Worst is behind iron ore plays

ANALYSIS: Rubbery figures and projections aside, WA’s iron ore miners are breathing a little easier thanks to improving prices and a favourable exchange rate.

Good times have not returned to Western Australia’s battered iron ore industry, but a painful period of job shedding and mine closures is coming to an end.

The recent rise in the price of high-grade iron ore to more than $US50 a tonne means that most WA mines should be profitable thanks to the currency effect, which lifts the local iron ore price to more than $A70/t.

At that level the biggest miners, including Rio Tinto, BHP Billiton and Fortescue Metals Group, will be handsomely profitable given that they have cut their production cost to $US16/t ($A22/t) or less.

Even smaller producers, which were struggling to survive, have been handed a get-out-of-jail card, even if they are mining a lower-grade ore selling for less than $US40/t ($A55/t).

Atlas Iron is an interesting example of the quality question. It produces ore assaying around 57 per cent iron, and in the December half sold that material for $A59/t. After suffering a near-death experience last year Atlas has managed to post a pre-tax profit of $20.5 million, which faded to a net loss after charges of $14.8 million.

BC Iron also felt the pressure of low iron ore prices in the December half, posting a pre-tax loss of $2.1 million after receiving an average price of $A58/t.

FMG, thanks to high volumes and falling costs, posted a December half pre-tax profit of $US1.3 billion and forecast that costs would fall from $US16.34/t to a target of $US13/t – the lowest of the major producers.

The big question for the industry today is whether the recent price rise can be sustained – and on that the jury is out.

In its half-year results statement earlier this week, WA’s second biggest iron ore miner, BHP Billiton, warned that “the iron ore price will likely remain low, constrained by weak demand and abundant seaborne iron ore supply”.

Rio Tinto, the industry leader, has a similar view of the outlook but is confident that more high-cost ore, which has helped create an excess of supply and was the major factor in the price falling below $US40/t late last year, will be squeezed out of the market this year.

“Price pressures led to about 130 million tonnes in high-cost production cuts from China and non-traditional seaborne suppliers (last year), in addition to the 125mt of exits in 2014,” Rio Tinto said in its annual profit statement on February 11.

What worries iron ore market observers is that the price rebound to more than $US50/t might simply be a result of steel mills restocking after Chinese New Year, with the price for premium-grade ore falling back into the $US40/t range, or lower, later this year.

One reason for the wariness about the outlook is that, in hindsight, almost everyone was wrong with earlier forecasts about Chinese iron ore demand; especially the two biggest producers, Rio Tinto and BHP Billiton, which until last year were tipping a continued rapid rise in Chinese steel production to more than 1 billion tonnes a year, a view that implied soaring iron ore sales.

The error factor in that forecast was around 20 per cent, with Chinese steel production slipping to 803.8mt last year, down from 823mt in 2014.

What saved WA miners as the price of iron ore fell by around 80 per cent between 2011 and late last year was a combination of a 30 per cent drop in the US dollar exchange rate, and heavy-duty cost cutting of the sort that forced high-cost mines out of business.

‘Suspended optimism’ is one way of describing the current condition of the WA industry, because at least two high-profile projects remain on the cusp of failure.

CITIC Pacific Mining’s Sino Iron project and the Karara mine of Gindalbie Metals are the two remaining sick men of WA iron ore, struggling to survive thanks to their high initial construction costs, high operating costs, and a business model designed for boom conditions.

How long the Chinese backers of the Sino and Karara projects will persevere with heavy losses is uncertain, but it is obvious that the dream of converting low-grade magnetite ore into a profitable export product has turned into a nightmare – and has cost investors a collective $15 billion.

Citic and Gindalbie are not alone in misjudging the market for iron ore, which was exceptionally strong during China’s version of an industrial revolution and the grand building projects that entailed, but which collapsed as the Chinese economy slowed.

