The big iron ore miners are back to a risky strategy

Photo: China Photos / Getty Images

Last week the benchmark spot iron ore price fell to the lowest level on record, taking prices back to levels seen nearly a decade ago.

From the start of this year, prices have tumbled more than 45% according to Metal Bulletin, creating trouble for not only Australia’s government revenues but also high cost, lower grade iron ore miners.

According to Sam Walsh, CEO of the world’s second largest miner Rio Tinto, the collapse has pushed weaker producers to the brink of survival.

Speaking on Bloomberg TV, Walsh stated that “there are a lot of producers that we believed would leave the market that are hanging on by their fingernails,” adding “they are burning up cash reserves of their shareholders.”

“I suspect that right now, even at a price of $39 a tonne, there are people that are suffering pretty loudly,” Walsh told Bloomberg. “Sooner or later the adjustment will take place.”

The adjustment Walsh refers to is the exit of high cost producers from the market, something that Rio and other low cost producers such as BHP Billiton, Vale, Fortescue Metals and new entrant Roy Hill, majority owned by Gina Rinehart, hope will bring the iron ore market back into equilibrium, helping to support prices in the years ahead.

The strategy, continuing to expand supply in an attempt to weaken their rivals, is not without its risks, and has drawn plenty of ire from other producers in the market.

Speaking last month, Lourenco Goncalves, CEO of Cliffs Natural Resources, the biggest producer of iron ore in the US, told Bloomberg that Rio and BHP were in an “imaginary world” with their strategy hurting themselves just as much as their competitors.

Earlier this year Fortescue Metals chairman Andrew “Twiggy” Forrest suggested that Australians should “write, email or ring your local Parliamentary Member” to protest against the strategy of Rio and BHP Billiton.

At the heart of Forrest’s argument was that Australians own the nation’s resources and that when miners sign up for the right to mine iron ore – and other resources – they agree to do so in the best interests of Australia.

His argument was that the strategy of continuing to ramp up supply amid weakening demand was detrimental to the iron ore price, harming Australia’s economic prosperity.

While true, as seen in the larger-than-expected budget deficit forecast announced by Australia’s government yesterday, lower prices also hurt the profitability of Fortescue and, as a consequence, the value of Forrest’s stake in the company.

It also didn’t help that Fortescue, like their larger rivals, were also ramping up production of iron ore at the time Forrest made the remark.

While Rio Tinto may be playing the “long game”, willing to sacrifice short-term profitability in order to become a more dominant force in the future, the strategy is certainly hurting Rio’s share price at present.

Rio Tinto Daily Chart Source:

From this year’s high of $65.73 struck on March 2, shares in the company have fallen by 36.5%. On a longer timeframe, from a peak of over $124 in May 2008, Rio’s Australian listed shares have slumped 66.4%.

The other key risk of the strategy, aside from eliminating weaker competition, is the premise that demand for ore – particularly from China – will remain firm in the years ahead.

Pushing out competition may eventually remove supply, but it will do little to support prices should demand drop at an equal or faster rate.

According to data released by the National Bureau of Statistics (NBS) earlier this month, Chinese steel production is already on the the decline, something many suggested wouldn’t occur for many years ahead.

The NBS reported that crude steel production fell to 675.1 million tonnes between January to October this year, down 2.2% on the same period a year earlier.

The decline in production came at the same time the China Iron and Steel Association (CISA) reported that losses at large and medium-sized Chinese steelmakers ballooned to 72 billion yuan ($11.34 billion) in the 10 months to October, a result of slowing demand for steel within China and crippling overcapacity in the sector.

Earlier this month the China Metallurgical Industry Planning Institute warned that Chinese steel production would likely outstrip demand again next year, forecasting that production would fall to 781 million tonnes, outpaced by a drop in demand to 648 million tonnes.

Clearly there is a growing risk that Chinese steel output, as a drop of a drop in domestic usage, may further diminish. This, in turn, may limit demand for iron ore – a key steelmaking ingredient.

While Rio is the lowest cost iron ore producer, providing the company with a natural advantage over their rivals, their efforts to reduce supply may come to little should demand fall at an even greater pace.

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