Tricky read on tea leaves from China

Boom or bust? That’s the critical question for the state’s biggest industry as the iron ore price falls, profits and jobs dry up, and the state finances take a hit.

The fall of about 20 per cent in the price of iron ore – from a two-year high of $US145 a tonne at the start of the year to the latest price of $US115/t – is a direct result of slow Chinese demand during new year celebrations.

But there could be another step down caused by something different: a glut of low-cost supply from new mines in Africa, especially the Simandou project in Guinea being developed by Rio Tinto and its Chinese partners.

The combination of flat (or even falling) demand from China with rising supply makes some recent forecasts of a fall to $US80/t likely, with an even greater collapse to $US60/t possible, especially as that’s the price used in the Australian government’s budget.

The potential for a significant drop in the price of iron ore has prompted a comparison with the crash in battery metals, where lithium has fallen by more than 70 per cent and nickel by close to 40 per cent, sending shockwaves through Western Australia’s mining sector.

“Supply-driven carnage” is how investment banker Dion Hershan describes events in battery metals, with the same outcome possible in iron ore as supply overwhelms demand.

The view from investment bank Citi is more optimistic. Citi calculates the recent price fall has reached a turning point, with Chinese demand to recover after the new year holidays and the meeting of the country’s rubber stamp parliament: the National People’s Congress (NPC).

The good news first, because Citi expects a Chinese economic recovery to boost demand after the weak start to the year.

“A subdued tone for China’s economy and an uncertain outlook for domestic steel demand has driven the (iron ore) price correction,” Citi said.

“Higher iron ore and steel inventories have heightened concern.”

However, China moves into its traditional peak construction time after the NPC meeting, which always follows the northern winter slowdown.

“As construction activities pick up and with the iron ore price down, a potential restocking by steel mills could offer upside to prices,” Citi said.

“Steel profit margins have improved after the ten per cent decline in the iron ore price, which should boost steel output over the next few weeks.

“In addition, a potential export ban or increased export duties in India could support an iron ore price recovery to $US130/t over the next three months.”

The bad news from Mr Hershan, a former Goldman Sachs banker and now head of Melbourne-based Yarra Capital Management, is that iron ore is tracking battery metals and a crash is coming.

“The carnage in lithium and nickel markets last year should be a stark reminder for all investors, supply matters,” Mr Hershan wrote in a note headed ‘Sidestepping the supply-driven carnage’.

His comparison of iron ore with battery metals hinges on a detailed analysis of what went wrong in lithium and nickel.

The lithium crash was not a big, one-off event, Mr Hershan said, but more a case of the spodumene ore price returning to about $US970/t before a speculative frenzy. The nickel price collapse was caused by a surge in supply from Indonesia.

The steep fall of both commodities came despite strong global demand for batterypowered electric vehicles (EVs).

“The central issue with these two commodities (lithium and nickel) is that supply has grown faster than demand, and when commodity prices move a mile away from their cost curve, it typically ends in a bloodbath,” Mr Hershan said.

“We have since observed lithium and nickel projects being deferred, mothballed, or curtailed. All of which is part of the natural business cycle,”

It’s now time for iron ore to be exposed to the same turn of the cycle, with Chinese demand stagnating and a supply surge looming in 2025 with the start of exports from Simandou.

“Logic would suggest this could result in a US fifty dollar-plus drop in the iron ore price to around US eighty dollars a tonne, which could slash earnings at BHP, Rio Tinto and Fortescue,” Mr Hershan said.

Not included in his gloomy outlook for iron ore is the effect on the WA economy, which is heavily dependent on iron ore, and the potential for a sharp fall in royalties paid to the state government and taxes paid to the Australian government.

Grains outlook

IRON ore is not the only WA industry facing a cloudy future, with wheat producers likely to be buffeted by the same force of supply exceeding demand as they face a 20 per cent fall in the wheat price during the past 12 months.

Excellent crop yields in most major grain-growing countries have driven down the price of all cereals and soyabeans, sparking a flood of speculative activity on commodity markets as traders place bets on even-lower prices for the rest of the year.

Net short positions in grain markets (traders betting that prices will fall) during the past month have blown out to a 20-year high across the wheat, corn and soyabean markets.

In the case of corn, the price on the Chicago Mercantile Exchange is down 40 per cent on 12 months ago. Soyabeans are down 25 per cent.

The shift from shortage to glut conditions follows turmoil in grain markets caused by Russia’s invasion of Ukraine, with reports of poor harvests from those two big grain producers encouraging growers in other countries to boost their planting.

Michal Magdovitz, a senior commodities analyst at Holland’s Rabobank, told London’s Financial Times that grain and oil seed prices were in a race to the bottom because “exporters were digging themselves out of massive harvests”.

Privacy issue

VETERAN Sydney financial analyst Warwick Grigor has raised an interesting point about how smaller investors are discriminated against by corporate laws meant to protect them.

His criticism is of a rule that limits private share placements to people with $2.5 million net assets and $250,000 in annual income. The government view is that, if you fall short, you’re not smart enough to participate in a private placement.

The problem is that private placements are 10 to 20 per cent cheaper than what’s offered in a full-blown prospectus sent to everyone.

“Why should wealthy investors be the only ones to get the cheaper price,” Mr Grigor asks.

Good question.