The newest entrant in the industry, the Roy Hill mine controlled by Gina Rinehart, is in a much stronger position than the troubled projects of Citic and Gindalbie. And while profits will be hard to earn as the mine steps up production to a nameplate capacity of a world-class 55mt of ore a year, it has two big pluses.

Firstly, Roy Hill’s has a size advantage, which brings essential economies of scale that drive down costs on a per-tonne basis.

Secondly, Roy Hill has a quality advantage because high-quality ore means a price premium, rather than the price discount faced by some rival mines with high levels of impurities attract.

In Roy Hill lies the secret to the entire WA iron ore industry, as it reverts to its traditional status as a business where logistics are arguably more important than geology.

The nature of all bulk commodity industries means transport costs, especially rail and port operations, dictate whether a business can survive fluctuations in market prices.

In a way, pricing iron ore on a daily basis has become a serious burden for an industry that is capital intensive and needs the price assurance that once came with annual price-setting negotiations with Japanese steel mills.

The current pricing structure is unbalanced and akin to a bank advancing 30-year mortgages while borrowing money from investors on a month-to-month basis – a recipe for disaster.

WA’s iron ore miners initially welcomed the short-term pricing structure but must now be wishing for a reversion to the long-term structure of the 1970s and 1980s.

If pricing is a problem there are advantages that WA mines enjoy, and that’s a combination of geography (close to Asian markets), political and financial (reliability), and geological abundance, which means iron ore mines here can outperform mines in most other countries.

African iron ore, which was viewed as a threat to the WA industry, has faded from the scene with the most significant exit (for now) being the quiet dropping by Rio Tinto of its plans to develop a big mine at Simandou in Guinea.

Simandou is not dead, officially, but when Rio Tinto earlier this month wrote-down the value of what was once billed as a $US20 billion project to a value of $US10 million in its 2015 accounts, it could be said the writing was on the wall for Simandou.

Rather than being a threat to WA’s iron ore industry, Simandou has simply become another failed (for now) African mine project, which has a geological advantage in the high grade of its ore but fails the logistics tests of rail and port infrastructure, while suffering the usual doubt about African governance, and the certainty of corruption.

WA’s iron ore industry, after the boom and the bust, has reached a back-to-the-future point where its proximity to Asian markets, a re-set cost base, and invaluable infrastructure, will ensure its survival and future profitability.

Growth, however, is off the agenda. The mine-building phase, which came when the price soared to $US130/t, is over and will probably remain off the agenda for at least another 10 years, and perhaps longer.

Hugh Morgan, a former chief executive of Western Mining Corporation and a pioneer of the WA iron ore export industry, reckons the iron ore investment cycle runs in 15-year waves, thanks to its capital intensity and long life of most mines.

Having driven costs down in a brutal display of hard-nosed business, the two iron ore numbers to watch in the future will be the production cost of mines and the price of iron ore – with both of those numbers falling into the rubbery category.

Costs, given different accounting practices by different miners, will vary, as will the mix of currencies; but with the big producers down to a cash cost of around $US16/t (and a target of $US13/t), the all-in sustaining cost should be around $US30/t, which implies strong profit levels.

The smaller miners, given their lower-grade ore (in most cases) and higher impurity discounts, will have substantially higher overall costs.

Price is another flexible number, with the widely quoted rate for ore assaying 62 per cent iron not received by most miners after discounts for grade and levels of steel-damaging phosphorous, alumina and silica.

A more accurate number for many WA mines is that for ore containing 58 per cent iron, where the latest price is $US39.70/t, or $A56.70/t on conversion, which should still be enough for most small mines to survive, just.

Two investment bank iron ore forecasts (which also fall into the rubbery category) are those from UBS and Macquarie.

UBS reckons high-quality ore will revert later this year to average $US38.30/t, and then down again to $US38/t in 2017, before recovering to $US42.80/t in 2018.

Macquarie is more optimistic, tipping $US53/t this year, $US52/t next year, and $US56/t in 2018.