surprise late player in this 21st century version of the game is the Japanese, who worry that their supply lines are being cannibalised by Chinese steel mills, leaving them in the unusual position of being exposed to the cold winds of market competition, after decades of plenty.

A defining feature of iron ore mining and processing is that the mines are usually large scale, requiring the movement of many millions of tonnes of product each year. The viability of such operations depends on an ability to gain access to transport facilities so as to take product to a port for export. Without a road or rail links and access to a ship loader, new projects are doomed. Capital costs associated with project development will rise if port infrastructure must be added as part of the development deal. Thus, FMG has had to overcome the fine and low-grade nature of its product and it also built its own rail and port infrastructure to deliver product to Australia's northern shores.

Players in the state's Mid West region are now working towards rail and port infrastructure that will support shipment of more than 40mtpa by 2012 and beyond. There is no doubt moves set in train during the 2005-08 iron ore boom will be felt by Western Australia for years to come. Several new mines are likely to be built in the Pilbara and at least three new projects are likely to emerge from the Mid West, while satellite operations to Portman's operation at Koolyanobbing (with Reed Resources) will spring up and a magnetite operation in the southwest (Grange) is also a firm starter.

However, not all the hopeful players will get a start. Other companies have projects in West Africa and South America, where the barriers to entry include dealing with corrupt or overly bureaucratic governments, as well as the usual funding hurdles for what inevitably ends up being a $2.5 billion minimum spend. Countries such as Mauritania and Cameroon also lack basic facilities such as banking and have no local engineering skills or even a mining culture to support the skill base needed for such an operation.

Given a relative abundance of iron mineralisation globally, Briefcase sees the likelihood that, by midway through next decade, a huge oversupply of iron ore capacity will have been established. Producers of lower quality and high-cost product will at that time meet their maker in an untidy fashion. Investors in the sector today need to assure themselves that the management of their chosen industry player knows what it is doing, that there is funding in place and off-take agreements that will endure any downturn, either of a short-term nature which may result from the 2009 economic recession and consequent demand slowdown, or of the longer-term variety, which may follow from an oversupply situation post 2012.

Meanwhile, base metal markets are already adjusting to new production cost realities. We have all heard about escalating capital costs for new project construction. Building anything today, costs about twice the price it did just three years ago. The price of steel framing continues to rise, as does the cost of ball mills and other equipment, while wage and labour cost inputs are also up 40 per cent. So all this new capital cost has to be paid for and financed, lifting the eventual cost of the metal produced by any new mine. Operating costs at existing plants are also taking a beating.

A large amount of the copper and nickel produced today involves hydrometallurgical processes, involving the use of sulphuric acid. The price of sulphuric acid has quadrupled over the past year. Rising demand for the use of acid in production of both metals and fertilisers, combined with a lag in development of new acid production facilities, has boosted prices for acid.

How the market has changed. When Western Mining commissioned its Kalgoorlie acid plant in 1997, the company had to pay $20 per tonne to get the stuff taken away, but today it could be selling sulphuric acid for $400 to $500/t. The net result, however, is that the production cost of much of the world's copper and nickel production is now bumping up against the current price, so that a growing tonnage of global production is becoming unprofitable at current metal prices.

Inventories continue to rise, but eventually, mine closures will cut back on production and the prices for these metals should rise into 2009, making life a little more pleasing to the survivors.

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- Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au