2014 marked a significant transition point in the iron ore market, with supply greatly overtaking demand. Indeed, combined production increases from the major iron ore producers including BHP, Rio Tinto, Fortescue Metals and Vale, likely exceeded 120 mtpa (million tonnes per annum) last year. Meanwhile, 2014 witnessed a slowdown in Chinese economic growth, and in particular its domestic consumption of steel, but steel production increased on the back of a surge in exports to approximately 90 metric tonnes (approximately 10% of Chinese production).
Excluding exports, demand for steel within China grew at less than 1%, hinting that fixed asset investment growth has likely peaked. All eyes now turn to whether the Chinese consumer can step up and provide the next leg of growth for the emerging economy.
2015 will mark another year of substantial supply-side growth for the seaborne iron ore market. Rio Tinto and BHP both remain 60mtpa away from their stated goal of production at 360mtpa and 290mtpa, respectively, with clear potential to expand beyond this. Roy Hill, the Hancock Prospecting mine in Australia, begins commercial production in the September 2015 quarter while Fortescue desires approximately 10-15mtpa of supply growth.
The supply surge is not restricted to Australia but includes production from Brazil, with Vale looking to add another 150mtpa in the next three to four years. For BHP, Rio Tinto and Vale, these additional tonnes will be low cost and with a high profit margin, with cash costs for BHP and Rio Tinto likely to fall below US$35/tonne Free On Board (FOB) by the end of 2015. At current iron ore prices this would see cash margins of well over US$30/tonne
Interestingly, input cost relief is likely to provide short-term help to junior miners. Declining diesel fuel costs, falling currencies of commodity exporters and freight rates halving will have the effect of giving hope to these miners, which will likely compound the oversupply issue. For example, several of the largest junior miners, with a combined production of 30mtpa, will continue to supply the market, even as they continue to burn through cash, in the hope of a rebound in the iron ore price.
Inevitably, however, these lower costs for production for marginal producers will likely just reduce the cost curve support price, leading to even lower prices and greater consumption of cash reserves. In our view, it is likely that one relatively large producer in Australia will encounter pressure repaying debt, as its debts now precariously exceed its equity market value.
On the positive front for iron ore prices, a supply response has been seen from non-traditional producers outside of Australia and Brazil. In particular, Chinese domestic production that does not have a freight advantage (i.e. proximity to steel mills) and other regions including Africa, Iran and Indonesia cut production of approximately 150mtpa in 2014, with further closures likely in 2015 and beyond.
Importantly for the iron ore price outlook for 2015, the March quarter will be the strongest for pricing due to weather disruptions with a couple of tropical lows having been encountered by Port Hedland in Western Australia in January so far, one of which required the closure of the port for less than 24 hours. Interestingly (and tellingly), these have not yet resulted in any material rally in the iron ore price, a sign perhaps of weakness in Chinese steel demand. However, after the end of the March quarter and as new low-cost supply is added to the seaborne market, iron ore prices will likely fade at least until the end of the September quarter. Thus, an iron ore price in the low US$50s per tonne could be a distinct possibility by that time, which is more than a 20% decline from current prices.
From a steel perspective, 2014 saw a recovery in steel maker spreads (the cost of steel less the input costs to make steel) from their 2013 lows. However, this was due to the decline in input costs outpacing the fall in steel prices. Anaemic steel consumption within China will likely continue and growing protectionism around the world will likely cap the ability of Chinese steel industry to continue to export its way out of trouble. Without further stimulus targeted at infrastructure and property development, it is difficult to see the Chinese steel sector outperforming and steel spreads could potentially collapse back towards their 2013 lows (see chart below).
The recent Chinese reduction in export rebates for Boron steel has reduced support for Chinese steel within Asia even further, offering limited hope of meaningful steel spread increases in US dollar terms. Indeed, if there is any hope for regional steel producers' spreads, it is likely to come from currency depreciation relative to the US dollar.
HRC steel spreads in US$/tonne
Source: Bloomberg, Steel Business Briefing, ABS, J.P. Morgan
The steel industry and its underlying iron ore industry are witnessing excess production and deflationary forces that are similar to the global energy markets. Industrial rationalisations are likely in the coming quarters, involving important credit events in several countries, but the situation should weaken before it improves, in our view.
The upside risk is that China, fearing the political effects of economic and financial retrenchment more than its zeal for reform, aggressively increases fiscal stimulus and thus perhaps fixed asset investment. Without this, the situation will likely remain quite challenging for the steel and iron ore markets even beyond this year.