A global outlook for iron ore and steel: Part Two

By Paula Wallace

Here is the second part of the report which was published in The Australian Journal of Mining newswire last week.
While the scale of the global economic slowdown is beyond what many have seen in their lifetimes and none could have predicted Citi’s chief economist Paul Brennan told conference delegates that the recovery may be protracted but that commodity prices have remained well above historical norms.

	Click to view a video extract from Alan Heap's presentation, discussing the global outlook for iron ore. Alan Heap is managing director of global commodity analysis, Citi Investment Research.
	Click to view a video extract from Paul Brennan's presentation. He provides a global economic context for Australian iron ore producers. Paul Brennan is Chief Economist for Citi.

 
“Progress is being made across a range of fronts even though it may not be on the front page of the papers.
“The other side of commodity prices though is that there’s a reasonably close association between commodity prices and currencies,” said Brennan.
Citi’s medium-term forecast for the Australian Dollar is 80 cents.
“We’re a believer that commodity prices ultimately will be well supported relative to their historical norms and that will in turn be associated with higher levels of the Australian Dollar.”
He described a process of correction of the terms of trade, which we are currently seeing and which could continue for the next 12-18 months. A consequence of this process will be lowering levels of investment.
“…but if you compare that with the early 80s when we had a huge mining investment boom, but there was no signal from the terms of trade that profitability was about to increase,” said Brennan, “What this tells me is that the investment response in this boom has been much more rational.”
He said that as investment is pulled back it will also help to “work off the oversupply.”
“…and given our positive view medium term about underlying demand for commodities, it sets the scene for a relatively positive outlook medium term for the mining industry.”
For the Australian economy though, what it means is this pull back from mining investment is going to have significant implications over the next couple of years due to the amount of work currently in the pipeline.
“…as that pipeline grinds to a halt then the question is…how do we fill that lack of growth in the economy and that’s going to be the difficult question,” said Brennan.
“We’ve seen a range of terribly bad news over the last six months but just as the financial sector led us into this mess it looks like there are some positive signs that the financial sector is about to…bottom out and look forward to a recovery towards the end of this year,” Brennan said.
Alan Heap, MD of global commodity analysis for Citi described the uncertainties around the global economic outlook as “enormous”, and similarly its flow through effects on steel demand, steel production and iron ore demand.
“The outlook for Chinese iron ore production is key,” said Heap, “China still provides about half of its iron ore from domestic sources, that production is high cost.”
With the collapse iron ore spot prices there has been a marked drop off of iron ore production in china.
On the Chinese demand side, Citi looks at fixed asset investment by sector, which shows that real estate and manufacturing each count for around 25 and 30 per cent of fixed asset investment respectively.
“So the point here is that infrastructure is important but it’s not the sole driver of fixed asset investment and indeed steel demand in China,” said Heap.
“I tend to believe that the supercycle simply has a puncture but where I think we got the supercycle thesis somewhat wrong was to overstate the importance of infrastructure and genuine Chinese domestic demand as a driver.”
Heap said that a synchronised global economic recovery is required to get the supercycle back on its wheels and rolling again and China cannot achieve this alone despite the fact that there is still a huge amount of infrastructure development taking place there.
“We never argued that china was decoupled from the world…it would be impossible to argue such with exports accounting for more than 20 per cent of GDP and sensitivity analysis which points to a 1 per cent fall in US GDP driving a 1.3 per cent change in Chinese GDP.
“The bit that we failed to really measure properly in its importance is steel that’s used in the production line of factories or machine tools for the production of goods, not metals intensive goods but still metals are used in the manufacture of those products…destined for export.”
Citi’s forecast for global steel production is down 8 per cent his year with a modest rebound in 2010.
Iron ore demand is moving in a similar vein with seabourne demand predicted to drop 7.5 per cent, with Chinese demand stronger than other major markets.
Citi is suggesting that operating margins for iron ore producers this year may come back from 70 per cent to around 50 per cent, costs will fall by around 25 per cent and prices will fall by 50 per cent – that is, by 30 per cent in the current round of contract negotiations and by 20 per cent thereafter.
However, Heap foreshadowed what could be the end of contract benchmark pricing for iron ore which has traditionally been negotiated between steel producers and iron ore miners annually.
“Here’s how we see a way to come at this issue in trying to formulate a view on prices in this highly uncertain world,” said Heap, pointing to a lack of confidence in demand forecasts.
“Starting with that assertion that the iron ore market is going to move towards substantial potential oversupply, prices I could argue would be set in the mix in between production costs and margin compression.”
Heap asserted that cost reductions will come primarily from falling input costs, from energy, labour etc, but it will take “a while” for these reductions to be realised.
“Production curtailment is the other source of cost reduction,” said Heap, “…by our count we’ve seen about 260 million tonnes of curtailments implemented and announced for this year and another 320 million tonnes for next year.”
He added that this a “very much a moving target” and that such announcements were ongoing.
“The other part of this jigsaw puzzle is margins,” said Heap. What Citi sees when it looks at the degree of margin compression in a trough, is that it tends to be consistent for any one commodity.
“In the case of iron ore, iron ore trough margins are some of the best in the commodities businesses, 50 per cent. That’s why the iron ore business has been such a great business to be in,” said Heap.
He believes this is partly to do with the shape of the cost curve for iron ore which is steep; there have traditionally been high barriers to entry and “some issues to do with contract price formation.”
Heap said the structural work conducted by Citi, across a wide range of commodities, has identified a handful of characteristics that high performing commodities and businesses all share. These include; high barriers to entry; consolidated ownership; negotiated markets; and steep cost curves.
“There seems to be something in that process which results in superior returns for the producers.”
Apart from issues around pricing, Heap also sees a challenge for the iron ore industry in terms of divergence of corporate strategies, the issue of volume versus price. There has been a divergence in export trends between Brazil, where Vale has curtailed exports in response to deteriorating markets, whereas Australian exports have continued to grow.
“The question here is what sort of price is going to be required to drive high cost production, particularly the Indian and high cost Chinese production and that I think will be a critical issue facing this industry,” said Heap.


AJM print edition – out in MAY 09
The next print edition of The Australian Journal of Mining will include an in-depth feature on the iron ore industry, including reports from the AJM’s Global Iron Ore & Steel Forecast conference. If you would like to contribute to this feature contact the editor at: paula.wallace@informa.com.au. If you would like to promote your organisation within this feature contact the advertising manager at: andrew.jones@informa.com.au

To read the first part of this report click here.