The iron ore price has taken a beating in recent days, plunging further into bear territory overnight and falling below $US105 a tonne.
While recent trade data coming out of China has put a focus on the demand side of iron ore ultimately it’s a supply issue that will dictate the commodity’s medium to long term pricing.
EY Global Mining Leader Michael Elliott told Business Insider the iron ore market was balancing but to reach that state of equilibrium there’s going to be some short term price volatility as more supply comes online.
BHP Billiton, Rio Tinto, Vale and Fortescue are all forging ahead with expansion and de-bottlenecking projects which will add extra tonnes, improve margins and force out higher cost producers.
“At the moment it’s a play that is sorting out the high cost producers in China which will eventually cease production because it will be unprofitable for them to continue and the large producers will take up that production,” Elliott said.
(In fact, late last week there were rumours of a default by a Chinese steel mill.)
Until the weaker producers – particularly in China but also some North American companies – are weeded out, Elliott expects iron ore will go through a period of short term volatility.
He warned debate over stockpile levels can be a “distraction” from what is fundamentally happening in the iron ore market.
“China previously held a degree of domestic production to supply its steel industry, increasingly it will become dependent on imported iron ore because it won’t be cost competitive,” Elliott said.
Looking at the iron ore price in the short term Elliott doesn’t expect a fall below the $US100 a tonne mark to be sustainable for very long.
“With increased supply the medium term price should be somewhere between the $US105 to $US115 a tonne mark,” he said.
At $US125 a tonne most of the Chinese production can continue producing but once it gets below the $US120 mark is when the pain begins.
Also weighing in on the iron ore price is the availability of finance.
“If there’s enough finance around for traders to take advantage of buying iron ore when the price dips and increase stock piles that puts some support under the price,” Elliott explained.
“But if there’s no finance there they won’t necessarily be buyers because they can’t finance it even if it is a good buying time so the price can fall further.”
It’s no surprise BHP Billiton, Rio Tinto and Vale are tipped to be the low cost producers which will make significant profits over the medium to long term.
“The margin that they would still make if prices were to drop even $US20 [below current levels] they would still make the margins but it’s the high cost producers that would start to hurt below $US100,” he said.
Fortescue is one major iron ore player which, when all-in costs are considered, would be squeezed at the $US80 mark.
Taking advantage of the higher iron ore price, Fortescue has done a significant amount of balance sheet restructuring and debt refinancing over the last year so it is making headway towards limiting exposure.
Today the company is less exposed to the cash flow effects of short term price falls compared to 18 months ago when it was considered more vulnerable.
But despite the refinancing and production expansion efforts Fortescue’s hosing on the market yesterday was significantly higher than its fellow Australian iron ore counterparts because it still carries significantly less margin as a proportion to profit.
As a result, with its higher cost base Fortescue shares could continue to be more volatile as prices fall.