Citi predicts iron ore below $40, which would cause big problems for Australia's federal budget

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Australia’s 2015/16 budget deficit, already forecast at $35.1 billion in May’s federal budget, could be about to get a whole lot larger if analysts at Citibank commodity research team turn out to be correct.

Analysts at the bank believe surging iron ore production from Australia and Brazil, along with cuts to steel output in China, will combine to push the spot price below $40 a tonne in the first half of 2016.

If correct, the spot price for benchmark 62% grade ore would be significantly below the $48 a tonne average level predicted in the federal budget, especially given this figure does not include cost of freight and rail which is incorporated into spot pricing.

In May the budget notes stated that “the rapid fall in the iron ore price has been the largest single contributor to write-downs to Government tax receipts over the past year.”

Economists estimate that each $1 fall in the iron ore price results in around $300 million in lost tax revenue for Australia, meaning pressure could be put on the budget’s bottom line should the price slump below the $40 a tonne level from the $56.86 level where it presently sits.

On the supply side Citi suggest that output from Gina Rinehart’s Roy Hill mine may add to oversupply already prevalent in seaborne markets.

The mine, about to enter the production phase in the months ahead, is described as the “impending whale” for seaborne supply by Citi.

“A more significant shakeout is likely in the first half of 2016 as Chinese mills reduce output while supply continues to build,” wrote Citi, according to a report from Bloomberg.

“The largest source of incremental supply is coming from Roy Hill,”.

Just as seaborne iron ore supply looks set to surge higher, Citi predicts that demand – both from China and other major steel-making nations – looks set to remain weak.

“Chinese steel mills face some of their worst conditions ever, and the vast majority are currently losing money,” the group said.

Outside of China the outlook is just as bleak according to the bank, citing a 2.6 percent year-to-date decline in global production ex-China.

The huge increase in iron ore supply against a backdrop of slowing demand has certainly taken a toll on the price of iron ore in recent years.

Year-to-date the spot price for benchmark 62% fines has fallen over 20% according to data provided by Metal Bulletin. The decline, part of an extended bear market, has seen the price for benchmark ore slump by 70.3% since hitting a record high of $191.70 a tonne in February 2011.

If Citi’s call proves to be correct that loss will extend to over 80%, and create an equally ugly scenario for Australia’s new federal treasurer Scott Morrison.

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